These are scary times for anyone trying to build or preserve their retirement accounts. Today’s roller coaster ride of economic ups and downs — with swings in the Dow Jones average of 500 points or more in just a few days — is enough to churn stomachs in all but the most steely nerved passengers.
Is this simply another predictable, even healthy, correction in a long-term bull market? Or are we poised for an investor meltdown?
No one knows for sure, of course. Even a modern-day Nostradamus couldn’t tell us what’s going to happen tomorrow. But no matter what, avoiding these six costly investment mistakes will help you to keep your head above today’s troubled waters.
“Fluctuations in the market are a natural part of our economic cycle,” says Stacy Francis, Certified Financial Planner and founder of Francis Financial in New York. ” When the market is in a downturn it may seem logical to cash out and go home, but before you do that you may want to think about your long-term goals for that money.”
Market downturns, even recessions, are relatively common occurrences in a free economy. A recession is defined as a decline in Gross Domestic Product, or GDP, for at least two consecutive quarters, making it rather easy for us to slip into one. But they have become shorter duration and less severe than they were in the past.
According to studies by Ned Davis Research, since World War II, the average expansion in our economy has lasted 57 months, while the average recession has lasted 10 months. In the past 20 years, according to the study, we haven’t had a recession last longer than eight months.
All of this suggests the rules of the game of profitable investing remain pretty much the same. During the current bumpy ride, investor concerns are focused on such things as the effects of the subprime mortgage crisis, the price of oil and the threat of a recession. While any of these may seem of formidable proportion, they are probably no worse than the concerns that bothered investors in the 1960s, or the 1980s, or any other period.
“Many people sell low and buy high because emotion drives their investment decisions,” says Lisa Featherngill, CPA/PFS, member American Institute of Certified Public Accountants. “Remember, you haven’t lost money until you actually sell the security.
“If you decide to sell, buy something else right away. Studies have shown that your investment returns will suffer dramatically if you miss the best days of the market. Nobody knows when the best days will occur, so stay invested.”
In short, investing for a financially healthy retirement still calls for the same kind of common-sense approach that has worked so well in the past. Most experts predict that the long-term future will most likely mirror the long-term past. That is, a steady pattern of economic growth with periods of expansions, recessions and downturns in the market.
“In an effort to sell newspapers and air time, the media trains investors to look out for the next economic number of the day,” says Jordan Kimmel, managing director at Magnet Investment Group in Randolph, N.J. “Whether it’s employment numbers, capacity utilization or inflation statistics, there is always a number of the day to tempt investors into overreacting. In reality it is nonsensical to react to daily economic reports. No investment strategy is better than identifying superior companies and holding them while letting your money compound over time.”
Some of the world’s most successful investors made their fortunes by buying when everyone else was selling. But that’s not easy to do. Investing steadily during market downturns may be too much of a psychological adventure for most of us, but there is a system that enables almost anyone to take advantage of those tempting buying opportunities. It’s called dollar-cost averaging.
“Dollar-cost averaging calls for spending a fixed dollar amount each month or quarter on a specific investment or part of a portfolio, regardless of the ups and downs of the share prices,” says Francis. “By following this pattern consistently, you will purchase more shares when prices are low and fewer shares when prices are high.”
For example, if you decide to spend $500 each month on purchasing shares, you will be able to buy only a few shares if the price is $100 per share. However, if the price goes down to $50 the next month the same dollar investment will buy twice as many shares.
“By making regular and consistent purchases over a longer period of time, your cost basis — the total amount you pay for a security — is spread out. That provides a cushion against normal market price fluctuations,” says Francis.
“Dollar-cost averaging is a time-proven and effective way to minimize the effects of emotion in financial management,” says Kimmel.
“It’s better to invest regularly, without regard for the general condition of the economy or the direction of the stock market,” says Darrell J. Canby, CPA/CFP and president of Canby Financial Advisors, in Natick, Mass.
“Timing the market, trying to determine the best time to buy specific stocks, rarely works,” he says. “You might get lucky once in a while, but your luck isn’t likely to last.”
Rick Willeford, M.B.A. and CPA/CFP, in Atlanta, Ga., says simply, “Market timing and day trading are for suckers. The financial press makes money from advertising, and they do that by keeping you breathlessly chasing the latest tip or fad. They make money whether you win or lose.”
Waiting for stocks to hit the “bottom” before you buy or hit the “top” before you sell has long since proven to be a loser’s game for investors. Select the stocks or mutual funds that you buy only on the basis of sound fundamentals.
If there is one point that virtually all financial advisers agree on, it’s the critical need for you to maintain an asset allocation suitable to your personal circumstances. Asset allocation refers to the process of dividing your investable assets among stocks, bonds and cash.
The diversification mix that is right for you at a given point in your life will depend on such things as your age and your tolerance for risk.
If your retirement is years away, most experts recommend relatively heavy investments in equities, 60 percent or more of your total portfolio. “However, if your time horizon is less than three years,” says Certified Financial Planner Greg Womack from Edmond, Okla., “stay in fixed investments like CDs, short-term bonds and money markets.”
Once you allocate your assets in the manner right for your circumstances, it’s important to rebalance at least once a year. As the price of equities goes up or down, the ratio that you have established will change. If the value of your equities has risen, you may want to sell off some of them to restore your original ratios. If their value has dropped, moving more cash into equities may be appropriate.
“If your portfolio is largely within an IRA or other retirement plan, consider rebalancing every quarter,” says Womack. “If it is regular, taxable money, consider at least annually, perhaps more during extremely volatile periods. For rebalancing strategy to work, you must own assets that don’t react the same way over differing market conditions.”
“Creating a plan such as dollar-cost averaging and sticking with it under all market conditions is the way to maximize your returns,” says Kimmel. “Human nature makes it difficult for the average investor to stick to an investment strategy unaffected by emotion. Sometimes it’s fear; sometimes it’s pure greed. Either way, allowing emotions to affect your investing decisions is certain to damage your financial future.”
“It’s human nature to chase hot sectors that have already made a significant move,” he says. “It’s also natural to panic and sell-out when everyone else is doing the same.”
While it may be the natural thing to do, it’s not the smart thing, according to Womack. “It’s important to have an investment strategy and stick to it. Remember: If the headlines are full of it and everyone else is doing it, you’re probably too late.”
There is, of course, much more to the maintenance of an investment portfolio that may well help you sleep during these scary investment times. However, sticking with these common sense fundamentals will go a long way toward achieving that end.
For more help with investing, see Bankrate’s investment calculators.
William J. Lynott is a freelance writer based in Pennsylvania.