“Usually when everyone else is buying, you should probably be selling and when everyone else is selling you should probably be buying”(a model and philosophy that has worked very well for Warren Buffett over the years).
Why? Because the average investor is far too emotional when it comes to investing decisions and is easily influenced by the herd. It’s always a challenge trying to figure out the best way to invest new money. But the task is even more harrowing when you’re dealing with a volatile market like the one we’ve had in recent weeks, where big sell-offs are followed by hopeful rebounds that give way to more unsettling downdrafts, creating a climate of fear and uncertainty all around the world.
So I’m happy to provide a little general guidance on this issue. I’ll try to answer in a way that can also give guidance to others out there who are unsure how to traverse a market like this, whether they’re investing new money or considering what to do with the money they’ve already invested. Especially, if you want to know if your financial advisor is guiding your portfolio in a way that allows you to sleep comfortably at night, keep this blog post in mind.
The first thing I think you need to do is be wary of some of the advice that’s already floating around out there. I don’t want to say much of it is flat-out bad. But I do think a lot of it is misguided.
I’m thinking not just of the obligatory stories recommending you move your money to “safe harbors” like money-
market funds and bonds or that you buy “defensive stocks” that are supposed to shelter you from losses, but also their opposite counterparts. You know, the ones that say now is the time to start scooping up bargains by buying on the dips.
In both cases there’s a presumption that you know what lies ahead – that is, that the market is headed down further
and thus you need to protect yourself or that most of the damage has been done so you’ll be buying in just in time to ride the rebound.
Let me be clear about this. Nobody knows where this market is headed over the short-term. And nobody can know because that will be determined not just by how things shake out in areas ranging from real estate to company earnings to inflation estimates and interest rate projections, but also how investors react to all this data.
So how does one invest during such uncertainty at a time when investors are also clearly on edge? I recommend you start by asking yourself the following three critical questions:
1. How long will it be before I need the money? This is always the first question you should ask before investing
money, but it’s especially important to ask it in a volatile market like today. If you’re going to need access to some of
your money within, say, two to three years, then you should invest that portion of your cash in money-market funds or short-term CDs where it will be immune from the ups and downs of the financial markets, notwithstanding the price of the dollar.
After all, if you’re depending on your money as an emergency reserve, or if you’re going to need it in a few years for a house down payment or college tuition, you want to be sure the funds will be there and your not as concerned with growth but with certainty. You don’t want to risk that it will be tied up in stocks that are worth 30 percent less than you paid for them, even if those stocks may eventually rebound to large gains.
On the other hand, you can afford to take a little more risk in pursuit of higher gains if you’re investing longer term since you have more time to recover from market fluctuations . The way to go after those higher long-term gains is by building a portfolio of stocks and bonds (or, more likely for most individual investors, stock and bond funds). Focus on stocks that have consistently raised the company dividend over the last 10 years or companies that have consistently raised the dividend and have NEVER decreased it. This is a superior set of stocks to have no matter what your long term objectives. (Research it)
The key, though, is that it’s your time horizon that determines the investment choice. Not some notion of what the
market is or isn’t likely to do in the near future or where you might find the highest returns.
2. Do I have the right stocks-bonds mix? Once you know you’re investing funds you won’t be touching in the short-term, you can start thinking about how to allocate that money between stocks and bonds in a way that makes sense for you. The first issue, again, is time. The longer the money will be invested, the more you can afford to put in stocks. If you’re in your 20s and you’re putting money into an IRA you won’t touch until you’re retired, you might want to put upwards of 90 percent in stocks.
Forty years from now, a market correction that occurs today will be hard pressed to be remembered. If, however, on the other hand, you’re investing money you’ll need in, say, five to 10 years, you still want some stocks for growth, but not nearly as large a stake.
In deciding on a stocks-bonds mix, you also want to factor in what I call a “risk check” – that is, you want to
realistically gauge how you might react if your portfolio takes a hit of 20 percent or more. There’s no sense in keeping
90 percent of your money in stocks if a market meltdown would have you selling your stock funds without even considering your objectives. This is called risk aversion and some people are extremely risk averse. Remember, as a rule of thumb, low risk equals low return and high risk equals high return. If you cannot stand the risk you shouldn’t complain about the low returns that you get because the potential for higher returns are the payoff for bearing risk. If you have a long time to invest you don’t have to flirt with high risk funds as a necessity as long as you consistently invest over time and take advantage of dollar cost averaging. However, if your portfolio is low and you are closing in on retirement you may have to increase the potential returns or increase the number of working years.
An Asset Allocator tool can give you some guidelines on how to handle this balancing act. Just answer a few questions, and you’ll get a recommended portfolio mix that can serve as a starting point for creating your own blend based on how much time you have to invest.
You can then go to the Asset Allocator tool in the Investment Guidance & Tools section of T. Rowe Price’s web site
to see how different stocks-bonds allocations might do in the future. (You don’t have to be a T. Rowe Price customer to use the tool, but you do have to register for the site).
If you want ease and convenience, you can simply opt for a target retirement fund that has a date that roughly
corresponds to the year you’ll retire. You’ll get a pre-mixed portfolio with a blend of stocks appropriate for someone your age investing for the long term. If you prefer to create your own mix, I suggest you consider doing it with low-cost index funds, or at least make them the core of your portfolio and supplement the index funds with a few good bond funds. I personally do not like straight mutual funds for a variety of reasons that I will go into during a future post
3. Am I acting on reason or emotion?
I was watching one of the cable TV financial shows as the market was in the midst of a steep decline. Based on the frenzied report of the mews anchor on the trading floor, you could easily get the impression that you’d better quickly dump your stocks before you get caught in a market crash.
Of course, just weeks before, the same show was so upbeat when the market was hitting new highs that you could
have gotten the impression you were an idiot if you didn’t take out a home equity loan and put all your money into the market. All of which is to say that you’ve got to be careful about getting caught up in undue pessimism during bad times and irrational exuberance when things are going great . It’s almost always a mistake to invest in the heat of the moment. Better to step back, take a deep breath, even let a day or two go by and then make sure that you’re making a decision that reflects YOUR long-term strategy, not some passing frenzy.
If you answer these three questions in a thoughtful and honest way, I think you’ll come away with a good sense of
how to invest any new money. And you’ll also be able to assess whether you’re doing the right thing with the funds you already have invested.
I can’t guarantee, of course, that this approach will immunize you from all losses. There’s no way to do that, if you want to earn decent returns. But at least you’ll know you’re making your decisions in a consistent and rational manner. Be sure to assess your portfolio mix based on your long and short-term strategies every single year, especially if you don’t have a financial advisor. Remember to do this while you still have time to make adjustments, like add more money or change allocations because you do want to be a year from retirement and realize you don’t have enough. Ugggh..
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Decoding Money Secrets 