When the markets are up, everyone is excited about investing. When they are down, not so much.
Long-term historical stock market returns average about 9% per year. That looks enticing given the anemic returns on cash today. Investing in equities has proven to be an excellent way to build wealth over the long term.
Over the short term, not exactly.
So, what is the first rule of investing? Some might say it is this: take your funds to a local discount broker and buy 100 shares of a top performer. But is that really wise?
According to stockpickr, a 2012 top S&P 500 stock performer was Bank of America (NYSE: BAC). Does this mean you should rush out to buy shares in Bank of America? Before you open up your laptop, realize that BAC was among the worst performers in 2011. Are you certain that it will continue its upward movement?
Picking the top performers of last year is not the recipe for success. First off, if a stock was a great performer last year, it’s likely to sport a frothy valuation. Bank of America has a price/earnings ratio of 40. Do you really think that one dollar of BAC’s earnings is worth $40?
When a stock is a top performer one year, its price gets bid up to unreasonable levels and it becomes overvalued. So, picking a top performer last year is not the first rule of investing.
Then what is the first rule? Before I tell you, consider this:
Given the recent upswing in stock prices, the pull is to get in and start picking stocks or funds. Your mind is telling you not to sit on the sidelines or you will miss out. Let’s look at a very real scenario. You take $5,000 and put it in a diversified stock index fund this week. Since markets are volatile, after a big run up like that of the past four and a half years it’s normal to have a correction.
Flash forward to the end of 2013, and imagine your stock fund has declined in value to $4,000 for a 20% loss. Will you be so upset that you sell and take the 20% loss in order to avoid further pain? Will you be afraid that the value of your investment will continue to decline? Do you know how you will react? Because that's the first rule of investing: Know your risk tolerance.
In any one year, your investments can go up from a few percent on up to 30% -- or even higher on occasion. That’s not a problem. The issue is when stocks have a drop of the same amount in one year. If you cannot stay invested throughout the ups and downs, your returns will suffer. The research is clear: Trade more often and reap lower returns.
You must know your risk tolerance before you begin investing. If you lose sleep and jump to sell at any sign of a market decline, then you are very risk averse. In that case, having a large proportion of your investment portfolio in individual stocks or stock funds may not be for you.
So how do you determine your risk tolerance?
There are many risk quizzes available to help determine what percent loss you can tolerate in your portfolio without rushing to sell. Examine your prior reaction to market declines. If you cannot sleep when your investments decline, then you don’t want 80% of your investment portfolio in equities. If you can handle only a small decline, such as 5%, then create a portfolio weighted toward cash and bond investments and lighter on the equities.
If there is a long time until you need your invested assets and you can weather a drop of 15 to 20%, decrease your cash and bond investments and ramp up exposure to the stock markets.
This moderately aggressive portfolio has two thirds invested in diversified stock funds and one third in a Treasury inflation-protected bond fund. The U.S. stock fund and the international stock fund offer great diversification but little protection against international stock market corrections. In a steady-interest-rate environment, the inflation-protected bond fund will hedge against some of the stock market volatility. This portfolio is for someone who is less risk averse.
If you are prepared and informed about the potential downturns in the market -- and you can stay invested -- you are on the path to becoming a successful investor. If you cannot tolerate periodic losses or are approaching retirement, stick with a portfolio weighted toward Government I Bonds, cash and conservative bond investments.
The Investing Answer: Before investing a dime (or more), determine your risk tolerance. Use your prior experience (How did you react when your investments dropped in value?), or check out this Risk Quiz developed by two finance professors at Rutgers University.