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Sunday, 2 September 2007

Four Tips for Riding a Seesaw Market

by Laura Rowley

My neck hurts. According to the Mayo Clinic's web site, whiplash occurs "when the head is jerked forward and back, stretching the soft tissues of the neck beyond their limits."

Lately, I find that an involuntary neck-snapping occurs every time I walk past a television, computer screen, or radio, and catch the latest stock market update.

This is typically followed by an ill-advised trip to the Internet to survey my investment accounts -- sagging like cheap hosiery bunched at the ankles. Who knew stocks and stockings could have so much in common?

If this market doesn't give you whiplash, stop reading. But if a 300-point drop in the Dow evokes the sensation of digesting bad oysters, here are a few tips to ease your market-induced stress.

Be True to Your Goals

Investing is about meeting life goals, so make sure your allocation reflects your aspirations.

I hate when people say that investing in the stock market is gambling. Money thrown on a blackjack table in Atlantic City can evaporate instantly (which, regrettably, I learned the hard way). But that's never happened with a reasonably diversified portfolio of stocks and bonds.

On the other hand, a diversified portfolio will swing in value, a natural reflection of the economic cycle. The investor's best defense is to develop a specific allocation strategy that's like Donald Trump's hairstyle -- highly individualistic and oblivious to passing fads.

"It's important to come up with an allocation to meet and achieve goals -- that's the biggest disconnect I see," says Michael Steiner, wealth manager with RegentAtlantic Capital in Chatham, N.J. "Clients will come in with a portfolio, and when I ask what the objective of the portfolio is, 99 percent say, 'To make money.' But what's the money for?"

Be Realistic

Financial goals need to be concrete, precise and measurable -- with real timeframes and credible numbers.

For instance, Steiner says, "If you want to retire at 62 and live on a $70,000 after-tax [income], then the portfolio should be constructed to meet that goal."

Nobel laureate Harry Markowitz demonstrated that the bulk of investment returns come from allocation -- the mix of investments -- rather than the choices made in each category. It's kind of like nutrition: You'll get fat if you eat more ice cream than vegetables. It doesn't matter whether it's Ben & Jerry's Chunky Monkey or Edy's Cookie Dough.

"That's the most basic investment decision most people will make -- how much you have in cash, bonds, and stocks," says Charles Farrell, of Northstar Investment Advisors in Denver. "Then, within the bond and stock categories, check to ensure that you're adequately diversified. People debate the appropriate amounts, and there's no correct answer, but what generally makes sense is to have a broadly diversified and balanced account." (Novice investors, see my blog for allocation how-to's.)

By contrast, if you're in the market with vague hopes of getting rich, you'll likely abandon ship when stocks decline -- which everyone knows is the ideal time to get in. "It's been proven time and time again: When there's doom and gloom, it's usually the best time to buy," says Steiner. "Emotionally, it's the hardest decision to make, even though fundamentally it makes sense."

Be Patient

Stocks are an excellent investment -- over time.

If you're unnerved by the latest market rout, it may be time to reconsider your risk tolerance. But first look at the timeframe of your investments.

"The more time you have -- for instance, until retirement -- the more you can tolerate the natural gyrations of the markets," says Michael Furois, president of The Planning Associates in Phoenix. Ariz. "When looking at your 401(k) or other investment account statements, you may have to remember this: The reduced value of your investments is only a temporary decline in price, not a permanent loss in value."

In its best year, the S&P 500 rose nearly 54 percent; in its worst year, it dropped about 43 percent, according to Ibbotson Research. Nobody knows what's going to happen in the future, but studies based on the past performance of the S&P 500 have found that since 1925, the chance of losing money over a year is 28 percent; over 5 years, 10 percent; over 10 years, 3 percent; and over 20 years, 0 percent.

"One good way to test your comfort level is to take a hypothetical market decline and apply it to the amount you have invested in the market," Farrell suggests. "For instance, if the market declines 20 percent, that will affect each one of us differently. If this is my first year as an investor and I have $5,000 in the market, my account might decline $1,000. Probably not a life-changing event. If I have $500,000 in the market and am age 50, I might see a decline of $100,000. Each investor has to honestly answer whether they're comfortable with that type of volatility."

From 2000 to 2002, investors experienced declines of 50 percent. Farrell points out: "Apply that number to the amount you have in equities and see how you feel. If you can stay committed during that type of cycle, and focus on the probability of long-term positive returns, then you're probably in the right place," he says. "If the potential decline in your account value concerns you, then you may be taking too much risk and it's probably time to consider some modifications."

In the meantime, also consider that from its low point in 2002, the Dow has risen about 6,000 points, or roughly 80 percent.

Be Introspective

Market volatility can be a reminder to reassess risk and rebalance.

If the market roller coaster is keeping you up at night, don't get down on yourself. You probably couldn't have predicted you would feel this way.

People make predictive errors for a variety of reasons, but one that's perhaps most germane here is something called "the hot/cold empathy gap." When people are in a "cold" or neutral emotional state, they often have trouble imagining how they would feel or what they would do if they were in a "hot" state -- angry, hungry, in pain, or, say, watching their E*Trade account plummet in value.

On the other hand, when we're experiencing a hot state, we have difficulty imagining that we'll cool off at some point (which is why, in the heat of the moment, it seems perfectly reasonable to sell all the stocks in your E*Trade portfolio and put the money under your mattress).

Meanwhile, studies on loss aversion have found investors tend to feel the pain of losses more than the joy of gains. "Investors generally make mistakes when they're reacting out of either fear or greed," says Farrell. "Having a balanced and diversified account generally helps combat the tendency to be driven by those two very powerful emotions."

Once you design an allocation strategy, rebalance it at least once a year to reflect the original mix. "Maybe you let those winners ride a little too long and weren't diligent about maintaining your allocation," says Steiner. "Maybe your 60-40 stock-to-bond ratios went to 50-50, and you felt too overconfident."

Get Help

If you're not sure how much risk to take, or whether your investments accurately reflect your life goals or appropriate timeframes, get some help. Many 401(k) providers have investment professionals available to talk to participants about their allocations. Or consider talking with a fee-only financial planner.

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