To date, 2011 has been a roller coaster year for investors. The market started out strong as the S&P 500 climbed 6.87% to a high of 1344.07 by Feb. 18. This quickly was given back as stocks retraced their steps over the next four weeks. Fast forward a few months, and we were within reach of setting fresh highs for the year, that the market eventually did make in May.
For casual and active investors alike, this is hardly an ideal situation. For the last four months of 2010 the S&P 500 rose a staggering 19.85% with little drawdown. The lack of consistency seen so far in 2011 challenges the recent bullish mentality and presents investment uncertainty.
The best way to combat this uncertainty is by lowering risk through simple portfolio modifications and strategies that can give you a better chance at success. Here are six tips, in two broad categories, for investing more effectively in volatile markets.
What many investors fail to acknowledge is that cash is an actual position. For the pundits who say that cash represents a waste of the time value of money because it doesn’t generate returns, ask them how their 100% long portfolio fared in 2008. Any cash portfolio easily outperformed the market averages during this time.
There is a lot to be said for sitting on the sidelines and going to bed at night knowing your portfolio is safe. And some online stock brokers offer high-yield savings for long-term cash positions that can serve as an extra boost to your bottom line.
For our purposes we are focusing on equities, but a balanced portfolio also should include alternatives. While cash often is the best alternative in volatile equity markets, a cash holding entails its own risk. In highly inflationary periods, cash can be a net-loser.
1) Match cash to confidence: Every investor has his or her own comfort level of what percentage of an investment portfolio should be sitting in cash at any given moment. For those investors who have a tough time managing their cash allocation, one easy way to determine your threshold is to consider the following question: "Do I feel confident that the market is going to rise over the coming month?" Give the answer a score of one through five with one being no confidence and five being extremely confident.
The lower your confidence, the lower your net exposure to the market should be. If it is a one, then a 80%-100% cash position is best. If a two, then 60%-80% is more suitable, and so on until you’re 100% vested in the market with no cash on the sidelines. For investors who are less active, this exercise could be conducted once a quarter or less frequently. Every independent investor should rely on one person, themselves, in making investment decisions. This exercise, while simple, reinforces self-dependence.