“The unexamined life is not worth living.” ~ Socrates
Question: As a retiree, I’m concerned about the recent market volatility. How will this and all the uncertainty in the world affect my investments and financial future? What are your thoughts?
Answer: You’re not alone with your concerns. Ebola, ISIS, Russia, falling oil prices, and slowing global growth, all contribute to economic uncertainty. The market has reacted in the short-term with fear. During the second week of October 2014, broad markets reversed their upward trend down sharply from recent highs. This change sparked activity among traders and speculators contributing to high volatility leaving markets weak and vulnerable. Any negative headline caused downdrafts while investors hungered for positive news and may have overacted on the upside in the short-term causing a rollercoaster effect. Volatility will always exist. How we respond to it is what we can control. The key to having peace of mind is knowing why you’re invested and how you’re positioned in the markets.
Having survived several market and business cycles over the past 30 years, I’ve learned a great deal about investor behavior and the importance of understanding why people invest. When I started in the business back in 1983, the Bureau for Labor Statistics reported that 62 percent of working Americans had some sort of defined benefit plan for retirement. Thirty years ago, there was more retirement income certainty so fewer individuals needed to rely on the stock market to fund their retirement. Employer-provided pensions and Social Security were the primary sources of retirement income, and funds were needed for fewer years because life expectancies were shorter.
My first ticket to the rollercoaster ride was an entry-level job with Dean Witter Reynolds in 1983. The atmosphere was much different; we were stockbrokers and traders back then in contrast to being financial planners today. The “buy-sell” fervor was the norm compared to today’s relative calm. Hit songs at the time were “Life in the Fast Lane” and “Hungry like the Wolf.” Movies such as “Wall Street,” “Boiler Room,” and “The Wolf of Wall Street” accurately depict what went on in some firms during those chaotic, crazy days filled with extreme excess. During the 80s, it was common to have bottles of Maalox, Dramamine and other liquids nearby to quiet nerves and stomachs. Today, our goal is to provide investors with logical investment policies, processes and disciplined plans to meet their needs, rather than react in fear to market gyrations, up or down.
Individual Retirement Accounts (IRA’s) began in 1974 because of the Employee Retirement Income Security Act (ERISA) while 401(k) Plans came along in 1978. These changes introduced Main Street to Wall Street. Prior to this, individual long-term investors like you were a much smaller part of the market mix.
Speculator, Trader or Long-Term
The three broad categories of investors are long-term investors, traders and speculators. The internet and financial news outlets provide instantaneous and short-term opinions that can confuse and frighten some long-term investors. This often causes people to act based on fear and emotion at the wrong time. Below are definitions of the three types of investors, along with details of how they often interpret and react to market volatility. See if you spot yourself in any of these descriptions.
Long-term investors: These investors build diversified portfolios of stocks, bonds, cash, real estate and other assets to produce smoother rates of return. It also allows them to avoid the need to jump in and out of the market at every negative headline because they have a plan and a process in place.
They understand that the economy and markets will experience difficulties, including recessions and bear markets and make necessary adjustments. History shows that the odds of success for this group are high.
Long-term investors are fully aware that market pullbacks (5-9 percent), corrections (10-19 percent), and bear markets (+20 percent) will develop over time. They would very much like to avoid the down moves but since their portfolios are diversified, they have the ability to ride them out and make asset allocation changes along the way. Yet, for the Trader and Speculator the game plan is much different and market moves mentioned above can have major impact on their portfolios.
Traders: There are generally two types of traders in the stock market. One trades on behalf of others and includes Wall Street trading desks that execute trades on behalf of others or in some cases for their firm’s own account. The holding period for these traders can be minutes, hours or days.
Another type of trader is buys and sells for his or her personal account. They most often are fund managers or, in some cases individual investors. Their holding period is likely to be longer than the Wall Street trader’s is, but still much shorter than that of the long-term investor. They seek to take advantage of short-term gyrations in the market, individual sectors, or individual securities to generate short-term profits. They will enter and leave the market rapidly.
Speculators: Speculators seek high returns in acceptance of higher risk. The speculator will be less likely to diversify, instead concentrating bets in individual securities or sectors. They may also choose to invest in securities that are more speculative. Finally, they may borrow funds to purchase investment holdings.
When uncertainty is high, traders tend to sell all holdings regardless of quality, then quickly re-enter trades whenever the trend reverses. This accelerates the downside and upside for general markets in the short term. Speculators, much like traders, often experience dire results due to the use of leverage (using borrowed money).
To illustrate, assume a fund has $1 million of its own equity and then borrows $2 million to buy a total of $3 million of securities that go up 5 percent, or $150,000. The speculator makes a 15 percent return on equity ($150,000/$1 million) on just a 5 percent move.
On the downside, if the securities decline 5 percent the loss is $150,000, or 15 percent of equity. To make back the 15 percent equity requires a 17.26 percent return on equity or a 5.26 percent gain on the $2.85 million available. Losses become more damaging as declines become larger. In the example above, if the securities decrease by 10 percent the returns needed to get to break-even double, and so on. Small fluctuations, fully acceptable to long-term investors, can create major problems for a speculator. Hence, the Maalox and Dramamine.
Traders and speculators control massive amounts of capital, so their short-term strategies can have a major impact on financial markets in the near term. Problems arise for the long-term investor when they let actions of short-term traders and speculators negatively influence long-term investment decisions letting emotion rather than logic drive decisions, selling (or buying) in the heat of the moment.
Some investors fall into all three categories with a larger core long-term portfolio and smaller amounts allocated to more aggressive trading and/or speculating strategies. There is nothing wrong with this as long they only commit capital they’re willing to risk in these strategies.
Successful investors clearly define to themselves and communicate with their advisors exactly they’re attempting to do and if they’re acting as a long-term investor, trader or speculator.
Investor, Know Thyself
Traders trade, and speculators speculate. It’s what they do. Understanding their impact on the markets as compared to fundamental changes with your holdings is helpful. If you are a long-term investor, this is a good time for self-examination and a portfolio check-up. Knowing that you are properly positioned to obtain your long-term goals promotes peace of mind. Stay focused, and invest accordingly.
This information is general in nature and is not a recommendation of any particular investment. There is no guarantee any particular investment strategy will be successful. Opinions expressed herein are those of the author and subject to change at any time. Consult with the appropriate legal and tax professionals for advice on these matters.
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This article provided by Darcie Guerin, CFP®, Associate Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at 239-389-1041, email email@example.com Website: www.raymondjames.com/InvestmentInsights