Beginner’s Guide to Market Volatility

Recent market moves are a 'swift kick in the butt to remind investors' of a key lesson, says wealth manager

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Key Points
  • To avoid big drawdowns in your investments, financial advisors recommend building a broadly diversified portfolio.
  • A "core and satellite" approach allows you to make a few bets without sacrificing portfolio stability.

The stock market has been on a bumpy ride to start the year. At current prices, the S&P 500 sits about 14% below its high on January 3.

That puts the market in correction territory, defined drop of 10% or more from recent highs, but short of a bear market, which begins after a sustained 20% drop.

Your portfolio may be feeling even greater whiplash. Consider the following tweet from Ben Carlson, author of "A Wealth of Common Sense," which pointed out that as of Feb. 3, investors holding a portfolio of the small-company stocks had, in fact, experienced a bear market when the broad stock market was only in "minor correction" territory. Facebook holders, meanwhile, were in the midst of a full-on crash.

Different parts of the market have shifted around a bit since then, but the overall point stands. Even when the overall market is behaving one way, pockets of the market can behave radically differently. And if you have high portions of your portfolio dedicated to a particular kind of asset, you could suffer big losses that could derail your plans.

Over the long haul, every investor is going to suffer short-term losses. To avoid the kind that can send you into a panic, however, financial advisors recommend spreading your bets across a variety of investments.

Volatility in early 2021 "was a swift kick in the butt to remind investors that overconcentration in a single stock or crypto can lead to significant, painful losses that may not rebound quickly, as we have seen from Zoom and Peloton to bitcoin — as compared to minimal drawdowns in a diversified portfolio," says Jon Ulin, a certified financial planner and CEO of Ulin & Co. Wealth Management in Boca Raton, Florida.

Why it's so important to diversify your investments

The bulk of your retirement portfolio belongs in a diverse array of investments, experts say. By avoiding putting too many of your eggs in just a few baskets, the thinking goes, you capitalize on the historical upward trajectory of the stock market while limiting the chances that any one single investment could drag down your portfolio.

If you've just begun investing, a good place to start might be a target-date fund, suggests Ashley Folkes, a CFP and director of growth strategies at Bridgeworth Wealth Management in Birmingham, Alabama. These funds hold a diversified mix of investments that grows more conservative as you approach the date you intend to retire.

"It's a good way to for somebody just getting into investments to do it, especially if they don't have a lot of money to spread around," he says.

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When it comes to diversifying among your stock holdings, many target-date funds follow a pattern you can replicate through purchasing low-cost ETFs, holding a mix of large and small companies, fast-growing and value stocks, and foreign and international names.

"We want negative correlation in our portfolios," says Michelle Petrowski, a CFP with Being in Abundance in Phoenix, Arizona. That means you want investments that move in different directions in different market conditions.

Sound counterintuitive? Petrowski suggests looking at a chart of historical returns among asset classes, such as Callan's Periodic Table. The lesson that becomes apparent: In any given year, some corner of the market is working better than others. And you want exposure to all of it.

Why to avoid overconcentration

There is no doubt that putting a significant portion of your assets in a single investment that pops can make you rich. But if the one horse you've bet on stumbles, your portfolio could take a hit.

Such drawdowns can cause permanent damage to your portfolio, either because a big loss causes you to panic and sell before the investment has a chance to bounce back, or because a particular investment doesn't rebound.

Still, just about every investor has one or two investments they're convinced are the Next Big Thing. If you fall into that camp, Folkes recommends a "core and satellite" approach by parking the majority of your money in a highly diversified portfolio and opening a smaller, side account for the individual investments you believe in.

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When market downdrafts inevitably come, you can stick to business as usual in your diversified core account, investing regularly in a move known as "dollar-cost averaging" to buy more shares of your investments when they're selling for cheap.

As for your satellite, things going south is reason to re-examine the long-term thesis behind your investment. "Ideally, you fill this account with high-conviction investments that you believe in and won't panic when they go down," says Folkes. Ultimately, though, because you're only speculating with a small portion of your portfolio, you don't run the risk of throwing off your retirement plans because a bet you made didn't work out.

No level of diversification or asset allocation can ensure profits or guarantee against losses. The views expressed are generalized and may not be appropriate for all investors. Carefully consider your financial situation, including investment objective, time horizon, risk tolerance, and fees prior to making any investment.

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