The secret to investing in the stock market is to buy low and sell high. Unfortunately, many investors found themselves doing the reverse — jumping out of the market near its low in March 2009 and then missing the rebound that followed.
Lately, the stock market’s behavior has been dicey at best. Since no one can pinpoint the exact moment that market volatility will subside, now may be as good a time as ever for those on the investing sidelines to wade back into the fray. Starting with a solid plan may help allay fears.
These six strategies can help you manage downturns while investing for your goals.
Boost emergency fund
Depending on your investment plan and time horizon, seeing your stocks sink can be a scary feeling.
To avoid feeling as though your financial future is going down the drain, keep plenty of money in an emergency fund.
“If you anticipate needing that money in two years or if you might need living expenses, you should have at least a year, maybe two years’ worth of living expenses in money markets or CDs that you can draw on,” says Ilene Davis, a Certified Financial Planner in Cocoa, Fla.
If you know your cash needs are taken care of in the short term, it’s easier to relax and let your long-term investing work.
Design a plan
A stable financial plan will take stock market volatility into account. Whether you’re running your own investment plan or hiring an adviser to do it for you, understanding your emotional fortitude, investing objectives and time horizon will help shape the plan.
“Investing should not be emotional. It should be very rational and it should key off of a financial plan,” says David Keator, partner at the Keator Group, a wealth management firm in Lenox, Mass.
The world has no shortage of investing theories. Finding one that suits you and sticking with it is the key to making your plan work.
Asset allocation goes a long way toward managing risk. Bankrate’s story, “How to build a sound portfolio,” shows different strategies depending on your investment objectives.
Consider risk tolerance
If you’re the type to fret during times of stock market volatility, it won’t matter if you can double or triple your money in a particular holding because you won’t make it to the end — at least not with your sanity intact.
A financial plan only works when you can stick with it.
“It’s not necessarily about just rate of return, but also hitting your objectives and making you emotionally be sound regardless of what is happening in the macro environment,” says Julie Murphy-Casserly, founder of JMC Wealth Management in Chicago and author of “The Emotion Behind Money.”
Dollar cost average
Instead of going in whole-hog, most experts recommend dollar-cost averaging your way back into the stock market.
“If you put it all in on one day, the market will probably go down 500 points right after that,” Davis says.
Besides warding off stock market calamities, dollar cost averaging allows you to buy more when the price is lower and takes the sting out of buying higher-priced shares.
“Mathematically, when you dollar cost average, your average price will always be lower than the average price of a particular security. (That’s) because you’re buying more units when the price is lower and fewer units when the price is higher, so you end up with a lower cost overall,” says Keator.
Whether it’s through dividend reinvestment or regular contributions from your paycheck, dollar-cost averaging takes the pressure out of finding the right time to buy.
For investors that buy individual stocks or ETFs, placing a stop-loss order on the position can mitigate the downside when the stock market goes down.
It’s basically a preset sell order that is triggered when the stock goes below a certain price. Be careful, though. Sometimes events can happen too fast for them to be very effective. The flash crash from May 6 is a case in point.
“It’s not foolproof, but it’s something that you use as a piece for protection in a portfolio,” says Keator.
Again, for those who invest in stocks or ETFs, options writing may offer a defensive strategy.
Buying puts can be useful in addition to covered call writing in a volatile stock market.
A put is basically insurance.
“If you are long equities and you want to protect those equities, you can buy a put on a security and that is like buying an insurance policy. If the stock goes down, you then have the option as the owner of the put to sell that stock at a predetermined (strike) price. So if it goes down lower than your put, you are actually making money,” Keator says.
He stresses that it’s important to have cash backing the puts to keep your risk defined.
Writing, or selling, a call means that you own a security or index and you’re willing to sell it by a certain date at a certain price that’s higher than the price at which you bought it.
Options trading is a sophisticated strategy, but it may protect you from losses when done correctly.