How to invest during volatile markets

After years of relatively calm and stable financial markets, volatility is back. Fears over slowing growth in China, a correction in China's stock markets and devaluation of their currency has raised many questions about how this will affect the global and U.S. economy. In typical and predictable fashion, Wall Street shoots first and asks questions later, and waves of selling and buying has caused three to four percent swings in the markets over the past several weeks.

A natural reaction of inexperienced investors (and inexperienced commentators in the media) is to panic. This fear leads to selling investments to reduce stock allocations, which may prove to be a money losing strategy over the long term.

While many investors may be panicking, seasoned investors and professional investment advisors do not. This is because they know that the markets have cycles, and their record for coming out of downturns is 100 percent.

Putting recent volatility in perspective

During my first year as an investment advisor, on Oct. 19, 1987, later referred to as "Black Monday," the S&P 500 experienced a fall of 20.5 percent in one day. I'll never forget it and I'll never forget the three lessons I learned as a result of it.

That is still the worst day for the stock market on record. If that occurred today, the S&P 500 Index would have to decline almost 400 points, or the Dow would have to fall over 3,400 points -- in one day. While days like Black Monday have occurred throughout history, they are rare and unpredictable. In fact, because Black Monday was a result of trading behavior and not market or economic fundamentals, the S&P 500 still finished the year with a slight gain. During the most recent financial crisis in 2008-2009, the market declined over 38 percent, and has fully recovered in less than five years.

The point is: Volatility is unavoidable in investing. Today's volatility, in my view, is not another financial crisis. During times like these, here are three simple strategies to keep in mind.

Don't time the market

Attempting to move in and out of the market can cost you. This is because a significant portion of the market's gains have tended to occur during short periods of time. And many of the best periods of time to invest in stocks have been when current conditions were the most unnerving. Investors face a losing proposition when trying to time the markets, and here's the data to prove it:

Hypothetical growth of $10,000 invested in the S&P 500 Index from Jan. 1st 1980 to March 31st 2015.

Number of days invested:

All days: $503,741 (portfolio value)

Missing best 5 days: $309,431

Missing best 10 days: $232,290

(Source: Fidelity Investments)

Diversification Matters

One of the most important things you can do to reduce risk is to diversify your portfolio. Diversification doesn't avoid losses, but it can help to limit them. In the following example, compare the returns of three hypothetical portfolios: 70 percent stocks, 25 percent bonds and 5 percent cash; 100 percent stock portfolio and 100 percent cash portfolio.

Portfolio performance

100% cash

Jan. 2008 to Feb. 2009:1.6%

Jan 2008 to Feb 2014:2.0%

100% stock:

Jan. 2008 to Feb. 2009: -49.7%

Jan 2008 to Feb 2014: 31.8%

Diversified 70/25/5:

Jan. 2008 to Feb. 2009: -35.0%,

Jan 2008 to Feb 2014: 29.9%

(Source: Strategic Advisors, Inc.)

The data proves that diversification reduced losses during downturns and gained almost as much as an all stock portfolio during a rising market.

Invest regularly, all the time

When you invest regularly, every month, or quarter, you can actually benefit during times of market volatility. When you invest a set amount every week, month or quarter, you'll buy at varying price levels and your purchase prices may average out to be lower versus if had you invested all at once. More importantly, you avoid the temptation of trying to time the markets. When you do this, add this one trick: During time when markets decline by 5 percent or more, increase the dollar amounts you are regularly investing and after larger market increases, scale back to your normal investment amounts.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.