Markets go up and down. Sometimes a lot in a short period. When markets will go down, when they will rebound, and why is anyone’s guess. But you knew that already.
The question on everyone’s mind is what to do about it.
Below are five ways to handle a volatile stock market.
Resist the urge to sell everything and move to cash. Be honest. I know this thought has crossed your mind. With markets up or down hundreds of points in a day and the scars of the 2007/2008 market decline still fresh, even the most level headed of investors has been tempted to fall into this trap.
Try to resist.
Markets do decline. Sometimes they decline a lot.
Significant market declines or corrections may last a year or more, but most of the time a market correction of 10% or more lasts less than 100 days (Yardeni Research, Market Briefing, December 4, 2018).
In fact, most of the time when the market has declined by 10% or more, you would have been better off to add money to stocks rather than take money out.
Maintain a diversified portfolio. Not all your money should be invested in stocks. Ever.
Money that is likely to be spent in the next five years probably should be set aside in less risky assets that are not subject to the short-term risks of the stock market. Bank CDs, money market funds and short-term bonds, come to mind.
Of the portion that is invested in stocks, spread it out among various asset classes: U.S. and foreign stocks, small companies and large ones, growth stocks and dividend stocks. These all have a role in a diversified portfolio and may reduce your chances of significant losses that are difficult to recover from. A diversified portfolio won’t prevent market losses, but it can help minimize them.
Focus on the long-term. The longer you leave money in the stock market, the greater the likelihood that your investment will pay off.
As I mentioned above, money that is going to be spent in the next 5 years probably shouldn’t be invested in the stock market. If you want to be more conservative, you could extend that time frame to 10 years.
Although there have been rare exceptions, most of the time when money is invested in stocks for 10 years or more it does at least as well as money invested in lower risk assets like bank CDs and money market funds. In fact, the longer your time horizon the more likely this will be the case.
Rebalance. Volatile markets are a good reminder of why it makes sense to occasionally rebalance your portfolio. If you are targeting a mix of stocks and bonds, odds are good that the percentage allocated to riskier assets like stocks has grown to be a larger percentage of your portfolio. Perhaps larger than you would like.
Rebalancing in a volatile market is also a great excuse to sell investments that are no longer performing well compared to other similar funds, have tax losses that can be written off, or for some other reason are no longer a good fit for your portfolio.
Rebalancing could also mean buying more of your favorite investments especially if they are down from their high points earlier in the year.
Smart tax planning. A silver lining in a down market is that investments in taxable accounts with capital losses can be sold and repositioned elsewhere. These losses can be used to offset other taxable gains in your portfolio. Each year up to $3,000 of capital losses can be used to offset ordinary income. Any losses that exceed that amount get carried forward into future tax years.
If you are considering converting all or part of an IRA to a Roth IRA, a down market may be a good time to do that as well. Since markets are down, any taxes due on the conversion would be less than if you had converted to a Roth IRA when markets were at their peak.
Likewise, if you are considering making a 2018 IRA contribution and haven’t done so already, a down market provides a great opportunity to make a long-term investment and to buy your favorite stocks and mutual funds at reduced prices.
The market volatility we’ve experienced in the fourth quarter of 2018 is some of the worst we’ve experienced in years. It may take a while but eventually, things will turn around and stocks will reach new highs. The key is to maintain a well-diversified portfolio, don’t invest money that you may need to spend in the next 5 years, make tweaks and adjustments as necessary, and remain focused on your long-term goals.