One of the themes that regularly receives way too little attention when it comes to saving for retirement, is how mom and pop investors should deal with market volatility. Naturally, the performance of markets and businesses will depend on what particular phase of the business cycle we are presently in.
But investors have a few proven investing concepts at hand that will allow them to navigate market volatility and press ahead with their retirement savings.
As the economy moves from a recession to an expansion, and ultimately progresses through a saturation stage which is characterized by declining growth and interest rates, investor will experience different levels of volatility.
When to buy stocks
Generally speaking, stocks will do well when the economy is growing. But this is only a half-truth: For the most part, stocks are increasing when investors are expecting the economy to continue to grow, which is why stock markets often rise before the real economy starts to take off.
This, of course, has profound implications for investors who are saving for retirement or for any other large, financial goal such as a home purchase.
In fact, stocks are most interesting in a recession because investors are way too fearful and pessimistic about the outlook of the economy. Emotions have a tremendous influence on decision making and investors do need to aware of them.
So, without further ado, let's look at a couple of things you need to know in order to get a good grip on your retirement planning and master the inherent volatility of the capital markets.
Yes. Oftentimes you will be your own worst enemy. Capital markets swing forever between fear and greed. A good example of this unnerving relationship is the housing bubble in the United States in 2006 and 2007 when investors took on large amounts of debt in order to speculate on ever rising house prices (the greed).
As the housing market collapsed and banks as well as homeowners realized they were holding the hot potatoes, panic quickly ensued (the fear) causing catastrophic losses for everyone with a financial stake in the capital markets: Mortgage originators, home buyers, banks, pension funds and, of course, regular mom and pop investors.
The best way to deal with market volatility is to be 1. Aware that volatility will occasionally set you back in the achievement of your financial goals and 2. To use volatility to your advantage. The latter leads us to our next powerful theme to benefit from volatility: Dollar-cost averaging.
This is an effective method to counter inherent market volatility. It is a straightforward investing approach and basically assumes that investors make regular stock purchases during a market downturn. The advantage? The average cost of your stock purchases falls when you make constant purchases in a down market.
The key to this strategy is to make regular purchases, such as every month, and purchases of equal dollar amounts, such as $100 every month. For instance, you could invest $100 every month in a mutual fund without caring about the state of the economy and the capital markets.
Over the long-run, markets will rebound to normalized levels of growth while you have steadily invested at depressed market prices.
An example might help to drive this concept home: Assume you bought 10 shares of Company X for $12 each and a total consideration of $120. Now a supply shock or a recession hit the market and your stock falls to $10 in the first month. If you invested an additional $120, you could buy another 12 shares of Company X. Now assume, that in the second month the stock falls further to $8 and you invested $120 yet again to purchase the same stock: Another 15 shares go into your investment portfolio.
The result: You have dollar cost-averaged. The average cost of your shares is down to just $9.73 and much lower (19% to be precise) than the initial purchase price of $12.
The Foolish Bottom Line
The most important thing investors can do to reach their savings goals is to develop an awareness of where we are in the business cycle and to adopt a long-term investing mind-set.
As long as you use volatility in the market to your advantage (via the method of dollar-cost averaging) and don't give in to your emotions, you will come out on top in the long-run.