5 Points to Remember When the Market is Volatile

Avoid making too many changes to your portfolio during big drops in the market.

By + More

Adam Bold
In the last few weeks, the stock market's declines have been remarkable. Fear and uncertainty have taken over, and investors haven't been placing much faith in economic fundamentals. Though no one can accurately predict the future, we're close to a bottom rather than this being the start of a bear market. Here are some things to remember when the market is going crazy:

Outside factors affect the stock market. Ultimately, economic fundamentals drive stock prices. This summer, investors have been worried about the U.S. government defaulting on its debt, along with the ongoing financial problems in the eurozone. Last summer, other events haunted the market, including the the BP oil spill and rioting in Greece.

[See 50 Best Funds for the Everyday Investor.]

Eventually, investors will turn their attention back to economic fundamentals. The latest update on employment was positive. Total non-farm payrolls rose by 117,000 in July, after little job growth over the last two months. Total private employment rose by 154,000 in July, with gains in health care, retail, manufacturing, and mining industries.

In corporate earnings, about three-quarters of companies have reported second-quarter results so far, and more than 80 percent of them have matched or exceeded estimates.

Despite the downgrade of U.S. debt by Standard & Poor's, interest rates are generally lower than two weeks ago. This helps make stocks more attractive than treasury bonds given that stocks can provide higher returns.

At some point, investors will rediscover the improving fundamentals and rationality will return to the financial markets.

[See What the Latest Fed Policy Means for Your Money.]

Avoid making investment changes on high-volatility days. It's easy to get caught up in the emotion of the day's events. If you're an investor and not a day trader, there's generally no need to worry about daily market moves, even when they're dramatic.

The market doesn't move in a straight line, so you'll see plenty of ups and downs. Corrections are a normal part of the market's activity from year to year.

Don't make big changes to your investments when the market is volatile. If fear is taking over, take a deep breath. Go for a walk. Wait a day or two before you make any investment decisions. The reality is, investing isn't a short-term process. You're in it for the long term. If you stick with your plan, and keep your emotions out of your investments, you can come out ahead in the years to come.

[See Is Cash a Smart Investment?]

Check your risk profile. No one likes to lose money. If you're uncomfortable with losing value in your investments (and you're losing sleep over it), the amount of risk (volatility) might be too high. You can reduce volatility by adding more cash-like investments such as CDs or money market accounts, and lowering exposure to aggressive stocks. Keep in mind that if you make changes now to reduce volatility, you might not get the boost in value when stock prices rebound.

Changes don't have to be all or nothing. It's not easy to recognize in volatile times, but market declines offer tremendous buying opportunities. Even if you agree that it's the right time to buy, you may not want to go "all-in" to the markets now. Instead, consider setting up an automatic investment plan that puts a specific amount into the market on the same date each month. That way, you're able to participate with your "new" money in market growth when it happens and also maintain some protection if the markets move lower.

This would be the same approach to use when you make regular contributions to your retirement plan at work or an IRA. You're using dollar-cost averaging in those instances, and it does several things. It helps eliminate emotions from your investment decisions and eliminates the need to decide how much to invest because your contributions are automatically deducted from your paycheck or bank account. Over time, dollar-cost averaging can lessen the impact of short-term market volatility.

[In Pictures: 6 Numbers Every Investor Should Follow.]

Let professional mutual fund managers do their job. If you have a well-diversified portfolio of mutual funds run by good managers, you shouldn't have to make drastic changes to your investments when the markets are running wild.

Professional managers spend all day searching for the best investments based on extensive research and analysis. They respond as needed to events and change holdings as necessary. Remember, the holdings of a fund listed on a web site or in a prospectus are as of end of the last calendar quarter. You don't know exactly what the fund owns today. Rely on these professionals to do what you're paying them to do.

Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast to coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.