Investing Articles

Recent volatility in the financial markets has been unsettling for many investors. For instance, the Dow Jones Industrial Average closed at 14,000 on July 19, 2007, but by August 16 it had plummeted to 12,846 due to subprime-market concerns. Then, after daily ups and downs, it rebounded slightly to 13,371.72 on Nov. 30.

Now, intraday moves of 200-plus points in the Dow-both higher and lower-are commonplace, further fueling public perception of market instability.This erratic behavior is clouding the judgment of some investors, who are rushing out to try to time the market and failing to maintain diversified portfolios. Anytime you see financial volatility,emotions can take over. A prudent approach–with a focus on long-term financial goals–is absolutely crucial.

Market Timing

The arguments in favor of market timing are persuasive, especially during periods of market declines: Follow a system for buying low and selling high, and you’ll profit during bull markets and minimize losses during bear runs. It sounds reasonable, but there are drawbacks to this approach. For instance, transaction costs such as trading commissions, price spreads and taxes (in taxable accounts) can reduce potential gains.

Additionally, research indicates that market timing is extremely difficult to implement because there is little margin for error. Consider the performance of the Standard & Poor’s 500 Index. If you stayed out of the market on the five top-performing days from 1980 through 2006, your portfolio’s value would have been 26% less than one that was fully invested for the entire period. Miss the top 30 days and your portfolio’s value plunges a whopping 73% versus a fully invested position, according to a report by Boston media firm Eons Inc.

The lesson is clear: Unless your timing system is absolutely foolproof, you risk paying a substantial cost for being out of the stock market on its best-performing days.

Inadequate Diversification

Your investments should reflect an integrated approach that incorporates your risk tolerance and financial objectives. However, if you don’t regularly monitor your portfolio, it can stray from its targeted asset allocation. This happens because many investors’ risk tolerance rises when the stock market is doing well and falls during down periods. As a result, you’re likely to increase your holdings of aggressive investments during bull markets and seek conservative investments when the markets are volatile or declining. However, both approaches overlook your long-term objectives.

Concentrated holdings are another potential problem. Perhaps you’ve received a large number of stock options as part of your compensation package. If you own shares of your employer’s stock in a retirement plan, over time those shares can become a large, concentrated position in your portfolio. A diversified portfolio is one of the ways to help avoid inadequate diversification. Diversification through an asset-allocation plan is a useful technique that can help reduce overall portfolio risk and volatility.

There are times when some segments of the market don’t perform well, and times when all the sectors don’t perform well. But if you maintain a properly diversified portfolio, you should be fairly well protected against massive declines versus having a highly concentrated position.

Staying on Track

Of course, there are times when it’s appropriate to adjust your portfolio. For example, you may want to modify your investment approach when starting a college education fund for a new child or transitioning from saving for retirement to taking post retirement portfolio distributions.

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