If you live in fear of the wild swings on Wall Street, here are the words of wisdom I give my own family.
What should you do with your investments if you hear that the Dow has suddenly dropped 1,000 points in 20 minutes? Or that euro-panic has sent stocks swooning? The right answer should be "nothing." Because if you have to worry about a 1,000-point Dow drop ruining your life, your problem isn't the Dow. It's that you're not running your financial life properly.
Watching markets move is a great spectator sport, but it's not a great participant sport unless you're a market pro, in which case you shouldn't need any help from me. But here's a little secret for the amateurs among us. The more violent that market swings get and the louder the shrieking you hear from TV, blogs, and various journalistic advice givers, the more reluctant you should be to engage in any transactions until the madness passes.
The worst thing amateurs can do is to obsess over the market, minute to minute. Do that and you'll get whipsawed. You'll buy when people are optimistic about rising prices and the market's expensive, and you'll bail out when pessimism reigns and the market's cheap. You want to buy cheap and sell dear, not the other way around. One good thing about the 1,000-point drop, though, is that it gives me a chance to dole out advice that may seem shopworn -- heck, it is shopworn -- but that works very well in both good times and bad. It is that to invest successfully, you need staying power.
You need to know you can ride out declines without losing sleep (or at least not much) because your eating money or rent money or next term's tuition aren't at risk. So don't buy stocks until you have a cash reserve large enough to cover your bills for at least three months if you and any other employed person in your household lose your job (or jobs). Six months would be even better.
The major exception to this rule is tax-advantaged retirement accounts, such as 401(k)s. When you're putting in pretax dollars, getting matched by your employer, and deferring taxes until you take the money out, it's a deal too good to resist. Even without an employer match, it's pretty good.
One caution: The best-sounding investment your 401(k) may offer -- the target-date fund that gets more conservative as you get older -- deserves special scrutiny. If it's a Vanguard target fund, it's okay. No, I'm not shilling for Vanguard, the second-biggest target-fund operator in the country. I'm just giving you the same advice I recently gave one of my children.
Although the Vanguard funds aren't perfect -- nothing is -- they're cheaper and simpler than competitors' offerings. They consist of investments in low-cost index funds, which replicate the markets rather than try to beat them. Vanguard's target fee varies from fund to fund but is around 0.2% a year, about what it would cost you to own the index funds directly. In effect, you're getting a free portfolio reallocation, with fewer stocks and more bonds, as you age.
Other target-date funds, including the most popular in the country -- Fidelity's -- are at least three times as expensive as Vanguard's. They may still be the best deal in your plan, but it's less clear-cut than the case for Vanguard. (For information on attempts to clean up the target-fund industry, see "The Senator Who Wants to Save Your Retirement.")
With the tax savings, employer match, and long period for investment income to build up, it's hard to lose money on a retirement account. In other accounts, it's a different story.
The broad U.S. stock market has fallen by more than 50% twice since early 2000. Yechh! Nevertheless, the best way for the average amateur investor to own U.S. stocks is through a low-fee, broad-based index fund, such as one based on the Standard & Poor's 500 or the Wilshire 5000. They've been far from great over the past 10 years, but at least they haven't gone down 50% and stayed down. By contrast, individual stocks can go to zero, and the stocks of even fine individual companies, such as Microsoft and Cisco, can stay way, way down for years.
So be careful, be prudent, and live below your means. That way, when the Dow drops or rises 1,000 points in a day or the euro goes nuts, you can watch folks freaking out -- but for you, it will be only a spectator sport.