The Wrong Way to Deal with Volatile Markets

Many investors irrationally respond to stock market swings.

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I can’t blame investors for being spooked by market volatility. The financial news is enough to trouble anyone. Our domestic economy is growing at a painfully slow rate. U.S. employers added only 69,000 jobs in May, down from an average of 252,000 a month from December to February.

Europe appears on the brink of economic disaster. Unemployment in the euro countries hovers around 11 percent. Spain recently joined Greece, Ireland, and Portugal in obtaining a bailout estimated to be $126 billion. There is serious concern that Italy could be next.

So, how did the markets react to the steady drumbeat of bad news? The DJIA closed at 12,554.20 on June 8, 2012, representing its biggest weekly advance since December. This is bad news for investors who followed the advice of “famed Dow Theorist” Richard Russell. In February, 2012, Russell predicted that “Dow 10,000 will be tested in the next few months.” Earlier, on May 18, 2010, Russell advised investors to “batten down the hatches” and “sell anything they can sell (and don't need) in order to get liquid.” According to Yahoo Finance, on May 18, 2010 the Dow closed at 10,510. It was actually time to open the hatches.

On July 15, 2010, well known bear Charles Nenner predicted the Dow would fall to 5,000 within two and half years. Not to be outdone, Harry Dent Jr. predicted the Dow would drop to 3,800.

Of course, the bears may turn out to be right. No one can predict the future of the markets, which is precisely my point. Legendary investor Benjamin Graham summed it up nicely when he stated: "If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what's going to happen to the stock market."

Trying to time the market by interpreting or anticipating the effect of daily news on future market prices is gambling and not investing. Here’s a better way:

If you have less than five years before you will need 20 percent or more of your invested assets, you should have no exposure to stocks. Instead, keep your money in an FDIC insured bank account, Treasury Bills, or in a high quality money market fund like the Vanguard Prime Money Market Fund (VMMXX).

If you have a longer time horizon, but can’t withstand short term volatility in your portfolio, reduce your exposure to stocks. The lower the percentage of stocks in your portfolio, the lower the volatility. You will also reduce expected returns, but that trade-off may be worth it if reduced risk permits you to sleep better at night.

Ignore all predictions, regardless of how well-credentialed the “predictor” may be. Wall Street is littered with horrific predictions made by those considered to be knowledgeable. One of my favorites was from Former Treasury Secretary Hank Paulson. In April, 2007, he was quoted as noting that: "I don't see (subprime mortgage market troubles) imposing a serious problem. I think it's going to be largely contained."

Joseph Cassano, the head of AIG, stated, in August, 2007: "It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of these [credit default swap] transactions." I guess he was being flippant since these transactions nearly bankrupted AIG and sent the economies of the entire world into a tailspin from which it has yet to fully recover.

Volatile markets are fertile ground for self-styled financial “experts” to strut their predictive mojo. While they speak with great confidence, their track record is far from stellar. They have no accountability for their past errors. Relying on them in any market can be harmful to your financial health.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.

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