By Stuart Ritter on February 8, 2012

As we have seen recently, the global connections among financial markets can result in sudden jumps or declines in asset prices around the world. Consider the first quarter of 2011, which witnessed political instability in the Middle East and North Africa, the continuing European fiscal crisis, and the earthquake and tsunami in Japan. Oil prices rose sharply, retreated during the events in Japan, then rose again. The S&P 500 performed similarly during the period—it rose 7% to begin the quarter, lost all of those gains and more within a month, and then rebounded to close the quarter up 5.4%.

Volatility increased sharply in the second quarter, set off by concerns about the downgrade of U.S. credit and renewed uncertainty with regard to global growth prospects. These swings in asset prices can be unsettling, even fearful. And in an interconnected world, no market is immune to the fallout in other markets. While we cannot predict when market-moving incidents will happen, we know that they are inevitable. This is why it is important for long-term investors to focus on the elements of investing that can be controlled.

The following four core strategies can help you manage short-term volatility by constructing a portfolio designed for long-term performance.

1. Establish a Proper Asset Allocation

The first step is to establish a mix of stocks and bonds that suits your specific circumstances, including your risk tolerance. A properly allocated portfolio will position longer-term assets for potential growth, while protecting assets you may need to access in the short term from market swings. Your time horizon—the amount of time before you begin drawing on your investments and how long those assets will need to last—is a primary consideration when determining the right balance because stocks you own may be volatile over short- and intermediate-term periods, a risk that bonds can help to dampen.

History shows that stocks have driven investment growth over the long term. During the 85 years between 1926 and 2010, stocks generated annualized gains of 9.9% compared with 5.4% for bonds and 3.6% for short-term investments. Moreover, stocks were the only asset class to outperform inflation during every 20-year period in that time frame, though they are also likely the most volatile assets in your portfolio. For this reason, stocks are particularly useful investments for long-term goals, and time is really the key factor to managing this volatility.

Time Smooths Returns

The stock market's record of more consistent long-term returns means your portfolio is far less likely to decline over a time horizon measured in decades.

The performance of stocks has been relatively stable over the long term. Comparing rolling one-year and 20-year returns for the S&P 500 between 1960 and 2010 reveals that investors who held stocks for only a year were exposed to the possibility of significant gains-and sizable losses. On the other hand, average stock returns were steady over rolling 20-year periods, with neither the highs nor the lows of their short-term counterparts.

S&P 500 Rolling 1-Year and 20-Year Returns

Charts are for illustrative purposes only and not intended to represent the returns of any specific security.

Investors with intermediate to short time horizons should consider adding bonds to their portfolios. Bonds tend to produce more stable short-term returns than stocks. For this reason, they can act as important counterweights to stocks. Indeed, the bond market produced gains in 90% of one-year periods since 1926, in all but two two-year periods, and in every stretch of three years or longer. Furthermore, bonds tend to produce their best returns during stock bear markets. Consider that bonds gained 13% at the height of the financial crisis in 2008 while stocks fell 37%.

T. Rowe Price research suggests that investors with time horizons of at least 15 years should hold an allocation of close to 100% stocks. As you approach your goal, you can gradually and steadily introduce more bonds and short-term investments into the mix.

Proper asset allocation will help you protect money you need in the near term from market declines. Also, it ensures that your portfolio's potential growth gives you the best opportunity to reach your investment goals—despite frequent volatility in the market.

2. Diversify Within Asset Classes

Every investment type in your portfolio follows its own cycle—and events around the world may affect each in different ways. As a result, an asset category that is a leader one year may lag the next, and vice versa. Diversifying your stock and bond investments can help you mitigate sector and business risk from unforeseen global developments and help manage your portfolio's volatility without compromising growth potential.

A well-diversified equity portfolio includes shares of large-, mid-, and small-cap companies in the U.S. and other developed markets, as well as emerging markets. Stocks should be spread across a variety of economic sectors, encompassing both growth companies, which have the potential to generate above-average earnings growth, and value companies, whose stocks are inexpensive based on the company's assets or other factors. Diversification in a bond portfolio entails holding a combination of government bonds, highly rated corporate bonds, high yield bonds, and international bonds in both developed and emerging markets. For each of these asset classes, investing through mutual funds provides a convenient, low-cost way to gain broad exposure to a wide range of individual securities. Of course, diversification cannot assure a profit or protect against loss in a declining market.

3. Contribute Regularly

Your ultimate goal as an investor is to grow your balance to the extent needed to reach your objectives. One path to increasing value is to implement an automatic investing strategy, whereby you invest at regularly scheduled intervals regardless of market fluctuations. Putting your savings on autopilot will free you from constantly monitoring global events and market swings. More important, scheduling your investments will guarantee that you capitalize on opportunities in all markets, which over time will lower the average price you pay for fund shares.

To understand how this strategy works, consider the case of the bear market of 2008 to 2009, which tested investor resolve around the world. Many investors withdrew from the market during this period of historic volatility and sustained significant losses. Yet a study of participants in 401(k) plans recordkept by T. Rowe Price found that 98% held on to their contribution plans and eventually benefited from the market's recovery—and, as a result, realized an average balance that was higher in 2010 than it was at the market's peak. To a significant extent, automatic investing helped these investors benefit from market volatility by increasing the number of shares they purchased during market declines.

At the same time, automatic investing will help you avoid the temptation to try to time the market, one of the most common and costly mistakes investors make. According to research by Dalbar, Inc., stock investors trailed the S&P 500's returns by an average of 5.9 percentage points annually over the past 20 years through 2010, largely because they overreacted to market swings. Automatic investing prevents short-term market developments from altering your long-term investment process. Of course, automatic investing cannot assure a profit or protect against loss in a declining market.

4. Rebalance Regularly

While you want to avoid overreacting to global events, you do want to keep in mind that your portfolio is likely to drift from your target asset allocation during periods of volatility. So it's important to review your investments at least once a year and consider whether you need to rebalance your investment allocation by selling overweighted assets and buying underweighted assets.

Imagine, for instance, that at the beginning of the year your asset allocation stood at its targets of 60% stocks, 30% bonds, and 10% short-term investments. If stocks declined by 33% over the course of a year, while the value of the bonds and short-term investments remained stable, your allocation to stocks would drop to 50%—considerably reducing your portfolio's growth potential. As a rule of thumb, consider rebalancing annually.

When you rebalance, be sure to review the subsectors you hold within each asset class. Say, for example, that 50% of your stock holdings were in large-cap U.S. stocks and that group generally outperformed stocks of other market cap sizes and foreign shares. In that case, your allocation to the large-cap U.S. subsector likely would exceed your target. You could bring your portfolio back to your target allocation by selling large-cap stocks and using new contributions to purchase shares of small- and mid-cap funds and international stock funds. In this way, you can ensure that your portfolio is properly diversified and stays within a level of risk that's consistent with your goals.

Stay Focused on the Future

Time is ultimately the best protection against global market risks. Factors that are the focus of everyone's attention today will be replaced by new—currently unknown—ones tomorrow. But they are not likely to have a significant impact over time on your ability to reach your goals if you adhere to the foundational strategies that enable you to manage—and perhaps even benefit from—the volatility inherent in today's markets.

Managing Volatility Through Asset Allocation

Adding bonds to a portfolio invested entirely in stocks can reduce your volatility, providing a better balance of risk and reward potential for your short- and intermediate-term goals.

Average Annualized Return (1926-2010)

All investments are subject to market risk, including possible loss of principal. Investing in foreign securities carries additional risks, including currency risk and political risk. These risks are heightened for investments in emerging markets. Bonds are subject to credit risk and interest rate risk, and high yield bonds can have significant volatility.

T. Rowe Price (including T. Rowe Price Group, Inc., and its affiliates) and its associates do not provide legal or tax advice. Any tax-related discussion contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i.) avoiding any tax penalties or (ii.) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this article.