An Analogy to Help Deal with Market Volatility

A financial planner whom I respect, Michael Zhuang of Washington DC, had a great analogy regarding market volatility in a recent post to his blog:

Imagine your house has a ticker symbol, and it scrolls along the bottom of CNBC together with other ticker symbols. The price of your house, like a stock price, is set by a bunch of people you’ve never met making apparently random bets based on a combination of intuition, general economic statistics, output of an automatic-trading program, and, a couple of times a year, the real price achieved by one of your neighbors actually selling a house.

Minute by minute, the price of your home would gyrate wildly. If you are a nervous type, you might lie awake at night wondering if its value would cover your mortgage in the morning.

Of course, no one frantically checks their home value every day, wondering if he should sell.  But if we had minute-by-minute reporting of real estate values, your house would be every bit as volatile as your stocks.

Granted, your house is not just an investment, it is your home which has more than financial value.  But the same principle applies if the real estate in question was a rental duplex or an office building.  Thinking of your investment balances as something to update on a year by year - or even over multiple year - basis, like your real estate, will help keep your emotions on par with your plan.

A Holistic View on Stock Market Volatility

The last few weeks have certainly been an interesting time in the markets.  But despite what the general media would have you believe, investors who didn't panic and bail out on their investment plan are doing ok. For evidence of that, consider in generic terms a hypothetical $500,000 portfolio invested half in Vanguard 500 Index Fund (VFINX) and half in Vanguard Total Bond Market Index Fund (VBMFX) as of the recent stock market peak of of July 22.  VFINX was at 124.01 on 7/22 and closed at 108.72 last Friday - a drop of about 12%. (ugh!)

Seeing $250k drop almost $31,000 down to $219,175 is gut-wrenching for sure.

But remember that is only part of the overall holdings.  The other half of the money was in the Total Bond Market Index Fund, which moved from 10.77 and to 10.99 over that same period - an increase of about 2%.  Which left the entire portfolio sitting at just over $474,000 on a combined basis - down about 5%.

Not great, but hardly tragic.

Obviously this is not a statistically accurate analysis of any specific portfolio and is certainly no prediction of any future performance.  And a properly diversified portfolio doesn't just hold U.S. large cap and U.S. bonds; real diversification means owning both large and small companies, domestic and international stocks, U.S. and foreign bonds.  But the concept is spot-on and critical:  the only sane way to look at your investments is to look at your investments as a whole.

And that reality is rarely as bad as we feel after watching the news.