It’s only natural to feel anxious when the stock market drops or spikes too fast. The stock market has been stable for so long that many of us aren’t used to the volatility anymore. I wrote this post the last time (2016) the stock market had a correction (10% decline from the peak) and it still applies. Today, I’ll rewrite the post with updated data. When the market is volatile, it’s best to focus on increasing your saving rate. This is especially true when you have 5 or more years left before retirement.
New investors tend to fixate on finding the “best” investments, but what they really should focus on is increasing their saving rate. Most people can increase their saving rate by 10 to 20% without a drastic change in lifestyle. On the other hand, it’s very difficult to beat the market consistently and increase your rate of return. When you’re starting out, your portfolio value will be relatively small and increasing your saving rate will have a much bigger impact than increasing your ROI (return on investment).
Let’s say your portfolio is worth $100,000. If you increase your ROI by 2%, that’s only $2,000 extra. It is probably much easier to cut back a bit and focus on investing $2,000 extra instead. Your saving rate is directly under your control, but the stock market is out of your hands, as the recent volatility illustrated.
When I was new to investing, I tried to pick the “best” investments. I did it all wrong, though. In my 401k, I picked the funds with the highest returns from the previous year. I didn’t know that over 90% of actively manage funds underperform low cost index funds over the long term. I also didn’t know that the stock market is cyclic. The best funds from one year probably won’t be able to repeat their performance the following year.
In my brokerage accounts, I purchased speculative tech stocks because the price kept increasing. This didn’t turn out well because a few years later, the dot com bubble popped and my portfolio crashed along with Pets.com. While experience is the best teacher, I still wish I had taken the time to learn about investing earlier to avoid those pitfalls. It sure wasn’t fun to go through those stressful periods.
That’s why I encourage everyone to start investing as early as possible. It can take many years to form an investing strategy that you’re comfortable with. You need to go through a few market cycles to see how you will react to the gut wrenching drops. Here is the investing strategy that I can live with through the ups and downs. It works for me, but it might not be the right fit for you. Everyone needs to find their own investing strategy.
- All of our retirement funds are invested in low cost index funds. This is the core of our investment portfolio.
- Our taxable account is mostly invested in high quality dividend stocks. Most of these companies should be able to maintain their dividend payout during a downturn. The price may drop, but quality stocks should come back when the market recovers.
- I have a few speculative investments to keep life interesting. This is a very small part of my portfolio.
- 20% of our investment portfolio is in bond funds. If the market drops further, I will have the option to trade some of these in for stocks.
- We have alternative investments in rental properties, REITs, and real estate crowdfunding. These investments provide some stability when the stock market is volatile.
With this strategy, we don’t have to worry about how the stock market is doing and we can just focus on saving as much as we could. In the short term, our portfolio will gyrate wildly along with the stock market, but it should be fine over the long term. Our net worth didn’t drop as much as the stock market because we have alternative investments to help cushion the sharp decline.
Let’s see how we did during the recent stock market correction.
Personal Capital made it easy to compare our portfolio against the S&P 500 index. The S&P 500 index fell 10% in about 2 weeks. Our portfolio dropped too, but not as much. This is due to the stabilizing influence of our 20% bond allocation and 10% alternative investments. (This chart doesn’t include our rental properties.)
It’s interesting to see how investors reacted to this latest correction. Some investors got scared and wondered if they should sell some stocks. Many investors took the advantage of the dip to buy more stocks. I didn’t do much except making the regular contribution to my 401k. After 22 years in the stock market, I don’t get excited by 10% anymore. I’ll consider buying more after it drops 20%.
BTW, don’t forget to increase your 401k contributions. The 401k contribution limit increased $500 this year. You should max out your 401k contribution every year. It’s the easiest way to build wealth over the long term.
When the market fluctuates like this, it’s best to ignore the movement and focus on increasing your saving rate. It’s actually really good for long term investors when the stock market drops. We can buy more shares for the same amount of money we regularly invest. This is a good buying opportunity for young investors who have a lot of time left. The market will recover and your portfolio will benefit from these gut wrenching drops. Once you’ve gone through a few of these, you’ll learn how to ignore the short term volatility.
This kind of volatility is much harder for investors who are very close to retirement. If you need to start withdrawing from your retirement fund soon, you’ll need to be more conservative. Now is the time to check your risk tolerance. It will be different than when you have many years of work ahead of you. For those near retirement, it’s best to be a little more conservative. Here are some steps you can take.
- A bigger cash cushion. A retiree should have at least 18 months of cash. This cash cushion would help you ride out most bear markets. Retirees need to fund their cost of living and it’s best to avoid selling when your investment is down. The average bear market lasts for 15 months.
- Double check your risk tolerance. Most people become more conservative as they age. Retirees need to ask themselves if they can stomach a 40% drops in the stock market. How will this affect their net worth? If not, then they will need to fix their target asset allocation.
- Consider funding your core expense with very safe investments. If you’ve saved enough, you can use safe bond investments to fund your core expenses. This will decouple your core expenses from the stock market.
Focus on your saving rate
Investing isn’t that difficult. You just need to come up with an asset allocation you can live with and stick with it. This can be challenging for young investors because a big drop seems scary. However, it’s best to keep investing because your portfolio will benefit in the long run. Focus on increasing your saving rate and ignore what the stock market is doing day to day. Everyone who has been through some crashes knows that you need to keep investing through thick and thin.
When I started investing, I focused a bit too much on maximizing the ROI and made many rookie mistakes. Nowadays, I just focus on my saving rate without worrying too much about ROI. I just need to keep investing through all market conditions. It’s simple and stress free.
Did your portfolio fluctuate much over the last few weeks? What’s your strategy for getting through the stock market roller-coaster ride?
*Sign up for a free account at Personal Capital to help keep track of your investment. I log in almost every day to check on my accounts and cash flow. It’s a great tool for DIY investors and I highly recommend it.
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Image by Tim Gouw
For 2018, Joe plans to diversify his passive income by investing in US heartland real estate through RealtyShares. He has 3 rental units in Portland and he believes the local market is getting overpriced.
Joe highly recommends Personal Capital for DIY investors. He logs on to Personal Capital almost daily to check his cash flow and net worth. They have many useful tools that will help every investor analyze their portfolio and plan for retirement.
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