How Can Younger Investors Take Advantage of Volatility?

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Christine Benz: Now let's tackle a question related to younger investors, which is how they can take advantage of the market's recent volatility to actually add to stocks when they're down. I love that question because it hits on a really crucial point. If you're getting close to retirement, as I just talked about, volatility is not your friend because you are seeing your stocks fall shortly before you retire. On the other hand, if you have a very long time horizon to retirement, these periodic bouts of market volatility are actually really advantageous to you, and they're a great to time to think about adding to your investment portfolio.

So a couple of things to think about if you are, say, 15 or 20 or more years from retirement. The first is that you'd want to think about bumping up your contribution rate if you possibly can. So if you move your 401(k) contribution rate up by even a percentage point, it may not seem like a lot, and it may not feel like a lot in terms of the reduction to your paycheck, but it can be really tremendously beneficial over the course of your whole long time horizon.

You might also think about automating your contributions to, say, an IRA. In 2020, the IRA contribution rate for people under age 50 is $6,000. If you're in a position to max out your IRA contribution, that's $500 a month, gets you to that maximum annual allowable contribution. And that contribution is the same whether you're making Roth or traditional contributions. So revisiting your contribution rate is a great place to start.

Some people who have student loans, federal student loans, have relief as part of the CARES Act to not have to pay on their loans for a little bit here. So that might be an idea as well, to think about taking that money that you're not having to put toward your student loans during this period to actually add to your investment portfolio.

Another thing I would say to younger investors who are looking to make smart decisions right now is to take advantage of any free sources of investment guidance that you have available. A really obvious one would be some sort of a target-date mutual fund, which are fixtures in 401(k) plans. And these are basically all-in-one investment options. They're designed to be appropriate for you, given your age, given your proximity to whatever you expect your retirement date will be. And so there are a couple of nice things about target-date funds. One is that they are really diversified, so they hold stocks and bonds, they hold a globally diversified portfolio, and they come up with what is a sensible asset-allocation mix given your life stage. So if you're a younger person, say, in your 30s and 40s, your target-date fund will be mainly stocks. It'll have a healthy allocation to foreign stocks and then it'll only gradually get more conservative as you get close to retirement.

Another neat feature about target-date funds or really any all-in-one fund like this is that it's periodically doing rebalancing back to the target allocation. And what that means in layperson's terms is that when stocks are down, because it's targeting a specific asset-allocation mix, it's going back to that. So it's buying stocks for you and it's doing something that we investors often have a hard time doing ourselves. We often don't feel comfortable adding to stocks. Well, the good news is that on those really bad days for the market, which are really advantageous to invest, the target-date fund is actually doing the buying of stocks for you.

So I like that idea of taking advantage of free advice. I've often urged investors, even if they want to retain a little bit more control over their portfolio than they get with a target-date fund, look at what target-date funds are recommending in terms of asset allocations, and use those to guide how you position your own portfolio. It's a way to piggyback on how professional asset allocators are allocating for people in your approximate age band. So that's a good way to take advantage of professional advice.

I also want to talk a little bit about things to avoid doing in this situation, because when things are as volatile and uncertain as the market has been recently, sometimes we see people step up and make mistakes as well. One key thing to think about is avoiding market-timing, and basically that means big all-or-nothing moves into or out of stocks. I think it might be tempting to try to maybe get your portfolio out of the market until this whole thing blows over and then maybe get back into a more stock-heavy portfolio later on. The trouble with that strategy, even though it sounds great, especially if you're a younger investor and haven't really tried this over a period of time, is that it's incredibly hard to do.

At Morningstar, we monitor a universe of what we call tactical asset-allocation funds. These are funds that do strategies like this. And what we see when we monitor their performances, by and large, these professional money managers haven't done a great job with market-timing. So really question whether you, as an investor, can do market-timing yourself. My bias is to just set up what's called a dollar-cost averaging plan, so you're socking money into the market at regular intervals, in regular amounts, and you're not overthinking the timing piece of it.

I also think it's important to avoid making really narrow bets. So avoid targeting specific sectors of the market or regions of the market, or even individual stocks. If you're just starting out, the idea is that you want to try to diversify as quickly as possible. You want to try to globally diversify if you possibly can. So hold non-U.S. stocks as well as U.S. stocks. The best way to do that would be to buy some sort of a very broad mutual fund. Index-tracking mutual funds are really great from this standpoint in that they give you super-broad market exposure at a very low cost.

It's boring, I know, but my bias is to keep things really diversified and really vanilla from the standpoint of investment specifics. Maybe later on, when your portfolio grows larger, you can add some of the more-niche investments alongside your diversified investments. But when you're starting out, I think it makes sense to go big and go broad.