How to Lose Money in a Volatile Market

The incredible market volatility of the past few weeks has shaken the confidence of millions of investors. News of Standard & Poor's downgrading the U.S. credit rating, along with some weak manufacturing data, prompted concerns that our economy was headed for a possible double-dip recession. And while I think fears of a return to recession will turn out to be unfounded, those fears have helped crank up the stock market volatility, with the Dow Jones Industrial Average tanking several hundred points in a day on multiple occasions, marking some of the biggest one-day losses since the onset of the financial crisis in 2008. It's enough to make anyone's head spin, and a lot of folks are wondering what to do next.

Ruled by fear
Perhaps not surprisingly, many investors are responding to recent volatility by heading for the exits. According to data from the Investment Company Institute (ICI), investors pulled a net $23.5 billion from U.S. equity funds in the week ending Aug. 10. And if volatility remains elevated, you can bet that many more billions will soon be making their way out of the stock market. Unfortunately, the trials and tribulations of recent years may be shaping a new generation of investors that is much more risk-averse than prior generations. For example, a recent report by MFS Investment Management highlighted the fact that investors from 18 to 30 years old have the highest cash position in their portfolios, at 30%, than any other age group.

And while it's certainly understandable that investors are fearful and want to avoid another rout like we saw in 2008, selling right now isn't the answer. And furthermore, while everyone is suddenly worried about the threat of another recession, most signs still point to continued, albeit extraordinarily slow, growth. True, there have been some troubling economic signs lately, and growth has likely slowed to a crawl, but leading economic indicators aren't yet signaling a return to recessionary conditions. I certainly don't see roaring gains ahead for the stock market in the near term, but investors are more likely to end up hurting themselves by trying to time the market.

In fact, a recent study by Fidelity highlights the fact that investors who dumped stocks during periods of high volatility back in 2008 and 2009 did worse than those who stayed the course and stuck with stocks. The study showed that 401(k) participants who ditched stocks when the market fell in late 2008 to early 2009 and didn't get back into equities by the end of June 2011 (about half of those who dumped their stock holdings) saw an average account balance increase of 2%. Investors who maintained at least some equity allocation during that volatile time period saw their account balances rise by an average of 50% through June of this year -- further proof that market timing is simply a losing strategy for the vast majority of investors.

Passive investing
And while actively managed mutual funds are bearing the brunt of investor ire and outflows, apparently folks aren't quite as dismissive of passive stock vehicles. According to Morningstar, domestic stock index funds have experienced positive net inflows every year since 2001, while exchange-traded funds have seen more than $850 billion flow into their coffers in the past decade. While the anger with active managers is understandable, I don't think investors are best served by ditching solid actively managed funds with good long-term track records. However, if investors are content to stick their money in passively managed investment vehicles like index funds and ETFs, I won't lose too much sleep over it. I'd much rather see folks buy funds like these if it means they still have exposure to the stock market, rather than keeping all of their assets in cash.

If you're one of these folks who sees passive funds as a viable option in today's market, my advice is to stick to well-diversified and inexpensive options, like these exchange-traded funds, which are some of my favorites:

Source: author.

The rewards of risk
Lastly, if you happen to be among that 18-to-30-year-old age group who has a large percentage of their assets sitting in cash out of fear of further market declines, you'll probably need to reexamine your attitudes toward stock market investing. While your reluctance is understandable, cash and bonds simply won't give you the long-term earning power that you need to fund a comfortable retirement. Stock market drops are scary, but if you're in this age group, you have decades to recover from any losses that happen in the short run. So while it may not seem like it now, today's events will just be a blip in your long-term game plan.

In volatile times like these, almost no one will be immune from market drops. That means you may lose some money from day to day. But unless you want to lose a lot more money from trying to time the market, don't flee stocks when the going gets rough. Stick with your long-run asset allocation and you'll see the rewards further down the road.