Long-Term Lens on Volatility

Summary Points

• A variety of issues have contributed to the market volatility of 2011, and investors may need to adopt more than one strategy when coping with it.
• Some observers believe that the financial system is undergoing fundamental changes that will contribute to heightened volatility for some time.
• Focusing on long-term financial goals may help investors avoid being distracted unduly by short-term events.

The list of factors driving the stock market's ups and downs during 2011 seems to grow all the time. Investors have witnessed a natural disaster in Japan, debt crises in the euro zone, persistently high unemployment, and Standard & Poor's downgrade of U.S. Treasury securities from AAA to AA+. Not to mention a housing market that has yet to recover from a multiyear slump.

There's no question that external events are influencing both the U.S. economy and investor perceptions about managing their assets. But when making decisions about your portfolio during 2011 and beyond, you do not necessarily have to be a victim to the news flow. Many market observers believe that the advent of high-speed trading, the growth of exchange-traded funds, and other developments within the financial system are causing changes that may not be understood for many years. In the meantime, high levels of volatility are likely to be the norm.¹ Creating a strategy to cope with it will not guarantee that your portfolio will not be affected, but you may be better prepared to deal with events now and in the future.

What Investors Can Do

When facing an uncertain market environment, consider the following strategies:

• Follow an investment plan based on your risk tolerance and time horizon. Many observers believe that the stock market's long-term direction is more important than day-to-day developments.
• Emphasize sector strategies that can help capitalize on short-term events while you remain invested in stocks. Given the recent volatility in Financials, Standard & Poor's recommends underweighting this sector.² In addition, investors may want to consider underweighting value stocks in favor of growth stocks because financial stocks typically are in the value category.
• Consider overweighting the Consumer Staples and Utilities sectors, which outperformed the S&P 500 year-to-date as of September 12, 2011.
• Look for investment themes based on long-term trends. As an example, the aging of the global population will continue for some time. This trend could present opportunities for medical device companies, retailers, marketers of personal care products, insurers, pharmaceutical firms, and other industries that potentially benefit from this situation.³
• Consider an allocation to bonds. Prior to Standard & Poor's downgrade of U.S. Treasury securities in August 2011, many observers predicted that a downgrade would prompt investors to sell U.S. Treasury securities, causing their value to drop. But this scenario did not happen. Instead, stock market volatility induced many investors to seek perceived safety in U.S. Treasury securities, which caused their value to rise.⁴ Although there are no guarantees about what might happen in the future, the Federal Reserve's plan to keep interest rates low for another two years may help to stabilize the fixed-income market.
• Dig for dividends. The S&P 500 Dividend Aristocrats and the Dow Jones Select Dividend Index^SM track companies that have paid dividends or increased dividends over time. Many investors believe that a history of dividend payments is a sign of management's commitment to providing shareholders with a return. Note that dividends are not guaranteed, and companies can reduce or eliminate them to conserve cash.
• Contribute to tax-advantaged accounts such as IRAs. With a traditional IRA, investors at any level of income can make contributions and contributions may be tax deductible if you meet income thresholds established by the Internal Revenue Service (IRS). Required minimum distributions after age 70½ are taxable. With a Roth IRA, you must meet IRS income thresholds in order to contribute. RMDs are not mandated, and qualified distributions are tax-free. Learn more from IRS Publication 590 available at www.irs.gov.

Just as more than one issue is contributing to the volatility of 2011, you may need to rely on more than one strategy for managing volatility over time. Keeping focused on your long-term financial goals may make it easier to avoid short-term issues that could thwart your planning.