It's easy for stock investors to be lulled into a false sense of security when everything is going their way. The past year, however, has brought reality back to the table and is evidence of the fact that stocks don't always grow unfettered into the sky.
Whether the bump in the road that stock investors are experiencing proves transient or longer term in nature, it does serve as a reminder that various risks abound in the global economic marketplace, and that nothing should be taken for granted.
Manage Expectations During a Volatile Market
While many investors get into the market expecting to make huge sums of money over a relatively short period of time, history would indicate that that is an overly optimistic frame of mind. Backward looking market returns over the past century have collectively averaged in the upper-single-digits per annum.
Investors taking a passive index approach who are expecting to double their money every five years, like they may have post financial crisis, may have found the 2015 market as somewhat of a rude awakening. Of course, if you have a portfolio loaded with FANG stocks (Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), and the like), you may have done exponentially better than average near term.
Chasing returns, however, rarely ends well. In the late 90s, sell-side stock analysts creatively encouraged investors to buy into weak stories they felt held promise simply because of their relation to the Internet. Some abandoned "old economy" stocks and embraced every "dot com" or technology infrastructure enterprise they could get their hands on. There were survivors, but as we know, many succumbed to their flimsy business models. Further, stock prices became so out of whack in many cases that it has taken more than a decade for survivors to build back capital sacrificed during speculative times.
Concentrated portfolios may provide more upside potential, but the counterpoint is that much can be lost and never regained if one becomes too speculative.
Today, with the market trading on the high end of an expected valuation spectrum, even more conservative expectations may prove optimistic. Newer investors or those with short-term memories should refer to index performance during the so-called "Lost Decade" from 2000-2010 for evidence on how price can stagnate.
Given recent volatility, investors with overly aggressive equity allocations - either by merit of stock type or sheer amount - may be losing a bit of sleep or feeling a knee jerk reaction to sell. While that may be somewhat normal, it might mean that the portfolio is in need of some housecleaning. Decreasing allocation to equities and increasing it to fixed income, cash, or potentially some other hard asset may be just what the doctor ordered.
More balanced allocations help smooth the volatility of a mostly equity portfolio and may help to decrease a knee-jerk reaction to sell assets potentially at the worst of times. While this may decrease your total return potential over the long term, it will promote less personal angst when the market decides to turn against your portfolio.
Conventional wisdom says that investors should stick to a plan and ride out the rough times - no matter how severe. The problem is that conventional wisdom is not a guarantee. Each and every dime you expose to equities is a dime that you are putting up as risk capital. Though it may stand to reason that shares of Microsoft will be higher in one decade, Microsoft will not be guaranteeing that fact, nor will the party that you are buying shares from.
While it probably isn't realistic to assume that Microsoft will go out of business in 10 years - rendering its equity worthless, no investor should be willing to bet their life that profits will necessarily be leaps and bounds higher either.
In times past, companies like Bethlehem Steel, Eastman Kodak (NYSE:KODK), and other household names were considered "widows and orphans" stocks, the kinds of investments that were bulletproof, set it and forget it ideas. As we know times change, economic conditions fluctuate, and an organization that can't compete effectively can end up in the bankruptcy bin. The investment space isn't as foolproof as it once was.
Market volatility is not always easy to get through. Arguably, the financial crisis was the scariest episode of economic history since the market crash of 1929 and the pursuant Great Depression. Though we were able to sidestep a potential catastrophe there, the sheer experience should serve as a reminder that stocks present an economic vulnerability beyond the individual investor's control.
Though the downside potential can be easy to forget amidst a bull run, it should not be forgotten or ignored. Understanding the realities behind fluctuating-value assets, maintaining reasonable expectations with that which you are investing in, and allocating assets in balanced fashion commensurate with life stage and risk tolerance are all free ways to get you sanely through volatility. With today's economic uncertainties and rapidly moving markets, volatility should not be just anticipated, it should be expected.