With the market’s recent volatility, your portfolio may have taken a hit. And you probably have feelings about that. Maybe some fear. Maybe anger. And you may be wondering what you can do to avoid taking a hit again. Unfortunately, you can’t avoid the hits altogether. The nature of the market is to go up and down—it’s just that it has been so long since the market went down, many of us got lulled into thinking it wouldn’t.
You can follow 10 key principles to help insulate yourself from market volatility and achieve your goals over the long term. Dimensional Fund Advisors recently described these principles in a piece titled “Pursing a Better Investment Experience: Key Principles to Improve Your Odds of Success.” Here are the 10 principles with a few thoughts on how to apply them to your life:
- Embrace Market Pricing: Dimensional calls the market an information-processing machine. Investors buy and sell millions of securities around the world every day, and the market takes in that collective information to set the price of securities.
- Don’t Try to Outguess the Market: Consider this: In 2016, investors averaged 82.7 million(!) trades a day. Such a mind-boggling number supports the ideas that:
- The market efficiently processes real-time information to accurately set prices; and,
- The market’s pricing power works against efforts to outperform through stock picking or market timing.As evidence for Point #2, Dimensional points to the fact that, from 2002 to 2016, only 48% of U.S. equity mutual funds survived, and just 17% outperformed their benchmarks. For fixed income funds, survivors totaled 57%, and only 18% outperformed.
- Resist Chasing Past Performance: If you’ve been investing for a while, then you can probably recite the mantra found on almost any piece a mutual fund company sends out: “Past performance is no guarantee of future results.” Research shows that most funds in the top 25% of previous five-year returns did not maintain the ranking for one-year returns in the following year. Or as the Securities and Exchange Commission writes: “It’s not uncommon for a fund to have better-than-average performance one year and mediocre or below-average performance the following year.” If you’re chasing performance from the past, then you’re probably going the wrong way.
- Let Markets Work for You: If mutual fund companies—which ostensibly hire people with the training, experience, and passion to study market movements day in and day out—cannot consistently pick the winners, why should we, as individuals, think we can do better? Sometimes people—or funds—get lucky, but over the long run, the market can’t be beat. We don’t have to beat the market. We can join it—and enjoy a less stressful experience in doing so. The key is to think long term since, historically, the equity and bond markets have provided long-term investors growth of wealth that has offset inflation.
- Consider the Drivers of Returns: Academic research has identified equity and fixed income “dimensions,” or drivers, of higher expected returns. For instance, take a company’s size. Historically, small cap stocks have outperformed large cap stocks, which means you want to keep this dimension in mind when structuring your portfolio. Here’s how Dimensional Fund Advisors breaks down the dimensions of returns:
Dimensions of Expected Returns
• Market (equity premium—stocks vs. bonds) • Company size (small cap premium—small vs. large companies) • Relative price (value premium—value vs. growth companies) • Profitability (profitability premium—high vs. low profitability companies)
• Term (term premium—longer vs. shorter maturity bonds) • Credit (credit premium—lower vs. higher credit quality bonds)
- Practice Smart Diversification: None of us owns a crystal ball that will predict stock-market winners and losers. And since we don’t, we need another strategy to stay in the market. The best strategy that I know of is diversification. When you own a little bit of everything (not just in the U.S., but globally), you broaden your investment universe and help insulate yourself against market volatility.
- Avoid Market Timing: Market timing can be an exercise in frustration, which is why I don’t practice it and why I don’t advise my clients to. After all, my goal is to help my clients worry less about their money so they can enjoy the rest of their lives more. Trying to time the market works against this goal. We can’t know who will outperform the market from year to year. Last year’s hot pick may be today’s nobody, and tomorrow will bring a new wave of contenders. However, by holding a globally diversified portfolio, you can better position yourself to achieve returns—wherever they come from.
- Manage Your Emotions: The recent volatility might drive the truth of this principle home for you. You may have despaired when the Dow fell 1,175 points on February 5—its largest one-day point drop ever. And maybe you considered cutting your losses by selling. Emotional decisions like this can short-circuit your long-term goals. Feelings of elation when the market is high (like it was in the weeks preceding the record drop) and fear when it’s low can lead to panic-driven decisions that hurt us over the long term. Instead of reacting to short-term market movements, stick with your long-term investment plan.
- Look Beyond the Headlines: A lot of the fear referenced in the principle above is probably amplified by the 24/7 news drubbing we experience. Daily market news and so-called market “gurus” can both stoke your anxiety and tempt you to chase fads. Again, keeping a long-term perspective is key. And perhaps turning off the news once in a while.
- Focus on What You Can Control: By focusing on what you can control, you can mitigate feelings of fear or greed, and you can keep your perspective on the long haul. You might also consider working with a fee-only financial planner who has the experience to help you stay focused so you can make smart decisions about your direction no matter what the short-term market is doing. Here are some goals you can focus on:
• Create an investment plan to fit your needs and risk tolerance. • Structure a portfolio along the dimensions of expected returns. • Diversify globally. • Manage expenses, turnover, and taxes. • Stay disciplined through market dips and swings.