Investing in volatile times

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From the Merrill Edge Minute e-newsletter.

Key points

  • As an investor you need to understand and control your own response to market volatility
  • Stay flexible, rebalance when necessary, maintain a sense of the big picture and understand your risk tolerance
Dramatic shifts in the market can make even the most seasoned investors uneasy. "When there is uncertainty due to nerve racking political or economic news, moment-to-moment information feels extremely important, and investors feel compelled to act on it," says Michael Liersch, head of Behavioral Finance and Goals-Based Consulting, Merrill Lynch. While your impulse might be to resort to panic selling or bold buying when the market is volatile, such risky behavior can be harmful to your portfolio. Fortunately, you can take simple steps to help you respond to volatility in a more considered way and maintain focus on your long-term goals.
Remember the big picture. If you're tempted to sit on the sidelines with cash until the markets are calmer, remind yourself why you're investing. "You may feel uncomfortable with the current market, but it's worth remembering that your goal, such as investing for retirement, may require you to stay invested," Liersch says. If you jump in and out of the market trying to time your moments to the market's peaks, you may miss out on possible rebounds.
Re-evaluate your risk tolerance. "If the potential for a large drop in an asset feels like too much of a risk or if you tend to be a reactive investor, consider reducing your allocations in investments in which you hold a concentrated position, such as company stock," Liersch advises. Also, take into account that the weak economy has created risks where none were perceived before. "The old rule of thumb was that muni bonds were a riskless investment with little probability of default, but that's not the case anymore," Liersch says. "You need to examine the risk of every investment you make today." That may mean adding low-volatility stocks or more diversification to your portfolios in exchange for potentially lower returns.
Pace yourself. You don't have to invest your money all at once. Dollar cost averaging,Footnote 1 in which you invest cash a little at a time at regular intervals, can prevent you from making rash investing decisions. "With dollar cost averaging, if the investment goes up, you will feel you took advantage of that upswing," Liersch says. "And if it goes down, you will feel you have an opportunity to buy at a lower price."
Stay flexible. Unlike mutual funds, exchange-traded fundsFootnote 2 (ETFs) can be bought and sold throughout the investing day and will fluctuate in value based on market conditions. Some ETFs also mimic particular hedge fund strategies, which aim for a low downside capture ratio, minimizing losses when the market drops, which could dampen the volatility in your portfolio. Note, however, that this approach may limit gains when the market rises.
Explore alternative perspectives. "Considering opposing points of view when making decisions about investments — called behavioral arbitrage — can help you evaluate potential opportunity," Liersch says. By taking this contrarian approach, you may be able to find value when perceptions — rather than fundamentals — are driving market prices. Of course, markets can remain mispriced for long periods of time, so knowing both your psychological and financial ability to stay the course is critical.
Revisit your portfolio periodically. Even if volatility doesn't faze you, it's crucial that you revisit your portfolio regularly during periods of heightened market activity. "During extreme volatility, different investments become heavily overweighted or underweighted because the prices have been changing so dramatically," Liersch explains. "You should consider rebalancing so you're not over- or underexposed to one asset class or investment — so you're back in line with your original target allocations." Don't confuse rebalancing with market timing, he warns. Rebalancing is about reallocating your asset mix to reflect your original investment strategy; it's not about changing your asset mix to try to chase returns by timing market ups and downs.Footnote 3
When markets are highly volatile, investors who focus on achieving the highest returns possible often take unnecessary risks, Liersch says. "Knowing your investment personality and the goals you want to accomplish will help you choose an appropriate strategy that volatility can't derail." Understanding yourself as an investor and planning for times of economic uncertainty can help you stay the course when the markets are anything but smooth sailing.
Next steps

Footnote 1 A periodic investment plan such as dollar cost averaging does not ensure a profit or protect against a loss in declining markets. Such a plan involves continuous investment in securities regardless of fluctuating price levels; investors should carefully consider their financial ability to continue their purchases through periods of fluctuating price levels.

Footnote 2 Exchange-traded funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. You should carefully consider the investment objectives, risks, charges and expenses before investing in this product. This and other important information is included in the prospectus, which should be read carefully before investing. Prospectuses can be obtained from your investment professional or through the investor's sign-in area of

Footnote 3 Rebalancing may trigger a tax event.

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

Neither diversification nor rebalancing ensure a profit or protect against loss in declining markets.