Home>Video>How to Mentally Prepare for a Volatile Market

How to Mentally Prepare for a Volatile Market

Thu, 23 Aug 2012

Understanding the role of short- and long-term investments, controlling what you can, and adopting a contrarian mindset can help investors mentally weather, and even profit from, a market downturn.

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Video Transcript

Christine Benz: Hi, I'm Christine Benz for Morningstar.com, and welcome to The Friday Five.

Fiscal cliff woes and ongoing troubles in Europe set the stage for a rocky ride ahead. Joining me to share five tips for handling a volatile market is Jason Stipp, site editor for Morningstar.com.

Jason, thank you so much for being here.

Jason Stipp: Thanks for having me, Christine.

Benz: Well, Jason, we should first acknowledge this a little bit of a turnabout. You usually interview Jeremy Glaser for this segment. Jeremy is out on vacation this week, so I'm going to interview you.

Stipp: Some big shoes for me to fill, but I'll do my best.

Benz: Jason, you have said that one of the most important concepts to bear in mind when you are bracing for a volatile market is that you need to know that this is mainly a mental exercise, not so much an intellectual exercise. Let's talk about what you mean by that.

Stipp: I think as investors you often think about the investment types that you hold, which funds are doing better, how they perform, but that's really just one of the important keys.

The second one is, when you buy and sell those investments. We often see great funds have poor investor experiences, because investors buy at the wrong time and sell at the wrong time, and that really comes down to your temperament. Warren Buffett has said one of the most important, or the most important, quality for an investor is temperament and not intellect, and that's what he's getting at.

Benz: Let's talk about how to come into a potentially volatile period with the right mindset. One of the keys, you say, is asset allocation, and making sure that if you have money that you're going to need to spend within the next several months or even within the next year, you need to have that liquid. Let's talk about that.

Stipp: I think for investors that are approaching that time horizon when they're going to start tapping their portfolios, it's even more critical, and mental errors come even more to bear because they know they're going to depend on that portfolio. They're probably scrutinizing it. And if the market is upset, they are really going to be paying a lot of attention, and I think it creates an environment where poor decisions can be made, and we are all subject to this.

Really the first thing, as you mentioned, is, if you need to tap that portfolio, you want to have a bucket essentially--and you've talked a lot about this and written a lot about it--a bucket that has very safe assets. So these are liquid assets. These are bank savings accounts, money market funds, CDs, potentially for a couple of years out, maybe short-term bonds.

And the thing that these give you, it's really twofold. The first is that these are less volatile assets, so they're not going to be mispriced when the market goes down. They're going to be much more stable. And what that allows you is to know that your short-term needs are going to be covered, so that you don't have to worry about what's going on with those longer-term [buckets] of your portfolio. It gives you that peace of mind to know, hey, the market is going to do something over the next few months, maybe even over the next couple of years. I'm covered for that time period. I'm not going to panic and do a lot of selling out of equities.

Benz: So, you would say this is a good strategy really regardless of market climate that you make sure that you have that liquid bucket.

For the longer-term piece, I think some people might be inclined to say, well, I'm going to take some of that and put more into cash right now. I'm worried valuations aren't all that attractive right now. What about that strategy and what should investors keep in mind as they think about that longer-term growth component of their portfolios?

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Stipp: Right. So, that short-term bucket feels great because those assets are safe, but you can overdo it when you don't really necessarily need to. And I think that's important and especially critical now to understand what role those riskier assets are playing in your portfolio.

So, in the market there is really no free lunch. You're going to have to give something in order to get something, and for riskier assets, the ones that will pay you greater returns over longer periods time, the trade-off is you've got to stomach that volatility that you get in the short periods of time, in the short term. And if you're not willing or able to do that, if you don't stomach those short-term volatilities, the long-term benefits of those investments will never come to bear for you, or they only will if you're just lucky.

So, it's really part of the trade-off, and I think it's important now especially when a lot of market watchers are saying we're going to have muted returns in a lot of areas across the market, you're really going to depend on those riskier assets to play an important role in boosting the long-term benefits of your portfolio, so you have to make sure that you're doing that trade-off correctly, stomaching the short-term volatility, so those assets can work for you over the long run.

Benz: I think that's a really good point, Jason, given that the payoff on cash and bonds right now is not looking too bright.

Stipp: Exactly.

Benz: So, Jason, one other point you have is, to the extent that you do have long-term volatile holdings in your portfolio, what kind of stress tests can you do with them to make sure that they are something that you're comfortable holding? What sort of metric should investors be looking at?

Stipp: If you have the right frame of mind about how these riskier assets behave in times of market stress, it can help you prepare yourself mentally for what you might see in the future. There's a few ways to do this.

On an absolute sense, look at your stock funds, look at how they did in a time of extreme market stress, 2008. Hopefully, we won't see anything like that again, but it gives you a sense of close to a worst-case scenario--or at least the worst case we've had in many decades--what did the losses look like? And then importantly, look at 2009 and 2010 and more recent time periods to see how they behave when the market comes back around and recovers; it's important to have both in mind. So, you get a sense, then, if you see a fund lost 30% or 40%, maybe a 10% loss or a 20% loss over a shorter period of time doesn't seem quite so bad because we've seen much worse, and we have also seen the market bounce back from much worse.

The other thing you want to keep in mind is a sense of relative performance, so how do these funds do compared to other funds that are similar. There are lots of metrics on Morningstar you can look at. The star rating helps to capture that by comparing a fund to its peers and the risk-adjusted returns that it got. You can look at how a fund did against its category, what is its percentile rank? So this stock fund versus other funds like it, if it's under 50, then you know that it did better than the average fund in that category.

Another interesting one is the capture ratio. So, this will show you for every fund when the market was up, how much was this fund up? Was it up as much as the market, more than the market, or less than the market? And on a flip side, on the downside, the capture ratio will show you, when the market was down, did it lose as much or did it lose less? And that helps you get a sense of how this fund will perform. And I would say, Christine, it's interesting on that front that even if a fund doesn't capture all of the upside in an up market, if it also is not losing as much in a down market, that's important to keep in mind because protecting on that downside can be important, and it might be a smoother ride for you in that stock fund over the long term, which can pay off for you.

Last thing is the bear market score; Morningstar has ranked funds against each other and how they did in bear markets. So that can also give you a sense of in a tough market, did this fund hold up better than other funds that are similar.

Benz: So look at that whole toolkit for examining risk. Your next point, Jason, looks at what factors you can actually control. You say that that's very important to coming into a volatile market period with the right mindset.

Let's talk about that category of things that you think investors should focus their attention on to try to keep their minds off what might be going on with the headlines from a day-to-day basis?

Stipp: When the market is in a downward spiral, it's easy to feel completely out of control, and that's completely natural. I think we would all feel that way. But knowing that there are some things you can control, no matter what the market environment is, it can help you keep some peace of mind, and you know you've checked off all those boxes and stacked the deck in your favor regardless of the market.

So there are several things. The first one is the expenses that you pay for your investments. So if you're paying up unnecessarily for a fund and you can get a similar fund for less, that's automatic return for you on the plus side. So making sure that you're minimizing your investment expenses is going to be key there.

The other piece that you can control is optimizing your asset allocation. So as we talked about in the first point, making sure that you have the right, appropriate amount of assets in that short-term bucket and the appropriate amount in the longer-term buckets, that's something you can control really at any time, and so if you set yourself up that way, you know that you will be able to weather those short-term volatility periods.

Also, a couple of other important ones, your savings rate, how much you are putting away. This is something you can control throughout your whole investing life. So that's going to be key, and it's going to give you a big leg up. Even if you have the best portfolio and you behave well, if you haven't saved enough, you're not going to be able to reach those goals.

I would also say if you're retired, how much you take out, how much you withdraw, can also be ... a factor that you can control that might help your portfolio last longer. If you choose not to [withdraw] as much money--and you can do that--when the market is down, that means you're not having to sell assets when they might be depressed. So that's another thing that can help on the margins.

Tax management, making sure that you are maximizing your tax-advantaged accounts to get all of that tax benefit and not paying more than you need to to Uncle Sam will also help you in the plus column.

Knowing that you can't control everything, but checking off those things that you can, it might make that right frame of mind where you won't suddenly panic because you feel like you're completely out of control with your finances.

Benz: Jason, your last point--and I think this is another one Buffet would completely agree with--is to not look at periods of market turmoil necessarily as a time to panic, but really maybe a time to think contrarian and get in there and see if you can find anything to buy. Let's talk about that one and why that can be so empowering?

Stipp: Paul Larson, who is our equity strategist here and editor of Morningstar StockInvestor, often tells me that he is most glum when the market is sideways or just sort of going up moderately, and the reason is, he looks for undervalued stocks. That's his whole strategy. It's done quite well for him. But he likes markets where there is some stress, some disruption, because he can go in and find bargains and benefit from those over the long term. So it's difficult. You have to have some intestinal fortitude in order to do that, but this is how the best value investors, that's when they do their most work and when they're creating their most value, during these times of market shock.

I think for individual investors, we're all emotional creatures, it can be tough. But one way that you can actually make sure that you're getting some value out of this principle is to dollar cost average and make sure that you are consistently investing. So when you're investing in a down market as a dollar cost average investor, you're picking up more shares on the cheap, you probably pay a little bit more at other times, but that will help you balance out and at least give you a fair price on your assets or close to fair over time, and might even allow you to pick up some of that opportunistic investment as you go along--just make sure you stick to that plan.

Benz: OK. Well, Jason, thank you for sharing these very valuable tips for managing what could be, maybe, a volatile period in the months ahead. Thanks so much for joining me.

Stipp: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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