A Strategy for Stocks? Look Inward First
By Kathy Kristof
Uncomfortable putting your hard-earned money in stocks -- even after the recent run-up that has helped recover a portion of the last year's losses? That's probably a good sign.
"When people as a group are the least comfortable is the best time to invest," said Gerald Appel, president of Signalert Corp., a money management firm in New York, and publisher of investment newsletter Systems & Forecasts.
Even though some investors, like Appel, are optimistic, many remain terrified that stock prices will plunge again soon.
They may be right if the recent rebound is no more than a bear-market rally almost certain to fizzle in the face of continuing economic woes.
"The level of fear that was in this market is unlike anything I've ever seen before," said Adam Bold, founder of the Mutual Fund Store and author of the book "The Bold Truth About Investing."
It's not foolish to be fearful, particularly if you panicked when the market fell into the mid-6,000s. But your fear shouldn't be about the market -- it should be about you. The market is doing what it frequently does -- testing investors' true risk tolerance with a good crash.
If you're wise, you won't ask whether the market will go up or down over the next six months. (That answer is obvious: yes. The only thing that's ever certain about stock prices is that they're volatile, swinging both up and down on a regular basis.) The question to consider is what you should do about it.
Here's a guide.
Measure your real risk tolerance
Risk tolerance is a mix of personality and practicality.
Your sunny disposition may convince you that what goes down will eventually go up and you shouldn't sweat short-term market moves. But if you've got a near-term goal that's likely to be derailed by a market upset, practical needs come first.
To evaluate your practical risk tolerance, look at how much you need to finance near-term needs -- the goals that need to be paid for in the next three years.
That could be next year's college tuition, a major repair for the junker in your driveway, or living expenses to handle a job loss or retirement.
No matter how risk-tolerant you are, that portion of your portfolio needs to be in bank accounts and short-term bonds that won't swing in value.
What if you have plenty of safe assets, but the market's plunge gave you ulcers, kept you up at night or left you screaming "Sell!" at your broker at the absolutely worst time? Then you may be risk-averse enough that you would be better off investing in safer vehicles, such as balanced mutual funds, even for long-term goals.
Do the math
But realize your risk tolerance is going to dictate your long-term investment returns.
So if you've decided you're hopelessly risk-averse, you need to save comparatively more than someone willing to take more risks.
How much more? Probably two to five times more, depending on your age and your investment mix.
A 25-year-old trying to accumulate $1 million for retirement 40 years away would need to save about $700 a month if she invested primarily in bonds, earning an average of 5 percent a year. But if she invested primarily in stocks earning an average of 10 percent a year, she'd need to save just $175 to get the same result.
There's no way you can afford $700 a month? You might want to take a middle ground.
If you put 70 percent of your savings in stocks and 30 percent in bonds, your average annual return should be around 9 percent, if the markets over time hold to their historical averages, according to Ibbotson Associates, a Chicago market research firm. That would allow you to accrue a little more than $1 million by saving roughly $225 a month. If you want to put 40 percent in bonds, you would earn an average return of about 8 percent, which would get you $1 million with about $300 in monthly savings.
Of course, there's no guarantee that average returns for stocks and bonds in the future will match what they were in the past. And if you're serious about making projections, you can end up dealing with many more variables than we've discussed here.
Control what you can
You can't control stock market swings, but you can control how much you need for major goals such as retirement, said Stuart Ritter, a certified financial planner with T. Rowe Price.
How? What you need depends on what you'll spend and how much of that spending must come from savings. If you buy less or work part time in retirement, you'll tap your retirement savings more slowly and need dramatically less.
Make an all-weather portfolio
A good portfolio ought to be manageable yet diversified. That means you need different types of investments -- stocks, bonds, real estate, cash and international securities -- and you need lots of different individual investments in each of those categories.
One good way to get that diversity is to invest through index mutual funds or through exchange-traded funds, which typically track an index and are bought on an exchange rather than directly from a fund firm. Such funds tend to be well-diversified and low-cost.
Once you've determined a good asset mix for your goals, you buy or sell only once or twice a year to maintain the mix, pulling money out of the sectors that have done unusually well and putting more in the sectors that have done poorly, Ritter said. That not only keeps your allocation plan intact but also helps you buy low and sell high.
Take your hands off the wheel
Investors have always had an innate desire to micromanage their money. But now they're also barraged with information about their investments. That makes it harder than ever to suppress the urge to react, said author Bold.
"It used to be that you'd get a 401(k) statement four times a year; now you're getting messages several times a day on your BlackBerry," he said. "People think because they have this information, they should act on it."
That's a big mistake. Academic studies say that the more you trade, the less you earn. Bold likens acting on the day-to-day gyrations of the market to tinkering with the engine of your car when you hear a slight noise.
"Once you have a plan in place that you feel comfortable with, don't look at it every day," he said. "Sure, you need to rotate the tires every once in a while. But that's it."
Kathy M. Kristof, author of "Taming the Tuition Tiger" and "Investing 101," welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls.
E-mail her at email@example.com.
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