Ben Baden and Kirk Shinkle
It has not been a relaxing summer for Wall Street. Economic blues at home and debt crises abroad, a sickly job market, and a general fearfulness among investors over the future direction of the market are still weighing heavily on the minds of many Americans. At times like these, it's worth taking stock of some of the investing basics that can make any portfolio a less fraught proposition. Consider the following a checklist for staying sane when markets seem to be anything but friendly.
Don't pay too much. High fees can really cut into a fund's overall returns. This week, Morningstar released new data showing how important fees are in predicting the success of mutual funds. Morningstar looked at the expense ratios of funds in multiple asset classes from 2005 through 2008, then tracked their progress from 2008 through March 2010. Bottom line: Research found the cheapest funds outperformed the highest-cost funds in each asset class over every time period. For instance, in 2005, the cheapest quintile of U.S. stock funds returned 3.35 percent, on average, over the five-year period, versus 2.02 percent for the highest-cost quintile of funds in the category. When selecting funds, keep in mind that some asset classes are pricier than others. Large-cap funds are generally cheaper than small-cap or international funds, for example. It's a good idea to compare your funds' expense ratios with the annual fees of their peers. Christine Benz, Morningstar's director of personal finance, says generally, investors shouldn't pay more than 1 percent in annual fees for domestic large-cap stock funds, about 1.2 percent for international stock funds, and between 0.65 and 0.75 for bond funds.
Keep it simple. Index funds and exchange-traded funds track indexes, so they're generally cheaper than funds that rely on managers to pick stocks. ETFs, which look like mutual funds but behave like stocks, offer a simple, low-cost way to invest and gain instant diversification. When you invest in an ETF or an index fund, keep in mind that your fund won't likely underperform its index, but it won't beat the index, either. "I'm a huge fan of simplification strategies, and I think indexing a broad-market segment is a great way to do that," Benz says. "It's possible to pick active funds that outperform index funds, but in terms of something that's low cost and hands-off, it's hard to beat indexing." Funds that provide exposure to U.S. stocks include Schwab's Total Stock Market Index Fund and its U.S. Broad Market ETF. Funds for a globally diversified portfolio include Vanguard Total World Stock Index Fund or Vanguard Total World Stock Index ETF.
Dollar-cost averaging. Many investors pull money out of stock funds when the market gets bumpy. In a volatile market, it can be difficult to stick to your investment plan. One way to stay on track is by practicing dollar-cost averaging--investing a set amount of money on a regular basis instead of investing a large sum at once. "It can provide discipline, and it can give you the courage to invest in what could--in hindsight--turn out to be a good time," Benz says. Dollar-cost averaging ensures that you'll continually invest in the market regardless of how it's performing at any given time. You can begin dollar-cost averaging by setting up an automatic investment plan through a fund company. T. Rowe Price, for example, will allow you to invest in more than 90 of its no-load funds if you agree to contribute at least $50 per month to a fund. One offering is T. Rowe Price Spectrum Growth Fund, which provides broad-market exposure through 11 underlying T. Rowe Price stock funds.
Diversify within asset classes. The so-called "lost decade for stocks" makes a good case for diversification. If you had invested only in an index fund that tracks the S&P 500 over the period starting Jan. 1, 2000, and ending Dec. 31, 2009, you would have earned virtually nothing. The culprit? Large-cap stocks that performed poorly during this time period. Meanwhile, other asset classes provided a solid return. For instance, over the past 10 years the Russell 2000 (a small-cap index) has returned an annualized 4 percent.
Keep an eye on cross-asset allocation. Large cap? Small cap? Those distinctions matter, but not nearly as much as the mix of different classes of assets in your portfolio. And it's not just stocks and bonds anymore that make up a truly diversified portfolio. Experts now say equities and fixed income should be held side-by-side with a raft of assets, including real estate, commodities, and other alternative investments in an attempt to prevent just the sort of damage that hit portfolios during the 2008-2009 crisis, when wide swaths of assets (homes, stocks, bonds) all lost value at the same time. Research shows that almost all investment volatility is driven by asset allocation decisions--how you carve out investments among stocks, bonds, real estate, international investments, and commodities. A classic study of pension funds showed that 91.5 percent of investment variation in quarterly returns is explained by investment policy rather than stock picking or other factors. "It's not so much what you put in your account, it's how you allocate what you put in your account that's going to help reduce volatility," says Brian Rimel, an adviser with Raymond James.
Rebalance periodically. It's important to monitor your portfolio and make sure your asset allocation changes over time, says Benz. "Making the judgment about what is an appropriate stock, bond, and cash mix, and also taking care to adjust that over time as you get closer to needing your money is a hugely important and impactful step--arguably more important than individual security selection," Benz says. Some experts recommend that younger investors fill their portfolio entirely with stocks, then begin to shift into other types of investments, like bonds, as they get older. Benz recommends target-date funds, in which a manager handles the asset allocation through a set retirement date. Fund families often employ different "glide paths"--or asset allocation that changes over time. As you approach retirement, target-date funds generally shift to a more conservative mix over time. If you decide to choose your own funds, remember to rebalance periodically.
Don't try to time the market. It's a common investing error: buying funds when they're flying high and dumping them when they fall behind. Over the past decade, Morningstar research has shown that investors simply aren't successful in timing the market. To illustrate, Morningstar calculates what it calls investor returns, which reveal how much money actual investors actually make or lose in a fund based on when they buy and sell. The difference can be huge. Many individual investors do a poor job of timing the markets and tend to lose more in funds than the actual returns show. Take Janus Twenty. It's a large-growth fund that ranks in the top half of its category over the past 10 years that has lost 2 percent per year, on average. According to Morningstar, investors in the fund, on average, lost an annualized 7 percent over that time period because they jumped in and out at the wrong times. Research has shown that the most volatile funds in the most volatile categories, where big swings in returns can make for a wild ride, have the worst investor returns when compared to average reported returns. "We tend to see with the more extreme types of funds that those are the funds where investors badly mishandle their timing decisions, so the more volatile the fund category the more likely you are to see a pattern of investors foregoing gains because they timed their purchases poorly," Benz says. For all categories, over the past decade, the average investor returns among funds representing all asset classes have been about 1.5 percentage points lower than the funds' average reported returns, according to Morningstar's research.
Don't pick (all of) your own stocks. You won't hear it on CNBC, but stock picking isn't for everyone. For investors who aren't willing to spend a good amount of time scouring stock charts or company filings, it's best to treat individual stocks like any other exotic part of your portfolio: They're fine to own in moderate amounts. Experts say a good rule of thumb for part-time investors is to keep less than 10 percent of your total portfolio in individual names, with the rest of your equity exposure in low-cost index or actively managed mutual funds. If you aren't willing to invest the time in digging deep into a company or industry, leave the stock picking to the pros. If you're dead-set on owning individual stocks as longer-term holdings, financial advisers say it's not a bad idea to play it safe by sticking with large, well-known global companies that pay a decent dividend along the way. Rimel says companies like Intel (with its 3.2 percent dividend) fit that profile. "They're very important to keep you ahead of taxes and inflation," he says.
Cut your losses. Any investor who's done it knows that selling at a loss hurts. But the best investors know that limiting losses can be just as important as picking winners in the market. That's because investors can recover from small losses quickly, but digging out from a sudden loss of 25 percent or more can mean a small portfolio will take years to recover. Longtime investors like William O'Neil have long advocated selling stocks when losses hit 8 percent. Other experts advocate selling half of a position at a 5 percent loss, and bailing out completely when share prices dip 10 percent. Either way, the ability to fall out of love with a stock can be just as important as picking the right investment.