Your Ticket to Surviving the Market’s Roller-Coaster Ride
The stock market’s recent volatility has been extreme enough to rattle even the most seasoned investor. As I’ve said before during periods of market fluctuation, the most prudent investment approach is to focus on what you can control. In any investment environment, maintaining discipline in your asset allocation and diversification improves your chances of long-term success.
Staying the course is easier said than done, however. In fact, the Investment Company Institute (ICI) reported that $12.3 billion and $10.9 billion flowed out of stock funds during the downturns in August and November 2007, respectively. And, illustrating just how quickly the investing public’s mindset can change, November’s $10.9 billion outflow was preceded by an inflow of $11.31 billion in October. (You can read the full report, “Trends in Mutual Fund Investing,” at the ICI website.)
Of course, knee-jerk reactions to market swings rarely pay off, and although recent financial headlines fixate on the S&P 500’s rocky start to the year, it’s important to look at some historical data. For example, when the large-cap index dropped 6.3% over the first eight trading days of 1982, it rebounded strongly to post a 21.6% gain by year-end. Investors who jumped out of the market in January 1982 were less than pleased with their decision in December. On the flip side, investors who chase hot stocks and sectors in a bull market inevitably overpay. For example, at the peak of the market in 2000, the price-to-earnings ratio of the S&P 500 Index was over 30.0, compared to 13.2 as of January 29, 2008, according to Standard & Poor’s. The inflated prices just added to the pain when technology stocks tanked beginning in 2000.
An investment policy statement (IPS) can help you avoid the inclination to flee from the market during a downturn or to buy at market peaks. Your IPS is a written document that articulates your overall investment goals and how you will reach them. It addresses your investment time horizon, risk tolerance, and specific diversification standards for investment, whether your goal is to remain 70% invested in equities, to limit emerging markets exposure, or to stay away from junk bonds.
The wisdom of implementing an IPS is bolstered by numerous studies that show people who take the time to write their goals down fare better than those who don’t. If you want proof, just think about what happened the last time you went to the grocery store without a list. You probably forgot the one item you really needed and ended up with several items you didn’t need. In the investment realm, written goals and a plan to achieve them can keep you motivated to save and will help you measure your progress. Most importantly, an IPS keeps you focused on the big, long-term picture and reduces the likelihood that your emotions will drive your investment decisions.
New research from Terrance Odean, banking and finance professor at the University of California, Berkeley, underscores that individual investors, swayed by their emotions and not governed by investment policy, often trade at the wrong time to their detriment. Odean’s working paper, “Just How Much Do Individual Investors Lose by Trading?,” (co-authored with Brad Barber of the University of California, Davis and Yi-Tsung Lee and Yu-Jane Liu, both of the National Chegchi University in Taipei), is based on the most comprehensive sample of trading behavior ever studied: all trades by all investors on the Taiwan Stock Exchange from 1995 to 1999.
According to Odean’s research, individual investors earn 3.8 percentage points less per year than the overall market. At the same time, institutions that adhere more strictly to an investment discipline and may be less tempted to bail in a downturn or to overextend themselves in a rising market enjoy a return of 1.5 percentage points higher than the overall market.
To make the most of your IPS, put your investment decisions on auto-pilot as much as possible. That is, make automatic deposits to your investment accounts and review your portfolio not after a market drop or surge, but on the same date every quarter or every year—perhaps the day you bought your home or your birthday or anniversary. Resist the urge to shuffle investments around more often than that since buy-and-hold investors tend to be the most successful over the long run. You should only consider making changes to your portfolio when your personal circumstances and needs dictate, not as a reaction to market movements.
Looking ahead to the rest of 2008, investors can probably expect to be euphoric one month and panicked the next, with plenty of indecision in between. However, especially in an uncertain market, an IPS provides the framework for the rational analysis that is so important in decision making. By minimizing the impact of emotional swings motivated by fear or greed, an IPS keeps you focused on what’s important—your financial goals, not market gyrations.