Economic downturns and turbulent investment markets can make people nervous. That’s understandable. But it may help to recognize that these events are a normal, although undesirable, part of the economic and investment cycles. 

One key to weathering market volatility is good, solid preparation. With basic investment principles and strategies, you’ll be less likely to make big mistakes — like selling an investment when its price is at rock-bottom.

It may be encouraging to know that there are strategic steps investors can take during these difficult market conditions, to help position themselves to benefit in the event of a market turnaround.

The stock markets routinely experience short and longer-term price swings. It’s the nature of the risk — and potential return — associated with stock investing. Even with this volatility, the stock market has experienced overall upward growth for the past 80 years, with average returns of approximately 10 percent a year.¹ That growth occurred in spite of the Great Depression, World War II, the Korean and Vietnam wars, and no less than 10 bear markets.

Although some investors had never experienced a market downturn until earlier this decade, most are aware of some of the more notorious drops. In October 1987, the Dow Jones Industrial Average, the most widely used indicator of the overall condition of the stock market, lost 508 points — or 23 percent — in one day, which is not-so-fondly referred to as “Black Monday.” The markets, of course, went on to experience record highs in the years shortly thereafter.

Here’s an example of how a portfolio of 40 percent bonds and 60 percent stocks would have performed following five past financial crises.

Past performance is no guarantee of future results. Returns reflect the percentage change in the index level from the end of the month in which the event occurred to one month, six months, one year, three years and five years after. The illustration does not account for portfolio rebalancing during these time periods. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. Stocks in this example are represented by the Standard & Poor’s 500®, which is an unmanaged group of securities and considered to be representative of the stock market in general. Bonds are represented by the 20-year U.S. government bond. Calculations assume monthly data. The data assumes reinvestment of all income and does not account for taxes or transaction costs. For the U.S. savings and loan crisis, August 1989 was chosen because that was the month the Financial Institutions Reform, Recovery and Enforcement Act of 1989 was signed into law. For Long-term Capital Management, September 1998 was chosen because that was the month the hedge fund was bailed out by various financial institutions. © 2008 Morningstar, Inc. All rights reserved. 9/18/08

Down markets are a fact of life. But they need not be a cause for panic or rash decision-making based on newspaper headlines or TV talk shows. Resist the impulse to react to market conditions in ways that can lead to regrets and sabotage your long-term goals.

Actions That Can Sabotage Investors’ Long-term Goals

Selling stock investments when the market goes down

Investors lock in losses, and more importantly, are not in a position to benefit from rebounding stock prices in the event of a market turnaround.

Getting out of the stock market on the way down and getting back in for the upswing

Since it’s impossible for even the experts to know where and when the market is going to move, trying to time the market in this way typically results in buying high and selling low. It also means that investors can miss out on growth opportunities when there’s a market upswing.

Reducing or stopping retirement plan contributions

Investors miss out on buying investments at a low price, then benefiting from investment growth when prices go up in a recovering market.

Keeping all or most assets in fixed-income investments (cash equivalents and bonds)

Investors face the risk of not accumulating enough savings for retirement. Historically investors have been rewarded with higher returns by allocating some of their assets to stock investments. Smart investing usually means taking on some investment risk.

The proportion of stock investments you have in relation to bonds and cash equivalents is referred to as your asset allocation. This mix of investments should take into account how many years you have until retirement and your ability to tolerate the type of abrupt price swings the market is encountering at this time. Think of your asset allocation as part of a long-term investment strategy that is intended to weather market downturns.

Compare the allocation of your investments with the following diversified portfolio ranges. Does your allocation to stock, bond and cash equivalent investments fall within these ranges, based on the type of investor you are and your years until retirement?

You’ll notice that investors nearing retirement can still afford to take some risk. Their retirement savings will be spent over a long period of time, perhaps 25 years or more. That means their time horizon is long enough that they can afford to allocate some of their assets to stocks in hope of a higher payoff.

There’s one thing to remember during a difficult market: Don’t get caught up in the madness. Instead, continue to focus on maintaining your sound investment plan. If you’ve set goals and developed a strategy, you owe it to yourself to keep your plan on track — especially during the market’s peaks and valleys.

1. Keep Things in Perspective

It’s easiest to stay the course if you really do focus on major life goals and not on the market’s day-to-day or month-to-month movements. It’s good to check on what is happening in the markets and to understand why certain things are occurring, but it’s rarely constructive to obsessively review your investment portfolio.

If you make changes to your investments, do so in a thoughtful way, and after careful consideration. Talking with a financial advisor could be a good first move.

2. Don’t Forget to Diversify

If there’s a lesson to be learned from market downturns, it’s that diversification is one of the most important investment strategies you can employ.¹ Nobody can predict when or where the markets will turn. That’s why it’s important to spread your assets among various investment classes. Anyone who invested heavily in technology stocks in the ‘90s without understanding the risks can appreciate that. By exposing yourself to different segments of the market, you can help lessen the risk should one particular market segment or asset class show weakness.

3. Realign Your Portfolio (if necessary)

Have you decided that you’re too heavily invested in stocks? Rather than moving current stock balances in a down market and locking in possible losses, consider increasing your future contributions to bonds or cash equivalents such as money market funds. This will slowly change your asset allocation to a more conservative investment mix.

4. Think About Buying Low

Declining markets often pose an opportunity many investors don’t consider — purchasing more shares at lower prices. Let’s say you bought shares of a mutual fund last year when prices were high. If you purchased additional shares when the price was dropping, you purchased those shares at a lower price. Although the markets may look grim at any given point in time, many investment professionals believe that stocks are “on sale” during significant market declines, and look upon them as good times to buy.

Although current market conditions provide growth opportunities for aggressive investors, avoid the temptation to shift large amounts of money into stock funds in hopes of a big turnaround. While the general trend of the stock market (as measured by the S&P 500 Index) has been upward for nearly a century, that growth has been accompanied by considerable volatility and prolonged downturns. It’s impossible to know what the market will do, or when.

5. Consider Increasing Your Contributions

Think about increasing the amount you contribute to your plan rather than taking on risk that doesn’t fit your comfort level. You can have a portfolio with much less risk (more cash equivalents and bonds, less stocks) if your contributions are a bit higher.

6. Rebalance Regularly

Volatile markets — or simply the passage of time — can change your proportion of funds in different asset classes, such as bonds, large growth stocks or international stocks. Rebalancing moves your portfolio back to your desired investment mix.

7. Review Annually

Your personal situation will change over time. Be flexible and willing to change your investment strategy if the situation calls for it.

8. Don’t Try to Time the Market

Investing in the market and staying invested is critical to the growth of your retirement savings. No one knows what the market will do on any given day. For instance, missing out on just the market’s 10 best days over the last decade had an enormously negative effect on return.

Source: Standard & Poor’s and The Standard’s internal calculation, 2008. This illustration is hypothetical and for illustrative purposes only and is not indicative of the performance of any specific investment. Past performance is no guarantee of future results. Investments are subject to market risk and fluctuate in value. The S&P 500 is an index of 500 widely traded stocks and is considered to represent the performance of the stock market in general. An investment cannot be made directly in an index.