How to react to market volatility
The key to managing your portfolio is often managing your emotions first.
Keeping your investing cool is a lot to ask when markets are in turmoil. As they swing from bullish to bearish and back again, it's hard not to feel a bit seasick. Investment decisions triggered by fear or greed can end up pushing you into the wrong decisions, often with disastrous results.
These times are especially challenging for those in retirement and those who depend on their portfolios for sustaining their lifestyle. A sustained downtrend in the market makes you vulnerable to the double whammy of having to withdraw funds to support your living expenses in a down-market.
Turns out, our brains are wired for fear and greed. According to world-renowned neuroimager Dr. Ravi Menon of The University of Western Ontario, brain-imaging studies show a battle between two competing areas: the ventral medial prefrontal cortex, which processes the lure of a big gain, and the dorsal medial prefrontal cortex, which processes the fear of risk. This battle of the brain is classic greed versus fear. Your emotions can easily get the best of you in these scenarios.
What's more, it happens to even the most seasoned of investors. Almost one-quarter of Canadian online investors surveyed in a recent TD Waterhouse poll said they bought a hot pick without doing sound research beforehand, 10 per cent said they bought when the market was at its peak and nine per cent said they reacted too quickly when the market dipped.
Time and time again I find one of the greatest challenges for investors is being able to build a portfolio that is aligned with their risk tolerance and time horizon. That's because investors are generally twice as sensitive to losses as they are to gains in their investment portfolios. In other words, the pain of losing something is twice as great as the pleasure of acquiring something of equal value. As well, investors tend to respond and act upon short term gains and losses, despite their actual time horizon.
Often, an investor saving for retirement in 30 years might evaluate their portfolio every three months when they receive a statement. At that time, they assess the performance of the portfolio and rethink their options. The evaluation is a three-month period so they behave as if the planning horizon (originally 30 years) is now only three months long.
My solution to market volatility: quality investments + diversified portfolio + patience.
If you have invested in quality investments, companies and funds in which you are comfortable, the chances are you will be less inclined to panic.
We've seen plenty of examples of market volatility — the crash of 1987, the Asian crisis, the dotcom bust and the economic and financial market downturn of 2008. But despite all these challenges, over the past 25 years to Sept. 30, 2011, the S&P TSX Composite Index has earned an average annual return of 8.23 per cent. And despite all the structural challenges faced by the American economy and a weak U.S. dollar, even the S&P 500 Index has earned an average annual return of 7.77 per cent measured in Canadian dollars.
If market volatility has you on an emotional rollercoaster, you are likely taking on too much risk. Working with an experienced financial advisor can help you better manage your emotions. If you are a self-directed investor, you can also do this by setting strict trading rules for your portfolio. Through their brokerages do-it-yourself investors can have access to tools online such as screening for stocks that meet their criteria as well as technical analyses to fine tune entry or exit points and manage the volatility in their portfolio.
A good starting point for many investors, and one that can satisfy the "sleep at night" factor is to begin with a balanced portfolio of 50 per cent equities and 50% fixed income. Based on your objectives, you can then tilt your portfolio towards growth or income by increasing allocation to either equities or fixed income, respectively.
When the markets get choppy, keep your eyes on the horizon. And when the headlines have you feeling queasy, remember that stepping back and managing your emotions can make you a better investor.
MSN.ca Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.
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