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Oops -- investors on Friday made a $400 billion mistake. That's the amount by which they left the U.S. stock market underpriced over the weekend, judging by Monday's dramatic 3% rise in the Dow Jones Industrial Average.
Of course, anyone who thinks Monday's spike was merely a sober reaction to changes in the appeal of shares should write financial headlines. A big part of the job is finding tidy explanations for frantic behavior: "Stock Soar On [Whatever Happened Today]."
Maybe stocks have been spasmodic of late because investors are caught between punitively low rates on short-term savings and a darkening outlook for company profits (see "Why the Stock Market Has Turned Bipolar"). Or maybe high-frequency trading has turned the system screwy (see "Is the Stock Market Still Fair?") There could be a cause that's not yet fully understood, involving, cell phone radiation and high-fructose corn syrup. Personally, when I'm unsure I always blame the baby boomers.
While we're trying to figure out the cause of recent volatility, here are some steps worried investors should take.
1. Keep a historical perspective.
It's true that stocks have swung more wildly since summer than they did in the spring, and that this year looks kookier than last. But we're not in new territory. Dramatic ups and downs have occurred less frequently of late than during the financial crisis of a few years ago, the dotcom stock bubble that popped in 2000 and, of course, the Great Depression, which was such a big deal that it gets capitalized in print.
There's some statistical evidence that, even though average volatility hasn't increased over time, the volatility of volatility itself -- the frequency of the market's fits -- is on the rise. That could mean trouble is brewing, or not. But it's no reason to reduce stock holdings to zero and load up on financially nihilistic asssets like gold.
2. Reduce your margin for error.
Monday's market gain notwithstanding, company earnings forecasts show early signs of weakening (see "Stock Forecasts Fall, Managers Go Mum"). In any market, some companies have higher share prices relative to their expected earnings and some companies have lower "price-to-earnings" ratios. If next year's earnings disappoint, as I suspect they will, the latter should have less to lose because muted expectations for growth are already built in to their valuations.
Value stocks have historically tended to outperform during economic downturns. The 2008-2009 crisis was one exception, because banks went from looking cheap to becoming much cheaper as their profits disappeared. The best approach for nervous investors now is to focus on value stocks, excluding banks. For some examples, see the 10 stocks I listed two weeks ago that have low P-E ratios, healthy dividend yields and some other promising signs (see "10 Cheap Stocks With Dependable Earnings").
3. Average your costs.
Investing money in periodic, regular amounts is a good way to keep your purchase prices down, financial planners like to say. They're wrong. It's true that "dollar cost averaging", as it's called, gets an investor more shares when prices are low and fewer when prices are high. But, despite the experience of the past decade, it's also true that the market generally goes up over time. Mathematically, the power of a rising market has historically offset the savings of dollar cost averaging and then some. So decide on an asset allocation that's right for you and then put your money to work.
But there are two methods of cost-averaging you should take advantage of. First, favor stocks that pay dividends, and then reinvest the payments into more shares of those stocks (companies from the aforementioned list will do nicely). An investor who continuously invests an incoming cash stream is poised to take advantage of market volatility rather than just endure it. Second, if you're lucky enough to have a workplace retitement account with an employer match on contributions, take advantage. The match is probably the best investment return going.
4. Reconsider your risk and reward assumptions.
If you're still waiting for the stock returns of the 1980s and 1990s to reappear, stop. During those years stocks did twice as well as normal, on average. Plenty of economists think even the concept of "normal" needs a reset. U.S. stocks returned about 7% a year after inflation over the past two centuries, but that period saw America's rise from a farm economy to the richest nation on earth. Growth in coming decades might be more modest, not least because the country has been on a borrowing binge that will need to be wound down.
Expect 4% to 5% for yearly stock returns, most of it from dividends. If you get more, you'll be pleasantly surprised, and if not, you'll hopefully have made the savings and planning adjustments to compensate. One implicaion of lower long-term returns is that it's more important to not suffer sharp losses, because it might take longer to make that money back. That means you might want to reduce your stock allocation--not drastically, but a bit. Monday's market jump offers just the opportunity.
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