When the stock market is running very hot or very cold, it is on everyone’s mind and few conversations last very long before turning to the latest numbers.
Whether it is the dot.com boom of the 1990s or the credit crisis of 2007, when the market is erratic and volatile, people are engaged.
The factors that lead to a boom-bust cycle in the market are important. Investment professionals and regulators spend a great deal of time trying to understand what happens in the market during these periods.
Individual investors have little influence on the market. While it is important to understand what happens and why, that is not the most important consideration for individual investors.
The most important influence on how your portfolio performs is how well you have prepared it. Preparation is the only factor you can influence.
Preparation means adopting a reasonable allocation between stocks, bonds and cash. It also means diversifying you holdings by industry sector, company size and growth and value stocks.
Most investors should consider a bond allocation equal to their age. For example, a 45 year-old investor should have 55 percent in stocks and 45 percent in bonds.
You can’t know with any assurance which turns the market will take – even industry professionals don’t know.
However, if you have five or more years before you need to convert holdings to cash, the odds are good that your portfolio will do as well as possible if you maintain a reasonable allocation.
There are no guarantees in investing. You assume that over the long-term your holdings will grow, however an assumption, even one based on historical truths, is not a guarantee.
Establishing an allocation and maintaining it is a challenging exercise. Here’s why:
Assume your allocation was 60 percent stocks and 40 percent bonds. If stocks are shooting up, the temptation is to put more money into the hot side of your allocation – ride the gains up.
What this often means is investors pay inflated prices. When the boom collapses as they all do, investors are either stuck with stock worth much less than they paid or they bail out with a loss.
The rational way to approach a rapidly expanding market is to watch your allocation and when it becomes out of balance, sell off stocks and add to bonds. This may let you take profits, but you may miss out on some future gains.
In a rapidly dropping market, investors should consider buying stocks to maintain balance. You may be able to buy stocks at depressed prices, which increases the odds of significant gains when the market returns.
Many investors would find their losses were lower and their gains higher if they would maintain a reasonable allocation regardless of what the market does.
If you can take a long-term approach, you could look at your holdings once a year (or maybe once a quarter in very volatile markets) and make adjustments.
The remainder of the time avoid the temptation to buy during a boom or sell during a bust.