22 Jun

I’ll Huff, and I’ll Puff, and I’ll Blow Your (Investment) House Down!

June 22, 2012

Okay, I agree with you. Over the last few months the stock market has been volatile and uncooperative. Does this mean you should panic? Probably not. Does this mean that it may make sense to talk to your advisor about your allocation? Maybe. One thing I do know is that risk and return are related, and eventually, the price investors pay in volatility will ultimately pay dividends in the form of wealth. So, how can you deal with the never-ending barrage of negative media headlines while maintaining your financial house? Let’s talk about it.

Pretend for a moment that you own an investment property that pays you a 10% annual income. You have assigned a value to your property based on a combination of: 1) what you paid for it, 2) what you think it is worth, and 3) what the tax assessor says it is worth. Now assume that I tell you that you have to sell your property by 11:59 tonight. How would you price it? Would you price it based on what you think it is worth, or would you price it because you have to sell it? Would it make any difference if I told you that not only do you have to sell at 11:59 tonight, but conditions for showing your property will not be cooperative? The weather forecast calls for high winds. How would you price the property now? Realizing that time would quickly run out during the day, any individual would price the property to sell; that is, price it low to attract many buyers.

Just like this example, the stock market has a closing time each day. Throughout the day, willing buyers and sellers negotiate prices to complete a transaction. Some sellers may realize they need short-term cash flow for income or unexpected expenses. Because of this need, they may ultimately sell at a price that may not equal what they thought the investment was worth. Other individuals that have a longer term focus may not have the same short-term cash needs, and as a result, do not have to accept short-term actively traded prices. Even if the market fluctuates a few percentage points each day, long-term investors can accept the volatility (price movements) in hopes of prices eventually increasing (i.e. more buyers buying than sellers selling). This is what creates positive investment return.

The bottom line is that investors who have short-term cash needs will likely need an allocation of bonds in their portfolio to provide a vehicle to sustain cash flow during periods of negative returns. By having bonds in a portfolio, there is no need to accept a short-term stock price and consequently, sell low. For investors that are more aggressive and have no bonds within their portfolio, there is no need to panic, sell low, and miss out on opportunities going forward.

My advice, be a strategic little piggy. Don’t let the big bad wolf of investor emotion blow down your strategy, because your allocation is built like a solid brick house.

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