The recent Brexit vote and many other factors have combined to create an environment ripe for market volatility. Follow these tips to steady your financial ship when the market is anything but stable.
The recent Brexit vote and many other factors have combined to create an environment ripe for market volatility. This is a concept that frightens many investors—particularly those who may be a little closer to retirement. The old adage is that younger investors with a long window before they’ll need to spend their investments can ride out market volatility, while the near-retiree who may soon be cashing in stocks and bonds to live off of can’t necessarily do that.
There’s truth to the old adage, of course, but as with all things financial, it’s a little more complicated than that. Let’s take a fresh look at types of risk and how they play into strategies you can use during market fluctuation.
Is market volatility bad for investors?
In a word, no. Volatility means significant upswings along with some potential downswings, and it can also mean increases in interest rates for some bonds and other investment vehicles, because of the inverse nature of risk and reward. Every retirement investor—in fact, every investor—faces risk.
Even the most conservative investing approach ever taken includes risk, because that approach may yield so little return that the original investment doesn’t keep up with inflation. That’s called inflationary risk, and it’s a very real thing that can damage portfolios.
Investment risk is the type of risk most often associated with market volatility. It’s the risk that your investment will decline in value. Generally, the higher investment risk you are willing to take on, the greater the opportunity for both increasing and decreasing the value of your portfolio.
Are there ways to mitigate investment risk?
Yes. One of the most important and commonly used is diversification. We’ve covered this topic in depth here, but let’s sum up: Diversification can be defined as managing risk by using a wide variety of investments within a portfolio, thereby minimizing the risk of a shortfall in any given investment on your overall investment portfolio. There are many types of diversification—including by investment vehicle, by industry, by geographic location, and more—and being truly diversified means incorporating one or more of those types. Diversification allows you to be more aggressive with some investments, knowing that if the market takes a tumble, your portfolio won’t completely crumble along with it.
Beyond diversification, you’ll want to consider asset allocation during volatile times. When you first start investing or saving for retirement, you select a mix of investments to diversify your portfolio, with some diversity of stocks, bonds, short- and long-term investments, index funds, and perhaps some international equities. But investments change all the time, particularly during a period of market volatility. As some asset classes grow and others sink, the weighting of each asset class in your portfolio will change. Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original state.
Rebalancing sounds simple, but it can actually be confusing for all but the savviest of investors. Financial statements, even when they come in the handy form of “easy to read” pie charts, can be confusing, and they may tell you your current mix of assets but not how that compares to the mix you want. Transaction costs and tax considerations will be part of the mix as well. If you have a trusted advisor, talk to him or her about whether or not you need to rebalance, how often you might need to do so, and exactly how to go about doing so.