Investors were dealt a heavy dose of volatility in 2018, as markets delivered two all-time highs and two corrections of 10 percent or more. It was the best of times and it was the worst.
As the investing public debates whether corporate earnings growth has peaked, or if the worst of the sell -off is behind us, we can expect market volatility to remain.
The lack of volatility in recent years caused many to forget that volatility is a normal part of investing. Negative volatility and the negative news cycle that comes with it is difficult to ignore, leading many to react to the events of the day, which can often produce suboptimal results.
[See: 10 of the Best Stocks to Buy for 2019.]
For example, the stock market volatility and decline in December 2018 were similar to 2008-09 and 1992 before that. Record outflows from equities for the month were followed by an 8 percent return by the S&P 500 index in January — the best-performing January in 32 years. Remember that not all volatility leads to a bear market; however, a bear market’s average length is typically about 14 months, which is a relatively short span compared to the average bull market.
Here are two key strategies to help investors keep perspective, as well as grow and protect their wealth in volatile times.
Dollar-cost averaging. Investing regularly over months, years and decades lessens the impact of short-term downturns on investment performance. Instead of trying to determine when to buy and sell based on market conditions, taking a disciplined approach of making investments at predetermined points in time (be it weekly, monthly, or quarterly), will reduce emotion and the risk of market timing.
Additionally, this strategy often forces you to save and invest more, as it is easier to squirrel away small sums of money than larger chunks.
If you keep investing through downturns, it will not guarantee gains or ensure that you will never experience a loss; but when prices fall, you may benefit in the long run. Because your dollar amount remains constant, you will be purchasing more shares when prices drop and fewer shares when prices rise. Effectively, you will buy more at bargain prices and less at what might be considered high prices.
Automating this process through automatic payroll deductions to investment accounts, or establishing recurring transfers from your checking account to your investment accounts, will create discipline and reduce the emotional bias against investing at the “wrong” time.
The bucket approach. Stretches of relatively high, predictable returns with no market volatility lull investors into a false sense of security. It is in these times that investors tend to make mistakes by taking on too much risk.
This was especially true going into 2018, as record-low volatility and interest rates forced those seeking income and growth to take on additional risk.
Creating separate pools or “buckets” that are invested to support a time frame and purpose may help to not only reduce emotional decisions, but also avoid permanent investment losses caused by reactionary decision making.
[See: 10 Ways to Maximize Your Retirement Investments.]
Investors should segment their portfolio into buckets that are based upon investment horizon and purpose. These buckets could be called the “now,” “soon” and “later” or the “irreplaceable capital” and “aspirational” buckets.
The “now” bucket is designed to cover living and emergency expenses, such as a major house repair or unanticipated medical costs over a one- to two-year period. This bucket should be invested in highly liquid investments, such as money market and high-quality, ultra-short-term bond funds. The “now” bucket will yield minimal return and likely not keep pace with inflation.
The “soon” bucket covers the next three to 10 years of expenses. Assets in this bucket should be invested for conservative to moderate growth, giving you higher returns than the “now” bucket without exposing an investor to extreme movements in the market. This bucket should hold income-producing investments such as intermediate-term bonds and high-quality, dividend-paying equities. Depending upon risk tolerance and income needs, this bucket’s allocation to equities should be between 40 and 60 percent.
The “later” bucket covers expenses that would occur at least 10 years from now. This bucket is designed for long-term growth and is heavily skewed toward equities. Having the first two buckets in place gives investors the confidence to invest this bucket in higher-growth opportunities.
The bucket strategy can insulate an investor’s portfolio from sequence and longevity risk. Sequence risk refers to the chance of earning lower or negative returns early when withdrawing money to support lifestyle needs. The latter means outliving one’s savings.
By limiting spending to the annual amount you set aside for each bucket, an investor should be accountable for living within that budget. Without a defined plan in place for withdrawing assets, an investor could liquidate holdings at the wrong moment in the market cycle. With a bucket strategy, however, an investor is pulling their liquidity needs from the low-risk bucket. Therefore, they can stay invested in equities long term and avoid the temptation of reacting to short-term price fluctuations in those holdings.
Similar to rebalancing your portfolio to a target allocation, replenishing the buckets is essential for this strategy to work. An investor should not expect more return from each bucket than what it was designed to do.
In periods of high market returns, there should be no regret that assets have been invested more aggressively in the safety buckets. The goal of the bucket approach is to help manage emotional decision making by providing predictability and peace of mind. Since investors can see which bucket is supporting each segment of their life, it provides greater clarity about their overall investment strategy.
[See: 7 Reasons to Buy Alphabet Inc (GOOGL) Stock Now.]
It’s important to remember that the stock market has its seasons, which include a few storms. Investors can brace for rocky weather by staying the course with a disciplined, predetermined investment approach, as well as segmenting their portfolio into buckets based upon investment horizon and purpose.
The key is to keep perspective and avoid being spooked by market gyrations.
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How Investors Can Weather Volatility originally appeared on usnews.com
