As we have seen in the last few weeks, the stock market can experience short-term volatility. After several weeks of downturn, the Dow Jones Industrial Average soared to consecutive triple-digit gains, the largest daily advances of the year.
According to The Wall Street Journal (2/10/2014), portfolio managers were confident that long-term growth would override any short-term concerns, and were encouraged that the temporary pull-back could motivate the Federal Reserve Bank to keep interest rates low for a longer period of time.
The WSJ also noted that most of the recent sellers have been short-term traders using program selling to lock in the gains from December’s strong performance. For long-term investors, it rarely makes sense to sell during market downturns.
Although it seems like the market performance has been a straight rise since March of 2009, you may be surprised to know that we had a 16% drop in the spring of 2010, two 20% plunges in the summer of 2011, and a 10% fall in the spring of 2012. After every one of these pull-backs the market returned to new highs.
Because we have short memories, each downturn comes as an unexpected shock to most investors. The people who lose money in the long term are those who panic and sell when the market turns down.
Investment risk comes in many forms, and each can affect how you pursue your financial goals. The key to dealing with investment risk is learning how to manage it. This three-step process will show you how.
Step One: Understand Risk
Fear of losing money is one reason people may choose conservative investments. Investment risk refers to the general risk of loss, and can be broken down into more specific classifications. Familiarizing yourself with the different kinds of risk is the first step in learning how to manage it within your portfolio.
Risk comes in many forms, including:
• Market risk: Also known as systematic risk, market risk is the likelihood that the value of a security will move in tandem with its overall market. For example, if the stock market is experiencing a decline, the stock mutual funds in your portfolio may decline as well. Or if bond prices are rising, the value of your bonds may also go up.
• Interest rate risk: Most often associated with fixed-income investments, this is the risk that the price of a bond or the price of a bond fund will fall with rising interest rates.
• Inflation risk: This is the risk that the value of your portfolio will be eroded by a decline in the purchasing power of your savings, as a result of inflation.
• Credit risk: This type of risk comes into play with bonds and bond funds. It refers to a bond issuer’s ability to repay its debt as promised when the bond matures.
Step Two: Diversify¹
The process of diversification, spreading your money among several different investments and investment classes, is used specifically to help minimize market risk in a portfolio. Because the goal is to invest in many different securities, mutual funds or exchange-traded funds are good vehicles to implement diversification.
Diversified portfolios are designed to take advantage of good markets and bad markets. “Growth” components use the positive momentum of the market to capture gains. The “value” component of the portfolio looks for bargains and welcomes opportunities when the market is down, like shopping at Macy’s when a sale is going on.
Dealing With the Risks of Investing: In a diversified portfolio, asset classes complement each other (i.e. when one goes down, the other tends to go up, and vice versa), further reducing risk. For example, when stocks are particularly hard hit due to changing conditions, bonds may increase in value. That may be because bond total returns can be tied more to income (which can cushion a portfolio) than price changes.
Step Three: Match Investments to Goals
Before you can decide what types of investments are appropriate from a risk perspective, you need to evaluate your savings goals. Is your goal preservation of principal, generating income for current expenses, or building the value of your principal over and above inflation? How you answer this will enable you and your Certified Financial Planner™ to build a customized portfolio for the long-term.
By the end of this year, few of us will recall what happened in January. Similar to relationships and vacations, we tend to remember all the good parts.
¹ Diversification does not ensure a profit or protect against a loss.
The opinions expressed above are solely those of Kondo Wealth Advisors, LLC (626-449-7783, [email protected]), a Registered Investment Advisor in the state of California. Neither Kondo Wealth Advisors, LLC nor its representatives provide legal, tax or accounting advice.