The stock market is an emotional roller coaster that has more drama than a daytime soap opera. When stocks are rising, investors feel too clever for their own good and enter a state of euphoria. When stocks decline, they often hold on in disbelief until they sell at the worst possible moment — the bottom. Either way, investors should have a game plan in place ahead of time to keep emotions muted.
Mr. Market has pulled investors in both directions over the past few months. After all three major U.S. indices defied expectations and posted record returns last year, stocks took a tumble early in 2014. In January, stocks posted their first monthly loss since August 2013. The Dow Jones Industrial Average dropped 5.3 percent, representing the worst January for the blue chips since 2009, and the second worst since 1990. Meanwhile, the S&P 500 fell 3.6 percent and logged a three-week losing streak — its worst run since 2012.
The selling pressure continued as February’s first trading day sent the Dow and S&P 500 sharply lower for their steepest decline since June. In fact, it was the Dow’s first break below its 200-day moving average since December 2012, and the S&P 500’s second worst start to February since 1928. Equity funds logged a record-high outflow of about $28 billion for the week ended February 5, 2014.
Having a sell discipline in place before this kind of volatility strikes is vital to keeping emotions in check and making sure you are making changes to your portfolio for the right reasons. Some investors remove emotion from their investing decisions by committing to invest a set dollar amount on a regular schedule, known as dollar-cost averaging. This results in more shares being bought when prices decline, and less when prices rise. Other investors may use asset allocation methods, buy and hold strategies, or even receive help from an advisor.
When receiving help from an advisor, it’s important to make sure they know your risk tolerance levels. “Advisors should have clients take a risk tolerance test to understand how much money a client wants safe and secure,” explains Drew Horter, founder and chief investment strategist of Horter Investment Management, LLC, in a phone interview. The next question is how much they want in low risk/low volatility types of assets in the portfolio. If you want more risk and more volatility, what percentage of assets do you want to allocate to that?”
The stock rally from the lows of early 2009 is attracting attention, but investors shouldn’t allow greed to corrupt their investing game plan. “We’re fairly long in the tooth in this recovery, which has been accentuated by quantitative easing,” adds Horter. “People are looking at their conservative portfolios wondering why they didn’t have more money in the equity markets. Advisors have to remind clients about the risk tolerance tests they took. What happens like it did in 2007 where the market reached its high, but by the beginning of March 2009, the S&P 500 lost over 50 percent from top to bottom? That means you have to earn 100 percent to get back to even. Do you want more risk and more volatility to participate in the equity markets, or are you really wanting to be more like the tortoise, and have minimal volatility and exposure to significant downturn.”
A common theme in recent years involves a rush to large dividend-paying names in the market. Some investors see this as a way to receive equity exposure while receiving a stable income stream. However, investors still need to be careful as many of these companies now have much higher valuations and are still exposed to market swings.
“The higher dividend-paying stocks are obviously something that can cushion market volatility in the marketplace. But what still happens, even if you have a large-cap stock paying a 3 percent dividend, and the market goes down 40 percent, that drop in the stock is equivalent to 13 years of a 3 percent dividend,” explains Horter. “So some investors are a bit disillusioned that a 3 percent dividend or so is the best thing to have, you still have to understand that a 40 percent drop in the S&P 500 is probably going to cause your high-dividend stocks to fall by about the same amount. It’s great to have a dividend, but when you suffer capital losses, especially when you’re older, you need to be very cautious.”
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