A good plan and long time horizon can help young people beat their fears of market volatility.
Imagine if you had invested in technology stocks a decade ago. You'd be pretty happy about your decision by now—but only if you had hung on through significant market drops and volatility.
So far this year, we've also had a roller coaster ride in the stock market. Britain's vote on membership in the European Union, the Chinese economy, and the Federal Reserve's stance on interest rates are just a few of the things that have jostled global stock markets. The good news: If you have a long time to stay invested, and you are invested in a diversified asset mix that reflects your time horizon, financial situation, and risk tolerance, you can ride it out.
Ignoring the stock market noise and sticking with your investments isn't easy. In fact, the human brain is hardwired to be wary of uncertainty. But while that might have helped early humans, it's a risky instinct for investors. Bailing out of the market when volatility hits can throttle long-term returns. In most cases, it's better to hold your ground.
Consider what happened in 2015. If you are like many investors, you were probably most fearful at the market bottoms around August 25, 2015, and February 11, 2016. But if you had sold in August, you would have locked in the 10% loss in the S&P 500® Index and would not have participated in the subsequent 13% gain over the next two months. Historically, the market has tended to recover from declines.
Even historic drawdowns can look like blips on longer-term graphs. The crash of 1987 sent the S&P 500® Index careening down about 20% in four-and-a-half days,1 sending shivers through investors' veins. When viewed on a chart of only a couple of months of data, the drop looks large. But if you look at that same pullback on the 40-year chart shown below, it is barely perceptible. "Keep this in mind the next time you are tempted to hit the sell button as markets dive," says Ann Dowd, CFP, vice president at Fidelity. "If you are a long-term investor with a solid plan, your best strategy is likely to stay the course."
So the next time stocks fall and your stomach sinks, consider these four strategies to stay calm and focused on the overall goal—getting your money to grow over the long term.
1. Don't stop investing.
No one runs away when prices go down at the grocery store: When there's a sale on Ring Dings, you stock up if you love them. Investments can be similar. If you liked an investment enough to buy it in the first place—and you still feel that way—a down market gives you the opportunity to potentially buy more of it at a lower price.
Sure, it can be tempting to think you can avoid stock market volatility by selling your investments and buying them back when things settle down. But it can be very difficult to pinpoint market bottoms or tops. Things can change fast, and missing part of a rebound could have you buying back your investments at a higher price than when you sold them. That would be selling low and buying high. Remember that you want to do the opposite.
If you're in a workplace retirement plan, continue to make contributions at least up to any employer match. Making regular, equal investments over time, like you do in a 401(k) plan, is known as systematic investing. There could be an advantage with this approach: You could end up with a lower cost per share, on average, than if you had invested larger amounts less frequently.
Tip: If you invest regularly over months, years, and decades, you can actually benefit from a volatile market through dollar cost averaging. Suppose you had $20,000 to invest in the market on January 1 and the mutual fund you are planning to purchase is priced at $42 a share. To use dollar cost averaging, you can break this purchase into, say, four parts over a year. So, hypothetically, you could invest $5,000 four times: at $42 in January, at $35 in April, at $37 in July, and at $46 in October. In this example, you end up buying 500 shares of this mutual fund at an average price of $40. Note, though, that periodic investment plans do not ensure a profit or protect you against loss in a declining market—you're simply buying your investments at varying prices, and this could work out favorably in the long run. Plus, you'll be staying invested in the market, which is nearly always better for potential long-term returns.
2. Remember that you have a long time.
The secret sauce in long-term investing is time. When you're young, time is on your side. You can always save more money, but you can't get time back.
The reason that time is so important to your long-term plan is compound returns. As your money earns a return, if the returns are reinvested, you have the potential to earn a return on your original principal, plus the money that has been added to the investment would be earning that same return. The hope is that your balance will eventually snowball.
Tip: Using the rule of 72, you can roughly estimate how long it will take your investments to potentially double at your average rate of return. Divide 72 by your annual rate of return. And voilà—you get an estimation of the number of years until your balance doubles. For example, if your annualized rate of return is 7%, you could expect your money to nearly double in roughly 10 years. Stock market returns are anything but predictable, but it illustrates the importance of staying invested.
3. Have a plan.
Let's take a step back. Long-term investing requires a plan. It can be a complicated plan involving many stock and bond funds or even individual securities—or it can be a simple one using a target date fund or managed account service. Generally, investing in a diversified mix of stock and bond funds or individual securities is an important part of successful long-term investing.
No matter what your approach is, remember that you bought your investments for very good, long-term reasons, and now that the market is topsy-turvy in the short term, those reasons should still be there unless your circumstances have changed a lot.
In general, whether it's a crisis in Europe, a stock market downturn in China, or uncertainty around the Federal Reserve, your strategy as a long-term investor shouldn't change because of short-term market gyrations.
Studies have shown that investors may underperform the market over time due to buying and selling at the wrong times. For instance, independent research firm DALBAR conducts an annual study of investor returns. For the 20-year period ending in 2014, researchers at DALBAR estimated that the returns of the average stock mutual fund investor trailed those of the S&P 500® Index by more than 4%.2 The explanation? Investor behavior: selling investments when the market is down and getting back into the stock market after prices have gone back up.
Tip: If your investment strategy makes you sick when the market drops, revisit your plan to make sure that your asset mix reflects a level of long-term risk that is consistent with your investment horizon, financial situation, and risk tolerance. Generally, we believe the younger you are, the more money you should have invested in stocks. Investing too conservatively may keep your balance from going down but limits the potential for long-term growth.
4. Don't become obsessed with checking balances during volatility.
Doesn't it feel good when you check your account and see that it's up? Peeking into your account after a big drop doesn't. Short circuit your impulse to flee stocks by not checking your investment as often during periods when the market falls.
Until you actually sell your investments, any gains or losses are just on paper. If you do sell, you've effectively locked in those losses. Selling investments may also cost money, in the form of trading commissions or redemption fees—but those costs are small potatoes compared with the opportunity cost of being out of the market. So, stick with your plan and stay invested. You'll probably be better off in the long run.
Tip: Go back to your plan to review your asset mix to make sure it is consistent with your goals, and review your reasons for continuing to own what you own. Don't have the skill, will, or time to do so? Consider investing in a target date fund or a professionally managed account.
It happens all the time.
Stock market volatility happens. Large drops happen. A recent study looked at historical data since 1927 and found that a correction of at least 10% happened 33% of the time. So one-third of the time since 1927, the market was falling at least 10%.3 The takeaway is that over time, the market has gone up most of the time over the long term—just not in a straight line.
Set up an investment plan based on your time frame, financial circumstances, risk tolerance, and goals to help weather anything the market throws at you. Once you're on the other side of the volatility, chances are you'll be really happy that you stuck with your plan.
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