Wednesday, September 12, 2007

Investing in Volatile Times

With the markets turning bipolar, and a bank or two being bailed out every week, investors are understandably nervous. Different asset classes take turns losing value. Investments thought to be safe, like money market funds, turn out to hold asset-backed commercial paper, a security some now deem toxic. Information about the extent of the subprime mortgage and related messes is inadequate. In these times of confusion and incomplete information, many market participants may be buying and selling for the wrong reasons. That only increases the seeming irrationality of the markets.

What’s an investor to do? Here are a few ideas.

1. Diversify. If you can’t reasonably predict which assets will rise and which will fall, diversification allows you to use gains from rising assets to offset losses from falling assets. Your portfolio’s volatility will be muted, and your antacid budget reduced. Diversification is also the sensible way to invest for the long term, so you’re doing your retirement planning a good turn.

2. Dollar-cost averaging. A standard investment technique is to invest a fixed amount of money at regular intervals. The bi-weekly or monthly contribution you make to your 401(k) or equivalent retirement account is a good example of this approach. By investing a fixed amount at regular intervals, you average out the costs of your investments and avoid the risks of trying to time the market. Most investors (and many professional money managers) are not very good at timing the market. Given the long term historical rise of the stock markets, it makes sense to stay in the game. Dollar-cost averaging ensures that you do so without having to guess which fork in the road the market will take tomorrow.

3. Ease back from 80 mph. Another way to reduce the volatility of your portfolio is to make it more conservative. Stick to well-established investments built around benchmarks you understand—index funds, short or medium term bond funds, and money markets. Or go with a lifecycle or target date retirement fund. These funds are long term investment vehicles where the fund managers do the diversification for you. Because they are retirement-oriented, they generally aren’t loaded with risk. Instead, they tend to stick to meat-and-potatoes funds for their equity exposure. See our discussion of lifecycle funds at Conservative investments may, in fact, do well in the next few years. Risk is being re-priced, and low risk investments may be relatively valuable for a while.

4. Save whichever way you can. If you really can’t stomach the ups and downs and uncertainties of the financial markets, put your money into safe, short term investments like money market funds, credit union and bank CDs, and high interest rate online bank accounts. See our earlier blog for suggestions about short term investments. If you’re concerned about interest rates dropping, buy a CD with a term of several years, or U.S. Treasury notes with similar maturities. That way, you’ll lock in current rates. This strategy could turn against you if interest rates rise (which isn’t forecast by most seers, but the one thing that’s certain is you never know for sure). With the uncertainties of the times, ensuring that you save, however conservatively, remains a smart move. If the only way you can bring yourself to save is to put your money into today’s equivalent of the mattress, then go for it. Maybe, when things calm down a bit, you can diversify. But the worst thing to do is to stop saving.

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