I am always struck by the financial media’s response to market turbulence. Pundits regularly react to events such as the current European debt crisis or the slow-to-recover US economy as if these challenges are somehow unprecedented, requiring a fundamental change in how investors should behave.
The reality is that volatility in financial markets is nothing new and the present turbulence we are experiencing is not in any way unusual or unexpected. The correct reaction to current world economic events is therefore not to abandon fundamental notions about how markets work or reject the core principals of prudent investing. In my opinion, the proper response is to realize that, regardless of the underlying causes, market volatility is a fact of investing life and incurring risk is the price one pays for the chance to achieve long-term wealth.
Long-term investing success requires us to embrace risk, not avoid it, but to do so prudently. I believe that adhering to the following core principles will help anyone increase their chance of achieving investment success and avoid falling victim to misinformation and fear-driven behavior:
- Control what you can, namely cost, asset allocation, and the impact of taxes
- Diversify stocks broadly, across different markets, both international and domestic, developed and emerging
- Do not use bonds to chase higher yields; instead, hold high-quality, shorter-term bonds as a dampener of overall portfolio volatility
- Rebalance periodically to maintain your desired overall risk exposure
- Never try to guess where the market is headed. As Peter Lynch once said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
- Maintain a long-term perspective and never put money at risk that you may need for near-term expenses, expected or otherwise
- Resist the temptation to chase the latest investing fad as a response to market volatility
Several of the above principles are characteristic of a “passive” investment approach, such as that followed by index funds, that avoids making individual stock bets or trying to time the next move of the market. Most investment managers who employ stock picking or market timing strategies, known as “active managers”, fail to outperform passive managers over time. While there may exist at any given time some active managers who do outperform, whether through luck or true skill, this is of no help to an investor because it is impossible to identify these managers in advance. Owning passively managed mutual funds, such as those from Vanguard or DFA, is the most practical way for individuals to implement a passive investment strategy.
Your financial success depends on sticking to the above time-tested principles. If you feel you can’t do this on your own, seek out the help of a fee-only financial adviser. Good advice is never cheap but it’s value is priceless since it will help you achieve your long-term goals while still being able to sleep well at night.