By Sean Hannon, CFA, CFP, of Covestor.com
During September, we have seen anunprecedented level of volatility in the
Dow Jones Industrial Average
. Through Sept. 22, the average daily move of the Dow hasbeen 262 points (2.34%).
The intraday swings havebeen even greater. If we look at the difference between the highprice and low price for the Dow, the average intraday swing during themonth of September has been 460 points (4.12%).
Considering thatvolatility has increased over the past six trading days, there is areasonable chance that the Dow could move a total of 10,000 pointsduring the month.
Extreme volatility offers ample opportunity forboth profit and loss. With markets swinging wildly, one must bepatient and disciplined. Look to book profits quickly andre-enter trades when the risk/return trade-off is favorable. What may looklike a foolish trade today is likely to look brillianttomorrow.
A more important lesson we can draw from thisperiod is to re-examine why we make certain investment choices.The basic investment choices can be broadly dissected into four majorcategories -- cash, bonds, commodities and equities.Across these asset classes, cash offers thelowest returns and equities the highest. As one would expect,cash offers the lowest risk while equities are the highest risk. Whendeciding where to invest your money, there are many different factorspeople will consider.
While we can run scenarios and attempt to definepeople's risk tolerance, it is often difficult to determine a concreteanswer. Most investors know that stocks offer higher returnsthan other assets and convince themselves that volatility can be toleratedas we search for higher gains. However, during chaotic markets,investors often panic, change their minds and make decisions at theworst possible time.
For this reason, I believe the mostimportant factor that should be considered is the investor's timehorizon. Funds that are needed in less than one year shouldstick with low-risk cash and fixed-income alternatives, while money that isnot needed in the immediate future should be in an equity portfolio thatemploys strategies with which you are comfortable.This distinction of time is one of the keytraps for most investors. During the height of the dot-com stockmarket bubble, I knew a very successful daytrader. After atremendous 1999, the trader had accumulated large gains and an equallylarge tax bill.
Knowing he would eventually need to pay the IRS,the trader had a certain amount of his portfolio designated for futuretaxes.
As the Internet market was hot during the first quarter of2000, this trader could not bear reducing his equity position to paytaxes. Instead, he decided to employ his capital and seek moregains. Initially this plan worked. However, by mid-March he hadsuffered losses he was unprepared to realize.
By May, he had missed filing his taxes, seen his positions decimated by margin calls and was left with an outstanding tax bill he would never be able topay. Knowing the government is not the most forgiving ofcreditors, this person has spent nearly a decade trying to recoverfrom past mistakes. How did a smart person with great experiencemake such a mistake? Faith was put in the flawed assumption thatsince equity markets offered higher rates of return, excess cashshould always find its way into the stock market. As the past few weekshave taught us, markets can act irrationally, oscillate wildly andcause frustration.
People who need of capital over short timeperiods would be better suited to reduce risk and seek safety.Those with time on their side should develop a strategy, execute it inthe markets and allow the strategy to deliver gains.
Constantlyreworking your risk tolerance, time horizon and investment goals willoften cause you to make poor decision at inopportune times.
Forthis reason, I recommend investors with a lengthy time horizon create aportfolio that balances risks across investment choices while stilloffering upside investment return. At the moment, construct aportfolio with 10% commodity weighting via the
, a group of well-priced value stocks with attractivedividends;
Bank of America
, and a small portion of your assets dedicated to long-term growth companies such as
Research In Motion
Such a diverse asset mix should provide current income, offer diversification and lean toward growth when the market begins recovering.
At the time of publication, Hannon was long DBC, BAC, GE, XTO, AAPL and RIMM.