Indexing and dollar-cost averaging are always sound approaches to long-term investing, but right now they're especially timely.
By Michael Sivy, Money Magazine editor at large
NEW YORK (Money) -- Volatility. That's the one thing that seems predictable in today's stock market. Share prices are swinging up and down more violently than they have anytime in the past five years. And that seems likely to continue.
Most bear markets are the result of economic recessions. As investors begin to anticipate weaker corporate profits, they pay less for stocks. Once it looks as though the downturn is almost over, however, investors become more enthusiastic and stock prices typically rebound. This whole process can take up to a year.
The current bear market, however, is the product of an unexpected economic shock - gigantic losses at banks because of irresponsible subprime loans. That's an important distinction because it makes market moves more sudden and unpredictable.
We still don't know how big all the loan losses will be or how long they will go on. We don't know what the Federal Reserve will do at its meeting this week or later this year. We don't know what the next round of economic growth figures will bring, or the trend in unemployment.
So you should be prepared for high volatility for an indefinite period of time.
What does this mean for your investing strategy? Professionals who have to try to beat the market on a quarterly basis face daunting challenges. But investors with a time horizon of a decade or longer just need to make sure that they are not diverted from a sensible investing plan.
Dollar-cost averaging should be the cornerstone of any such plan, especially now. It is the practice of investing money at regular intervals and it has two advantages.
First, you limit the risk of putting all your money in when the market is at a high. And the more volatile the market is, the more important it is to spread out your contributions, so that some go in when stocks are cheap.
The second advantage is that contributions of a fixed size will buy more shares when prices are down and fewer when prices are up. The greater the price swings, the lower your average buy price.
Investors normally use dollar-cost averaging with index funds, because that's an easy way to contribute small amounts of money at frequent intervals - every month, for instance - and get broad diversification.
The other advantage of index funds is that they typically have very low annual management fees, especially if you pick an index fund at a large company such as Fidelity or Vanguard.
Writing in a financial journal in December, Princeton economics professor Burton Malkiel cited two mistakes that investors often make. One is to overestimate their ability to predict the future. The other is to overestimate how much they can control outcomes.
In fact, it's wiser to stick with a plan that pays off whatever the future holds. Moreover, there is one thing you really can control, which is the level of your annual expenses. So choosing a very low-cost index fund is one of the few things you can do that will surely improve your long-term results.
The most common index funds, which are also likely to have the lowest fees, are those that try to track the S&P 500. These funds hold primarily blue chips and are very broadly diversified among different industries.
S&P 500 index funds are also particularly timely now because the index tilts toward growth investments. And blue-chip growth stocks are undervalued by up to 20 percent, while value stocks are fairly priced. That means that the most convenient index is also focused on the most attractive part of the market.
So don't allow current economic turmoil to throw you off balance. If you have an orderly plan for building your retirement savings, stay on track.
And if you're younger and you haven't begun investing yet, this is a great time to get started. Open an account for an S&P 500 index fund and start contributing regularly every month or every quarter. You'll be helping to develop an important savings habit.One thing you do know is that the market is depressed right now. And whether it turns up soon or goes a little lower, if you begin dollar-cost averaging now, you'll be getting in on the ground floor.