We interrupt our series on waiting to take Social Security so that we may bring you a special report on what you should (and shouldn’t) do in light of the recent volatility in the investment world.
The natural inclination is, of course, to PANIC! and toss aside years of saving, investing, and planning, liquidating whatever investments you have that are exposed to the volatility.
But a more measured approach may serve you better in both the short and long runs.
The damage may not be that bad
When you hear about the Dow Jones Industrial Average dropping hundreds of points in a day, you may think that whatever wealth you’ve accumulated has been wiped out.
But with the Dow around 16,000 or so, a 500 point drop might represent a 3% decline in the index. Certainly enough to raise concern, but not nearly to the point of obliteration.
Even a fall in the Dow below the 16,000 mark still brings the index back to where it was about ten months ago. If you didn’t freak out then, good for you, but revisiting that number doesn’t necessarily mean you should freak out now.
Besides, the Dow Jones Industrial Average is comprised of the stock prices of thirty very large companies, and the index’s direction doesn’t always mean that all other stocks and mutual funds are rising and falling to the same degree.
Last but not least, if you’ve maintained a suitable level diversification with bonds, bond funds, money markets, CDs, etc., the decline in the stock portion of your allocation shouldn’t be enough to decimate your overall net worth.
Re-evaluate your allocation
The decline of the past few weeks may even be beneficial if it compels you to take another look at where (and how) your money is invested.
If you won’t be needing the money for several years (at least ten or more), you can probably remain in a fairly-aggressive stance, with a greater portion of your investments allocated towards stock-based mutual funds.
This guidance is especially applicable if you are still setting aside a chunk of your money in these investments. For example, when you’re putting money aside in your at-work retirement plan that won’t be tapped for at least a decade.
But for those who are several years closer to needing the money than they were during the last “correction”, now might be a good time to ease up on the “growth” portion of your allocation, and move more money towards the “income” and “safety” categories.
Know potential risk vs. reward
Even those who are still fully bullish should be aware of the “tortoise and the hare” exercise in potential gains (and losses).
Say you have two hypothetical investment options. Portfolio A will give you a guaranteed return of 3% each year for five years.
Portfolio B will provide a 10% annual return in four out of the five years, but in one of the years it will decline 20%.
Since Portfolio A will only provide a 3% annualized return after the five years, many savvy investors would gladly choose Portfolio B, agreeing to suffer the 20% one-year decline in return for the four years of 10% gains.
But after those five years, Portfolio B’s ups and down will still only net you a 3.2% annualized rate of return.
And your annualized return from Portfolio B will be even lower if you bail out after the 20% decline occurs, and don’t wait around for the better times that may eventually come.
So the best steps to take are to take a deep breath, look at both your situation and the big picture. Then decide if you really need a higher rate of return, and are willing to endure the declines that are certain to come sooner or later.
And if that strategy doesn’t work for you, then as a last resort you can always choose to panic.