Safe to say that with a fair amount of monumental events happening throughout 2011, investors experienced the upsides and downsides of stock market turbulence. Throughout the years I have developed a few ways to weather stock market turbulence and reduce volatility through diversification.
Weathering Stock Market Turbulence
I recommend that investors take these five steps to weather the stock market turbulence:
1. Distinguish financial resources required to meet short-term goals from long-term goals.
2. Understand your portfolio liquidity needs and cash-flow requirements.
3. Be aware of how volatile your investment portfolio has behaved in percentage terms relative to the risk of the overall stock market.
4. Modify your investment plan by reducing your exposure to stocks if your needs have changed, or you are uncomfortable with the current volatility of your portfolio.
5. Stick to your long-term investment plan if you have sufficient financial resources to meet immediate needs and you can accept a higher-degree of risk with funds targeted to fund long-term (> 3-5 years) needs.
Diversify: Reducing Volatility by Understanding Correlations
An investment strategy practicing broad diversification can pay-off with reduced downside volatility. One-way to accomplish this is by carefully selecting different types of investments (technically referred to as “asset classes”) that have low correlations. Correlation is a statistical measure of how different investments behave relative to each other. It can range from +1.00 to -1.00. A correlation of +1.00 indicates perfect correlation. For example, rain and umbrellas have a correlation close to +1.00. Rain and sun have a correlation closer to -1.00 (but not absolutely -1.00 as an analytically-minded engineer would surely be quick to point-out). The correlation between rain and a cow is perhaps 0.00 and implies that these two items are uncorrelated and have nothing to do with each other.
This is an updated post of an article that originally appeared in the May 2001 issue of The Business Monthly.
Copyright © by PARR Financial Solutions, 2011.
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