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Portfolio Diversification

Coming to terms with stock market volatility

There’s no getting around it. The stock market is volatile. Every day the stock market goes up and down in reaction to any number of issues involving business, the economy, or geopolitical events. Most of the time investors take the market’s ups and downs in stride. It’s only when the market declines substantially that investors can become unnerved and make decisions that can be harmful to their long-term retirement portfolios.

To understand market volatility, it’s important to look at history. Since World War II, the stock market, as measured by the S&P 500 Index, has had average declines of 34% during bear markets, but it has risen 175% during subsequent market advances. As a result, investors who stayed the course during turbulent times were usually rewarded with better performance.

While market downturns are a fact of life for investors, there are steps you can take to minimize these declines to the value of your portfolio. These include: putting time on your side, diversifying your portfolio, investing regularly, and
sticking with your plan through good times and bad. These are the fundamental principles of investing; and by creating an investment strategy based on these basic tenets, you will build up your portfolio’s defenses against market volatility. This will allow you to keep your eye on long-term trends, rather than short-term market fluctuations.

When will you need your money?

The answer to this question can help you determine the investment choices you select for your retirement plan portfolio. You’ll often hear this referred to as your “time horizon.” If you are 35 and plan to retire and begin withdrawing money from your plan at 65, your time horizon is 30 years. Your investment choices may be very different from someone who is 60 and has a five-year time horizon.

Time is your ally when it comes to investing. The rule of thumb is the longer you have to retirement, the more aggressive you can afford to be and the less you have to be concerned about short-term market downturns. A decline in the stock market that lasts for a relatively short time is unlikely to have a significant impact on your retirement plan account over the long term. If you have a relatively long time frame, you might consider investing most of your retirement dollars in stocks.

Stocks are the engine of growth in a portfolio

Stocks have been the investment of choice for retirement plan participants with long-term time horizons. Why? Because stocks, more than any other investment, have the greatest potential for growth over time. There’s no doubt that stocks are the most volatile investments, and history has shown that they have risen and fallen to a higher degree than bonds or cash equivalents. Still, over the past eight decades, stocks have produced greater returns than bonds or cash equivalents.

While past performance is no indication of future results, the chart below shows the powerful returns on stocks over more than a half century. While there were several substantial short-term stock market declines during this time period,
stocks outperformed other types of investments by a wide margin.

Diversification and asset allocation—defenses against market volatility

Among investors, the words “diversification” and “asset allocation” are often used interchangeably, but there is a difference. If you put all of your retirement dollars in different types of stock—for example, investment choices that favor large- company, mid-sized company, and small-company stocks—you’ve diversified your assets among stocks, but you haven’t allocated them. If stocks go into a decline, it is likely that your whole portfolio, made up entirely of stocks, will lose value.

When you allocate your retirement plan contributions, you spread them around three main types of investments: stocks, bonds, and cash equivalents. With this type of strategy, you reduce the risk that the poor performance of any one asset class will affect your entire retirement portfolio. Ideally, no matter how volatile the market becomes, at least one asset class should do well. If the stocks in your portfolio are declining, your bonds may be on the rise. At a time when bonds are lagging, your stocks may be moving higher. And, of course, cash equivalents usually provide a steady stream of income to your portfolio.

Asset Allocation Basics

Source: Transamerica Retirement Services: Brochure:  Market Volatility

Information is provided for review and consideration only. Please consult legal and tax advisors for practical advice pertaining to your business and personal situations.

This page was last reviewed and/or updated on Friday, August 13, 2010 10:46 AM