Investing in a Volatile Market
Here are some things you should keep in mind when investing in the stock market; the market will fluctuate, there will be years with negative returns, the stock market is for long term investing, and the media and prognosticators will greatly exaggerate negative information to create news and get attention. If you keep this in mind, you can dramatically improve your long term investment returns and sleep better at night. Based on numerous studies conducted by DALBAR, the average investor earns several percentage points below the market average due to market timing and emotional reactions to market fluctuations. It’s how we are wired. When the market goes up, we feel good and we want don’t want to miss out on the opportunity to make money. As a result, we buy stock when the market is at its peak. On the flip side, when the market drops we worry about losing money, and sell when the market is at the bottom. It’s hard to make money in this cycle of buying high and selling low. When investing in the stock market, try to avoid overreacting to the inevitable short term fluctuations in the market.
Other factors that can help you ride out dramatic fluctuations in the market include establishing a solid financial foundation and maintaining an asset allocation that meets your investment timeframe. Establish a solid financial foundation by living within your means, minimizing the use of credit, and maintaining an emergency fund of 3 to 6 months of expenses. A strong foundation helps you avoid pulling money out of the stock market at inopportune times should an emergency arise.
Once you have established a strong financial foundation you can start investing in the stock market. One key to success with stock market investing is establishing an asset allocation that’s in line with the timeframe in which you will need money. Money that is needed in the short term should not be invested it the stock market. As a general rule, do not invest any money needed within the next five years in the stock market. Over long periods of time the stock market has trended upward, but in the short term there have been periods with substantial drops. Give yourself time to ride out the natural fluctuations in the market.
Additionally, it is important to diversify your money across a wide variety of investments. You can reduce the amount of risk you take by diversifying across different companies, municipalities, industries, and countries. When one type of investment is doing poorly, another may be doing well. This helps to buffer the losses you may experience in your portfolio. An excellent way to diversify is through the use of a variety of different types of mutual funds. Mutual funds pool your money with money from others to invest in a large number of companies or government entities based on a predefined investment objective.