Putting market volatility into perspective

The fall of 2008 may be a textbook illustration of stock market volatility in action – a wild ride for investors and their investments.

It was in the weeks leading up to the presidential election that:

The Dow Jones Industrial Average tumbled 18%* in the week ending Oct. 10
The Standard & Poor’s 500 shed more than 40%* of its value from the
previous year
Virtually every asset class got bashed and battered

Yet, by Election Day, the Dow had rebounded 14% - only to begin an erratic excursion of more ups and downs and thrills and spills.

In the face of such volatility, what’s an investor to do?

First, understand what volatility is and what causes it.

Volatility is measure of risk

Securities prices rise and fall in value every day. This up-and-down movement is known as volatility and is a common measure of investment risk.

It is generally accepted that:

The more volatile the investment, the greater the risk of short-term losses
Conversely, higher volatility investments may have the potential for higher
returns
Stocks tend to be more volatile than other securities, such as bonds
Although periods of higher volatility in the stock market are common, they’re
also generally short-lived

What causes stock price volatility

Seldom does a single factor cause stock price volatility. Rather, it’s a combination of several factors coming together at the same time.

For instance:

Stock prices normally move up and down based on a company's earnings
record. If earnings are growing, the company's share price is likely to
rise. If sales and profits are declining, you’d expect the opposite to be
true.
Investor expectations can play a role. When a company’s future looks rosy,
investors tend to pay more to own its shares.
Overall, economic and stock market conditions also can be factors. Investors
who are optimistic about the continued strength of the economy and the stock
market usually want to own stocks Interest rates affect stock prices. When
rates are rising, investors often prefer to own lower-risk, higher quality bonds
and money market instruments, rather than stocks.
Other factors that can influence market volatility are domestic and
international economic and political uncertainty, supply or price
pressures on commodities, and currency exchange rates.

Three strategies for coping

Regardless of what may cause a particular period of volatility, it's important to remain calm and focused. By recognizing that market volatility is common, you may be less likely to overreact and make quick and potentially costly changes to your portfolio.

Moreover, you may better reach your investment goals if you follow some strategies the next time market volatility shakes your confidence. Such as:

Keep things in perspective
In February 2007, the Dow fell a seemingly dramatic 416 points in a single
day. Yet the drop actually represented a loss in value of only 3.29%.
Compare that to the first day stock markets reopened after the Sept. 11,
2001 terrorist attacks: The Dow ended the day down 7.1%.
Focus on the long term
If you're investing for a long-term goal, such as funding your retirement or
paying for your child's college education, you should have time on your
side. A longer period may help you benefit from compounding and may give
your portfolio more time to recover from a market downturn. If your time
horizon is shorter, however, bonds, cash equivalents and other investments
with lower volatility may be a viable choice.
Diversify your portfolio
Diversification helps manage risk and may help improve the consistency of
returns. A mix of stocks, bonds and stable value/money market funds with
a long-term outlook is often an appropriate approach for most investors.
Historically, when one asset class loses value, another may deliver gains
that can help offset losses. Please realize that the use of diversification and
asset allocation as part of an overall investment strategy does not assure a
profit or guarantee against loss in a declining market.

The bottom line

Experienced investors know that investments rise and fall in value all the time, and they generally make few abrupt changes to their portfolios.

If you've allocated your investments to help meet your financial goals and investment risk, you may be smart to leave your portfolio mix unchanged - no matter what the market is doing.

However, it’s always wise to regularly review your investment accounts and financial goals with an investment professional.

Money market funds: These funds are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other federal government agency. Although they seek to preserve the value of your investment at $1.00 per share, it’s possible to lose money by investing in money market funds.

^{*Source: Bankrate.com, December, 2008}

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