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So, you want to sue the stock market for whiplash?
You can't. But, investors can learn to protect themselves from stock market volatility.
First, if you're a younger investor (40-years-old or less), and you're investing for the future, volatility actually helps you, because it offers you the chance to buy more shares on the cheap.
Investing fixed dollar amounts regularly into stocks or mutual funds is called "dollar cost averaging." The idea is that you buy more shares when prices are down and fewer shares when prices are high. I discuss dollar cost averaging in Becoming An Investor.
There's not much to dollar cost averaging. Just keep making regular investments regardless of the market. Yet, dollar cost averaging isn't much psychological comfort if your stocks have dropped 30%. It's even less comfort if your stocks are down by 60%!
When the market drops, people quit investing in droves. In Wealth and Democracy, Kevin Phillips tells us the masses invest during times of euphoria and mania, but many people stop investing when the market goes down. The ability to ride out the storms and think long-term separates successful investors from non-successful investors.
Further, time is your friend when investing. This is due to the power of compounding, which I discuss in detail in Becoming An Investor. The basic idea is this: Money invested will grow at some rate of return. That adds money to your investment, which will grow at some rate of return. The cycle continues.
For example, assume you receive a 10 percent rate of return on your investments in a year. Assume you have $10,000 invested. At the end of the year, you have $11,000. If that $11,000 continues to grow at 10%, the next year you have $12,100.
Incremental amounts don't seem like much. But, assume you've invested for 30 years. At a 10% rate of return, you'd have about $175,000. In 40 years, you'd have about $450,000. That assumes only a one-time investment of $10,000.
Even if you don't have $10,000 to invest, you can do well by investing only a few thousand a year. Most people in their thirties who are investing $6,000 or so per year into a 401(k) will be millionaires by the time they retire. In Becoming An Investor, I give some equations for calculating cumulative sums, based upon an assumed number of years and a given rate of return. Or, you can find online financial calculators to help you estimate how much you'll have in the future. Kiplinger.com is one source of financial calculators.
However, if you cease investing, compounding will cease to work for you. So, too, will dollar cost averaging.
If you're an older investor, the best way to protect yourself from market volatility is to be sure you aren't forced to sell shares to meet income demands. People like buying and selling shares, because capital gains are taxed at a lower rate than income. And, that works great if shares are going up. Yet, share volatility is a serious problem if you're forced to sell shares when your shares are down. Essentially, you're dollar cost averaging in reverse--you need to sell more shares when they are down to meet your income demands. Your wealth can quickly evaporate.
Because of this, you should arrange your portfolio so that you don't need to sell shares of stock to generate the income you need. If possible, have stock dividends and interest meet your income needs. If that's not possible, have short-term investments, such as short-term bonds, etc., to sell to generate the income you need.Peter Hupalo, author of
Becoming An Investor
Building Wealth By Investing In Stocks, Bonds, And Mutual Funds