It's not surprising that first-time investors often worry about the timing of their initial stock purchases. Getting started at the wrong point in the market's ups and downs can leave you staring at big losses right off the bat.
But take heart, Fools: Whenever you first invest, time is on your side. Over the long haul, the compounding returns of a well-chosen investment will add up nicely, whatever the market happens to be doing when you buy your first shares.
Don't Waste Time
Rather than fretting about when you should make that first stock purchase, think instead about how long you're planning to keep money in the market. Different investments offer varying degrees of risk and return, and each is best suited for a different investing time frame.
In general, bonds offer smaller, more dependable returns for investors with shorter time frames. According to Ibbotson, short-term U.S. Treasury bills yielded roughly 3.7% per year from 1926 to 2003. (We picked 2003 as an endpoint because it was right after the end of a bear market.) While this seems relatively meager, remember that inflation was nonexistent for most of this period, making a 3.7% average annual return fairly attractive until the 1960s.
Longer-term government bonds have provided slightly higher returns: an average of 5.4% annually from 1926 to 2003. Surprisingly, their gains have been relatively volatile. In the 1980s, for instance, they returned nearly 14% annually, but in the 1950s, bonds lost an average of nearly 4% per year.
Stocks have also been very good to investors. Overall, large-cap stocks have returned an average of 10.4% per year from 1926 to 2003 -- quite a bit higher than bonds. Surprisingly, the range of the returns for stocks is not that much larger than the range for bonds over the same period. Stocks suffered a slight decline in the 1930s, but enjoyed several particularly strong decades as well, including the 1950s (18% average annual return), the 1980s (16.6%), and the 1990s (17.3%).
When Will You Need the Money?
The longer you have to amass your cash, the greater risk you can accept, since you'll have more time to wait out periods of bad returns.
If you need the money within the next five years, you'll want to avoid individual stocks and stock-centric mutual funds. If you need the money within the next three years, you should also avoid bond mutual funds and real estate investment trusts (REITs), which can drop if interest rates increase.
With those options eliminated, you have a few choices left: buying individual bonds or certificates of deposit (CDs) with durations of less than three years, putting your money in a money market fund, or using a savings account. Each vehicle generates income while guaranteeing the return of your principal. The sooner you need the money, the less you can afford to lose, right?
On the other hand, stocks are a very attractive option for long-term goals like retirement. The higher returns are simply too good to pass up.
When to Sell
Once you've decided what to buy, and when to buy it, you'll next need to decide when to cash out. Since bonds essentially sell themselves when they mature, this question primarily applies to stocks or stock mutual funds.
Some investors believe they can "time" the market, accurately predicting when it will rise and fall. As a result, they counsel selling all your stocks when the market is about to fall, and buying them all back when the market prepares to rise. Unfortunately, if investing were that easy, these same folks would be sunning themselves on beaches in Acapulco, rather than trying to sell their timing methods to other investors.
Granted, when overall economic woes begin to hurt corporate earnings growth, and companies start to flounder, you might consider selling some of your overvalued, lower-quality companies. But beyond that very general scenario, an accurate system for timing the market remains an investor's pipe dream.
Many mutual fund investors are quick to withdraw their cash when returns turn sour. But several academic studies have proven that investors who jump from one fund to the next, chasing performance, tend to do vastly worse than those who stay put. Be prepared to stick with a fund through good times and bad -- with one exception.
In an actively managed fund, you've entrusted your cash to a professional money manager. If that manager abandons your fund to manage another, his or her replacement may not manage your money with equal skill, and you may want to consider selling. Otherwise, a few months of poor fund performance are no reason to jump ship.
Selling stocks can present a more complex set of questions. Two major warning signs may suggest that it's a good time to sell:
• The business's fundamentals change. Is a new competitor rendering its basic products obsolete? Is the company branching out into areas wildly unrelated to its core competencies, leaving you no longer able to understand the business?
• The stock becomes overvalued. Has the market bid the company's shares up to unsupportable heights? Is the stock likely to crash on the slightest bad news? Does the risk of such a tumble outweigh any tax hit you'd take by selling now?
While both those red flags can provide excellent reasons to sell, many of the other screaming sirens surrounding the market can be safely ignored.
Don't Listen to the Noise
The media pays meticulous attention to Wall Street -- but it tends to focus entirely on one particular index, assuming that it reflects the entire market. Index goes up? The market is bullish! Index goes down? Here comes the bear market! Index yo-yos back and forth? Now the market is "volatile!"
Some investors, particularly those keen on technical analysis, study the ups and downs of market graphs to gauge whether investors will take the market higher. For Foolish investors, this is an exercise in futility. Successful investing relies not on monitoring the market as a whole, but on analyzing the strengths and weaknesses of individual companies. Whatever the market's doing at the moment, a buy-and-hold approach to investing is the best way to earn reliable long-term returns.
Review, Review, Review
Of course, you can't just load your portfolio with a few stocks -- however well-chosen -- and forget all about them. Like houseplants, investments need regular care and attention to flourish. Unless you've parked your money in government bonds, with their guaranteed rates of return, you need to check on your investments regularly to make sure they're beating the market -- and doing so more substantially and less expensively than other, similar options.
Reviewing your investments, particularly when you may have made mistakes, also offers a crucial opportunity to learn from your mistakes. Everyone makes errors now and then, but most successful investors avoid making the same goofs twice. Set aside time to review your portfolio at least once every three months, if not every week. While you shouldn't be glued to the computer screen, tracking your investments minute-by-minute, don't forget them entirely, either.