Dealing with a volatile stock market can be difficult. To help you get through this period, we've included several articles on the topic:

• Coping with Volatility
• Risk and Your Stocks
• Reassessing Your Risk Tolerance
• Why Bother with Asset Allocation?
• How Time Helps Manage Risk
• Increasing the Value of Your Portfolio
• The Economy and Your Investments

If you have any questions or would like help reviewing your current portfolio, please contact us at (612) 496-1019 or Fred@fjfinancial.com.

Coping with Volatility

Keep repeating to yourself, "I'm investing for the long term. Short-term fluctuations are an expected part of investing." Still having a difficult time remaining calm during this volatile period? Try these strategies:

• Review the reasons why you have invested. If you haven't done so yet, put your target asset allocation in writing. Indicate why you have adopted this strategy and what long-term returns and short-term losses you expect from this allocation. You may also want to write down the same information for each individual investment. Then, when market volatility makes you nervous, review your written reasons for investing as you did. That reminder should help keep you focused on the long term.
• Check if you should rebalance your portfolio. Revisit your asset allocation strategy, comparing your current allocation to your desired allocation. Due to the strong stock market of the past several years, your portfolio may be overweighted with stocks. The recent volatility in the markets may now make it apparent that there is too much risk in your portfolio. You may want to reallocate some of those stock investments to other alternatives.
• Don't review the value of your investments too frequently. You should only be invested in stocks for long-term goals, so it's not important to review your stock values on a day-to-day basis. Instead, limit yourself to a monthly review.
• Determine how much of a loss you can withstand. Calculate the total value of your stock portfolio and reduce it by 20%, the official definition of a bear market. If that loss is more than you can comfortably withstand, consider shifting some stocks to other assets. Be realistic about how much loss you can withstand. It's better to sell now than to find out at a market bottom that you feel compelled to sell.
• Keep in mind the tax aspects of selling. While it is tempting to lock in some of your profits, you may have to pay taxes on those gains if the stocks aren't held in tax-advantaged accounts. The capital gains tax rate on assets held over one year is 20% (10% for taxpayers in the 15% tax bracket). It may take you longer to overcome the tax bite than to overcome a bear market.
• Reacquaint yourself with the stock market's past history. While the stock market suffers declines in some periods, over the long term the trend has been upward. Of course, past performance is not a guarantee of future results. Even though short-term setbacks can make even the most knowledgeable investors anxious, take comfort in the fact that staying in the market over the long term, through different market cycles, can help manage the effects of market fluctuations. See the article "How Time Helps Manage Risk" for more details.
• Continue investing based on your investment strategy. During periods of volatility, it's tempting to abandon your plan due to fears about where the market is heading. Instead, stick with your original investment plan, reminding yourself that you are purchasing stocks at low prices.

Still need additional reassurance? Please call if you'd like to review the reasons why you invested as you did or if you'd like to review your investment portfolio in light of the current situation.

Risk and Your Stocks

How much the major market indexes have declined during this volatile period has been widely reported. But how have your stocks performed? Have they experienced sharper or milder declines than the indexes?

Answering these questions will help you determine how much risk your stocks are subject to. Basically, stocks are affected by two types of risk - market risk and nonmarket risk. Nonmarket risk, also called specific risk, is the risk that events specific to a company or its industry will adversely affect the stock's price. For instance, an increase in the cost of oil would be expected to adversely affect the prices of stocks for the entire oil industry, while a major management change would only affect that company. Market risk, on the other hand, is the risk that a particular stock's price will be affected by overall stock market movements.

You can reduce nonmarket risk through diversification. By owning several different stocks in different industries whose stock prices have shown little correlation to each other, you reduce the risk that nonmarket factors will adversely affect your total portfolio.

However, no matter how many stocks you own, you can't totally eliminate market risk. Beta and standard deviation are two tools commonly used to measure risk.

Beta

Beta, which can be found in a number of published services, is a statistical measure of the impact stock market movements have historically had on a stock's price. By comparing the returns of the Standard & Poor's 500 (S&P 500) to the returns of a particular stock, a pattern develops that indicates the security's exposure to stock market risk.

The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market and has a beta of 1. A stock with a beta of 1 means that, on average, it moves parallel with the S&P 500 - the stock should rise 10% when the S&P 500 rises 10%, while the stock should decline 10% when the S&P 500 declines 10%. A beta greater than 1 indicates that the stock should rise or fall to a greater extent than movements in the stock market, while a beta less than 1 means that the stock should rise or fall to a lesser extent than the S&P 500. Since beta measures movements on average, you cannot expect an exact correlation with each market movement.

Standard Deviation

Standard deviation, which can also be found in a number of published services, measures a stock's volatility, regardless of the cause. It basically tells you how much the short-term returns of a stock have moved around its long-term average return. The most common way to calculate standard deviation is to figure the deviation from an average monthly return over a three-, five-, or 10-year period, and then annualize that number. Generally, the higher the standard deviation, the more volatile the stock is.

Let's look at an example. Assume you own a stock with an average return of 10.2% and a standard deviation of 15%. 68% of the time, you can expect your return to fall within a range of -4.8% to 25.2%, while 95% of the time, you can expect your return to fall within a range of -19.8% to 40.2%. (This example is provided for illustrative purposes only and is not intended to project the performance of a specific investment.)

Taken together, beta and standard deviation can provide important information about the volatility of your stock investments. If your stock portfolio is riskier than you realized, you might want to take steps to reduce that risk by reallocating. Or, when you invest new funds in the stock market, check the beta and standard deviation of the stock first. Consider investing in stocks with betas lower than 1 or with a low standard deviation to help you reduce the impact of any stock market moves.

Reassessing Your Risk Tolerance

When you designed your investment strategy, you probably answered several questions to assess your risk tolerance. But there's nothing like a real world test to find out how much risk you can tolerate. While you can't be expected to be comfortable with all of the recent movements in the stock market, it is instructive to review how you have handled this volatility. Ask yourself these questions:

• Have I reacted calmly to the recent volatility or have I been anxious about my stocks' value?
• Do I frequently calculate the value of my stocks, worrying about any declines in value, or do I only occasionally check their value?
• How would I react if the stock market continued to decline, possibly hitting declines that typically qualify as a bear market (defined as a 20% drop from a market high)?
• How long could I withstand a declining market before I felt compelled to sell?

These questions are designed to gauge your emotional tolerance for risk. You can objectively determine your risk tolerance based on factors like your investment period, income level, asset levels, debt levels, liquidity, and family responsibilities. But your emotional tolerance for risk assesses how calmly you can face market declines.

If the recent market volatility has been difficult to handle, look for ways to reduce the risk in your portfolio or to become more comfortable with risk. Some strategies to consider include:

• Diversify your portfolio among several investment categories, including cash, bonds, and stocks. A properly diversified portfolio contains a mix of asset types whose values have historically moved in different directions or in the same direction with different magnitudes. See the article "Why Bother with Asset Allocation?" for more details.
• Stay in the stock market through different market cycles. Remaining in the market over the long term helps to reduce the risk of receiving a lower return than you expected. See the article "How Time Helps Manage Risk" for more details.
• Become familiar with different investments and the risks they are subject to. Over time, your comfort level with risk should increase as your understanding increases.
• Maintain reasonable return expectations. Otherwise, you may become disappointed if an asset does not perform as expected.
• If you want to invest in more aggressive investments but aren't sure you can handle the risk, start out by investing a small amount. Increase your exposure as your comfort level increases.

Why Bother With Asset Allocation?

With the stock market turning in above-average returns the past few years, many investors have wondered why they should invest in anything but stocks. But when the stock market turns volatile, the reasons for adopting an asset allocation strategy start to look a little clearer:

• It provides a disciplined approach to diversification. An asset allocation strategy reflects your personal decisions about how much to invest in different investment categories, another name for diversification. Since different investments are affected differently by economic events and market factors, owning different types of investments helps reduce the chances that your portfolio will be adversely affected by a particular type of risk.
• It encourages long-term investing. An asset allocation strategy is designed to control the long-term makeup of your portfolio. It should not change based on economic conditions or fluctuations in the markets.
• It eliminates the need to time investment decisions. With an asset allocation policy, you may not have to worry about timing the market, you just have to ensure that your investments stay within the predetermined percentages of your total portfolio.
• It helps reduce risk in your portfolio. Investments with higher returns typically have higher risk and more volatility in year-to-year returns. Asset allocation can allow you to combine more aggressive investments with less aggressive ones. This combination can help you reduce your portfolio's overall risk.
• It provides a means to adjust your portfolio's risk over time. The risk in your portfolio can be adjusted by changing allocations for the different investments you hold. By anticipating changes in your personal situation, you can make those changes gradually.

Your asset allocation strategy will depend on a variety of factors unique to your situation, including your risk tolerance, return expectations, investment period, and investment preferences.

How Time Helps Manage Risk

Although investment returns can fluctuate significantly over the short term, long-term investing tends to lessen the volatility of those returns. For example, the chart below shows the range of total returns for the Standard & Poor's 500 (S&P 500) for the period from 1949 to 1998. Holding the S&P 500 for a one-year period during this time produced returns ranging from 52.6% to -26.5%. The range of return narrowed the longer you held the S&P 500. If held for any 20-year period during that time, the range of returns was a positive 6.5% to 17.8%.

The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future performance. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment. Source: Stocks, Bonds, Bills, and Inflation 1999 Yearbook, Ibbotson Associates.

Increasing the Value of Your Portfolio

The ultimate value of your investment portfolio is determined by four factors:

• how much you save,
• how long you invest,
• the rate of return earned on your investments, and
• how much is paid in investment costs and taxes.

Of these four factors, it's tempting to concentrate on rate of return, especially during the past several years when above-average stock market returns have boosted the value of many portfolios. However, when the market becomes volatile, how long those above-average returns can be sustained comes into question. Thus, to continue the growth in your portfolio, it may be time to concentrate on the other three factors. Some strategies to consider include:

• Save more. Even modest changes in the amount you invest can dramatically affect your portfolio's value. Consider the example of a 35-year-old who is debating making annual investments of 6% ($3,000) or 8% ($4,000) of his $50,000 salary. If he earns 8% compounded annually, his nest egg at age 65 would equal $339,850 with 6% contributions and $453,133 with 8% contributions. Each increase of 2% of his salary would mean additional investments of $30,000 over 30 years, but would increase the ending balance by $113,283.*
• Invest sooner. The compounding of earnings can have a dramatic impact on the ultimate size of your portfolio. Consider the following example. Four individuals, ages 20, 30, 40, and 50, each invest $5,000 this year. What will that balance equal when each individual reaches age 65, assuming an 8% return compounded annually? The 50-year-old will have $15,861, the 40-year-old will have $34,242, the 30-year-old will have $73,927, and the 20-year-old will have $159,602. Even though all invested the same amount, the 20-year-old will have a much larger balance due to the compounding of earnings.*
• Invest in a tax-efficient manner. Using strategies that defer the payment of taxes for as long as possible can make a substantial difference in your portfolio's ultimate size. For example, a recent study found that high-net-worth individuals could increase their annual total return by at least 2% by using tax-efficient investment strategies (Source: Trusts and Estates, March 1998). There are a number of strategies to help you invest in a tax-efficient manner. Consider utilizing tax-deferred investment vehicles, such as 401(k) plans and individual retirement accounts, which defer the payment of taxes until sometime in the future. Or emphasize investments that generate capital gains rather than ordinary income. Minimize turnover in your portfolio, so you can let unrealized capital gains grow for many years.

* These examples are provided for illustrative purposes only and are not intended to project the performance of any specific investment. They do not take into consideration the payment of commissions or any taxes that may be due.

The Economy and Your Investments

Recent events have shown how intricate the relationship between the economy and investment performance can be. One day the market is reeling from concerns that inflation is increasing. Those concerns are calmed only to find the market worried about corporate profits.

Stocks and bonds can be significantly impacted by three statistics - interest rates, inflation, and corporate profits. The trend in these three statistics will depend in large part on the economy's stage in the business cycle:

• As a recession begins, interest rates are poised to decrease, corporate profits are falling, and inflation is either stable or rising. Typically, stocks may fall because of disappointing earnings and bonds can rally in anticipation of falling interest rates.
• Toward the end of a recession, interest rates, corporate profits, and inflation are all falling. Stocks can typically start to rise as investors anticipate an economic recovery.
• At the beginning of an expansion, interest rates are still falling, corporate profits start to rise, and inflation continues to decline. This is generally a good time for stocks, as evidenced by the situation in the United States for the past several years.
• As the expansion ages, interest rates start to rise, corporate profits continue to increase, but there is now concern about inflation. Stocks may continue to do well until fears of a downturn set in.

The reason so much attention is being paid to inflation now is because there is concern that we may be heading toward recession. Compounding that concern is the fact that the Federal Reserve has expressed its willingness to increase interest rates at the first sign of increasing inflation. The markets are likely to remain volatile until these concerns are resolved in investors' minds.