How to React to Stock Market Volatility

Stock market volatility continues to rear it’s ugly head. The Dow Jones Industrial Average  topped the 15,000 mark for the first time in history last month. This news was met with articles praising the recovery of the economy, articles deriding those who were enjoying the moment and predicted doom for the stock market, and articles that fell in between both ends of the spectrum.  Since that market peak was reached, the market has painfully declined.

How should you react to the highs and lows of the stock market? Is it time to pour more money into your investments or move a chunk of your portfolio to cash?

The answer, fortunately and unfortunately, is none of the above.

How to Handle Market News

There are two ways you can react to the ups and downs of the stock market.

Wrong: Emotional Reaction

The financial media want you to click, watch, and listen. They want your eyes on their content in any form they can get it so they can sell advertising. It is a simple model, and it works.

They draw you in with over the top headlines and dramatic shows urging you to buy, buy, buy and sell, sell, sell. (Jim Cramer, anyone?)

If you’d like to personally consult with me on how best to grow your assets during this volatile time, let me know.  I have a limited number of slots available so you can connect with me. each week.

When “big news” happens in the market they want to get you reading, listening, and watching. That means every small piece of news is hyped up as much as possible to make it seem like real news. Real, historic news — like the Dow Jones Industrial Average closing above 15,000 for the first time, ever — gets even more hype, coverage, and headlines.

The same is true with negative news like the housing bust and financial fallout from that. The stock market plunged and many eyes were glued to CNBC watching their retirement funds disappear.

We would all be better off if we just turned it all off , ignored the news and stopped trying to predict the future.  But completely sticking our heads in the sand isn’t the true answer either.

Right: A Planned Reaction

The best reaction you can have is not to run around with your hair on fire, but instead to calmly look at the current situation and compare it to your investment plan.

Your thought process should look like this: “The Dow hit 15k. Should I sell off some of my stock holdings? Well, let me look at my investment plan. What does it say I should do?”

It sounds complicated. How can your investment plan take every scenario into consideration?

That’s the beautiful thing about a well-crafted investment plan. You speak in general terms about how to react to ups and downs, what your target asset allocations are, and so forth.

In other words you don’t need a specific section for Dow 15,000 or Dow 16,000 or Dow 1,000. Instead you know what to do when you start getting that itch to do something, anything with your investments.

Maybe you force yourself to sit tight, maybe you allow yourself to swing your asset allocation by 5% in one direction, or maybe you simply rebalance your asset allocation any time you are feeling nervous about the market.

Having a solid investing plan will keep you from making mistakes that can cost you dearly in the long run.

The Risks of Handling Market News Poorly

It seems natural to want to do something when the market is going crazy whether good or bad. Your emotions are telling you to put more money into the market, or take it all out, or to jump on that hot investment sector.

Doing nothing seems ignorant. Your emotions are screaming at you: Everyone else is running around with their hair on fire! Do something!

What we miss is that inaction is an action. It is a choice to not react to news. Often it is the most difficult choice of all.

Allowing your emotions to rule your investing can have serious consequences. Let’s look at an example.

Financial Crisis, Housing Bust, and the Great Recession: A Buying Opportunity?

On September 19, 2008 the S&P 500 closed at 1,255.07. In less than 6 months it would bottom out at 683.38. That’s a loss of 45.5% of the entire S&P 500.

Imagine having a $250,000 stock portfolio in September 2008, turning around, and it is worth $136,250 less than six months later. Painful.

The average investor panicked to say the least. Despite their advisors begging them not to — for their customer’s sake — investors pulled tons of money out of the stock market right at the bottom. The 45.5% paper loss in their stock investments became an actual loss.

Some moved to cash, some moved to bond investments, but it didn’t matter. In less than two years the S&P 500 returned back to 1,255 and continuedhigher. On December 31, 2010 the S&P 500 closed at 1,257.64, a staggering 84% gain from the bottom in March 2009. If the paper losses had stayed on paper, they would have been wiped out and actually turned into gains in the years to come. Simply staying put was a good option.

An even better option would have been to reallocate some of your bond investments into stock investments toward the bottom of the market. For example, an investor with a $250,000 portfolio that was 75% stocks and 25% bonds in September 2008 would have a significantly different portfolio in March 2009:

• September 2008
  • Stock holdings: $187,500
  • Bond holdings: $62,500
  • Total: $250,000
• March 2009
  • Stock holdings (-45.5%): $102,187.50
  • Bond holdings (+0.20%): $62,625
  • Total: $164,812.50

The bond holdings are now 38% of the portfolio when the target allocation is 25%. A smart investor would have trimmed the bond holdings back to 25% by selling about $21,000 of the bond investments and reallocating the cash to stock investments. If this was done during the bottom of the market — it doesn’t have to be perfectly timed to the absolute lowest point of the market; market timing is impossible — the investor would have seen even greater gains on the stock portfolio of the side in the coming years.

The bottom line: reacting emotionally is never a good thing when we’re talking about investments. Put together an investment plan of your own and be ready for a wild ride. There is no telling where the stock market will head next. The only you can know is how you’ll react.