How to Ignore Market Volatility

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The following guest post comes to us from Rob Berger, the founder of the popular personal finance blog, The Dough Roller. It’s an honor to have him guest posting on our site today! Enjoy the article!

“We have met the enemy, and he is us.”— Pogo

You’re no doubt familiar with the above quote. It comes from a comic strip character, Pogo, created by cartoonist Walt Kelly. The quote appeared in an anti-pollution poster on Earth Day in 1970. And boy does it apply to investing as well as the environment.

Study after study shows that investors are their own worst nightmare. We buy when the market is on the rise with big fat dollar signs in our eyes (investing can be addictive!), only to sell when the market goes down out of gut-wrenching fear. In other words, we do exactly the opposite of what famed-investor Warren Buffett preaches:

Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.

—— Warren Buffett in his 2004 Berkshire Hathaway Chairman’s Letter.

Of course, buying in down markets and selling in up markets is much easier said than done. Having managed my family’s investments now for twenty years, here are some tips on how I ignore the market’s ups and downs.

Asset Allocation:

Having a sound asset allocation (think stocks versus bonds) won’t insulate you from market losses. In fact, with any asset allocation that includes equities and debt, periodic losses are certain. But, a portfolio consistent with your investing goals will give you confidence that over the long run, your investments will grow.

The single biggest asset allocation decision an investor will make is how much to invest in stocks and bonds. As an investor nears retirement, his or her exposure to equities should give way to more bonds and fixed income securities. Taking unnecessary risks often cause investors to react negatively to market volatility.

Index Funds:

Over the long term, index funds generally outperform managed funds. They are also less expensive. And these are the two reasons index funds and ETFs are trumpeted as the preferred investment vehicle. But there is another reason to favor index funds—stability.

Managed funds depend on the stock-picking prowess of the fund managers. If these funds start to underperform the market, investors often sell and search for a different manager. This realization led me to leave Bill Miller’s Legg Mason fund in the 90’s when it was still trouncing the S&P 500. I knew his winning streak couldn’t last forever, and I didn’t want to sell when the fund was taking a dive. So, I moved my money to an index fund.

With index funds, there’s never a concern that poor performance is the result of human error. Knowing that the fund simply tracks an index can help an investor stick with the fund through thick and thin.

Minimal Debt:

This may seem out of place, but I’ve found that too much debt can cause some to make bad investing decisions. Particularly for those nearing retirement, too much personal debt may cause investors to sell investments in retirement accounts at any sign of a market decline. A family member of mine with significant debt made this exact move following the market declines in 2008. The result was that she missed out on the market gains in 2009. And, this move was made shortly before her retirement.

Low Investing Costs:

Finally, keeping investing costs down can help investors stick with their investing plan. Of course, low costs are important in their own right. But, I’ve found that investors who put cash in high cost mutual funds are more likely to sell when the market declines. These high costs may seem palatable when the market is on the rise and the fund is booming, but they sour quickly during a bear market.

As a rule of thumb, I try to keep the weighted average cost of investing below 50 basis points (0.5%). With ETFs and index funds, the cost of investing can be even lower. And for stocks, I always trade with an online discount broker (Scottrade is my choice, but there are number of good options).

How about you all? How often do you keep track of the overall position of the market? Does it bother you to find out the market has decreased several percentage points in a day, or do you shrug it off pretty easy?

Do you find yourself falling prey to selling when the market is low and buying when it is high?  What techniques do you use to maintain a long term investing perspective and not allow sudden dips and increases in the market bother you?

Share your experiences by commenting below!

Jacob’s Thoughts – Listed below are my random thoughts as I was reading this article.

• @ Investors being their own worst enemy –
• Thanks so much for sharing this article with us Rob!
• As a big fan of passive investing myself, I am a believer that for the majority of individuals, selecting individual company stocks to buy and sell (or buying in to a mutual fund that picks individual stocks in an attempt to “outperform” the market) will ultimately result in a loss of money in the long run.
• As Rob mentions, this often happens because investors are not confident enough in their investment selection in order to stick with it once they start to lose money. 
• @ Warren Buffett –
• It’s no secret that Warren Buffett is arguably one of the best (if not THE best) individual stock investors of all time. 
• However, in a quote I found while putting together the Festival of Frugality in September of 2010, he mentions that even though he does not believe the market is ALWAYS efficient, he does believe that the majority of individuals would be better off buying an index mutual fund instead of trying to buy/sell individual stocks.  
• @ How to determine your asset allocation –
• Determining the appropriate asset allocation for your personal situation is a big decision. There’s no way around that. 
• One exercise that helped me to develop my investing strategy was to consider having a $100,000 investment. From there, ask yourself how much of that investment you would be able to emotionally tolerate losing in a single year time period?
• Your honest answer to this question will help you take the first step in determining an appropriate level of fixed income asset allocation. 
• @ People in debt investing significant amounts of money in stocks/mutual funds –
• I would definitely agree that people that have large amounts of debt would be more prone to overacting to market downturns by selling prematurely. 
• This is logical, since I’d imagine that people in debt would have less of a safety cushion as far as how much money they can afford to lose temporarily.
• I think it’s also important to note that if people are in large amounts of debt (particularly credit card debt), they should remember the account hierarchy priority order of financial needs and make sure to save up enough money for a cash emergency fund prior to investing significant money in stocks. 
• @ Choosing an online discount broker for trading individual stocks and ETFs –
• When I first started investing, I was a customer of Scottrade for several months.
• However, I found their trading fees/commissions ($7 per trade) to be higher than Sogotrade ($3 per trade) and Zecco (the ones I currently use, if I use any play money to invest in individual stocks). 

***Photo courtesy of http://www.flickr.com/photos/rwhitlock/4931419824/sizes/l/in/photostream/