Investing in volatile times: A tale of two investors

Text size: aA aA aA
A tale of two investors in volatile markets
See why staying invested in a diversified portfolio has the potential to produce higher returns.
From the Merrill Edge Minute e-newsletter.

Key points

  • Being overly conservative or taking too many risks can reduce your returns by up to 5%
  • Trying to time the market can result in selling stocks at low prices and buying them at high prices, which could result in subpar performance
  • Sticking with an appropriate asset allocation for your goals can help you stay on track in uncertain markets
  • Get investment strategies to use in changing markets
No one wants to lose money. Yet investors can give up an estimated 2% to 5% in returns every year by being either overly conservative or taking too many risks, according to research tracked by Michael Liersch, head of behavioral finance, Merrill Lynch Wealth Management. "Investors often react to market volatility with surprise," says Liersch, "causing them to freeze and do nothing or overreact and make emotional decisions."
When you are new to investing, it can be a challenge to understand changing market conditions. But the fact is market movements have always been unpredictable. That's why looking at historical patterns can help you understand the possible risks of making portfolio changes in response to the market's ups and downs. Below, find out how different responses to volatility in the especially dramatic period of market swings between 2008 and 2014 played out for two hypothetical investors who are investing for retirement.

Two investors. Two reactions. Two results.

To illustrate the possible risks and rewards of different reactions to market volatility, consider Bob and Diane. Both investors had the article about financial capacity to take on a moderate level of risk and were comfortable doing just that, when they first invested in October 2007. Likewise, they had handled their investment portfolios in a similar way, checked their portfolios regularly and maintained their original target asset allocation prior to September 30, 2008, when the financial crisis was at its most extreme.Footnote 1
Comparing two volatile market investors

Bob gets cold feet and pulls back

Bob is an example of a reactionary investor in volatile markets Watching the stock market index fall throughout September 2008, Bob was very worried about potential losses and continued turbulence. So, on September 30, after seeing the Dow's biggest one-day point drop ever, he adjusted his portfolio mix to a more conservative asset allocation of 20% stocks, 55% fixed income and 25% cash.
Bob adjusts his portfolio allocation based on market changes

Diane stays the course

Diane is an example of a steady investor in volatile markets Although Diane was also uneasy when she saw the market falling, she reminded herself that she was investing for the long-term and that her reasons for making that investment selection still fit. So, she decided to maintain her original asset allocation throughout the rest of the bear market and the bull market that followed.
Diane doesn't adjust her allocation based on market changes

Bob misses the rebound

Against the backdrop of a falling stock market, Bob's switch to a more conservative asset allocation may have looked smart at first. But after the market bottomed out, and then eventually surpassed its previous highs, his low allocation to stocks limited his portfolio's growth.
Bob didn't know when to get back into the market and therefore never realigned his portfolio with his pre-2008 investment goals and target asset allocation. By the end of 2014, his balance was $121,895. Although Bob's portfolio was worth about 22% more than its original value, it was a smaller gain than Diane achieved.
Bob misses the market rebound
Bob's 12/31/14 balance: $121,895

Diane comes out ahead

Because Diane held firm in her original asset allocation and long-term investment goals, she was in a position to benefit when the stock market recovered. By the end of 2014, Diane's portfolio had gained more than 50% of its October 2007 value, with a balance of $154,930.
Diane benefits from keeping her allocation steady
Diane's 12/31/14 balance: $154,930

Lessons learned

After more than seven years, although both Bob and Diane earned positive returns on their initial investments of $100,000, Diane's portfolio performed much better.
Diane's steady portfolio comes out ahead
In some cases — such as when an investor is nearing retirement and doesn't have time to wait for markets to recover — staying the course may not be practical. But for long-term investors, sticking with an appropriate asset allocation through volatile times often makes sense. Taking that approach may help you coolly and rationally pursue your investment strategy without losing ground over time.
Next steps

Investing involves risk. There is always the potential of losing money when you invest in securities.

Asset allocation does not ensure a profit or protect against loss in declining markets.

Footnote 1 The asset classes comprising each of the portfolios used in this hypothetical example are based on the performance of S&P 500 Index (for stocks), Barclays Aggregate Bond Index (for fixed income) and 3-month T-Bill (for cash) for the time period represented. Indexes are unmanaged and it is not possible to invest directly in an index. This hypothetical example is meant for illustrative purposes only. It does not reflect an actual investment, nor does it account for the effects of taxes, any investment expenses or withdrawals. Investment returns are not guaranteed, cannot be predicted and will fluctuate. Investor results will vary and may be more or less. It is not intended to serve as investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances.

AR5Q5YKG-EXP050518