Chip Lawrence is well aware that the U.S. stock market has been blazing hot, nearly tripling in value over the past eight years. He’s pretty sure that means that returns are going to drop at some point. But he doesn’t know when or by how much and doesn’t want to fret about it. So he hired a financial planner to align his portfolio with his family’s financial goals.
Whether you do it alone or with professional help, experts maintain that investors would be wise to follow Lawrence’s lead. Hot markets create and encourage investment mistakes that can leave investors burned. Reviewing where you might go awry and taking steps to correct your direction can make you a better investor in almost any market.
“Investors can make mistakes at any time, but they’re more common when the market gets heated and investors get too comfortable,” says Anthony Danaher, president of Guild Investment Management in Los Angeles. “This is the perfect time to review investing fundamentals so you don’t make debilitating errors.”
What are common mistakes bought on by hot markets and what can you do to avoid them?
Mistake: Gambling with rent money
If you had started investing in just the past eight years, it would be easy to imagine that the stock market is a safe place to put your cash – all of your cash. After all, stocks have not only tripled in value over that period, there have been only a handful of bad days when the market has dropped by more than a few percentage points. Thus when online financial advisers at Betterment say to forget cash – invest your emergency fund in a “moderate risk” portfolio made up of as much as half stocks – it doesn’t sound like crazy advice.
But the stock market’s relatively steady recent performance is an anomaly. Nearly nine decades of historic market data compiled by Ibbotson Associates shows that stock prices could be up as much as 54 percent or down as much as 43 percent in any given year. So-called “bear markets” – long stretches during which stock prices drop by 20 percent or more – are also a regular occurrence. That makes stocks a risky place to put cash that you might need in a hurry – or even within a year or two.
“Long bull markets tend to make people feel invincible,” says Judith Ward, senior financial planner with mutual fund giant T. Rowe Price.
That said, risk and reward go hand-in-hand in the financial markets, which means stocks also provide the best returns over long stretches. “Investing is all about balancing the need for growth with the need to mitigate risk,” Ward adds. “It’s all about trying to attain your goals.”
Solution: Create investment buckets
Consider what your money is invested for. Is it to handle emergencies? College? Retirement? A new car – or a combination of these and other goals? Estimate how much current savings is needed for each goal and roughly when you hope to fund it. Then start divvying your money into short-term (6-months to two-years away), medium-term (three-to seven-years away) and long-term buckets.
Assets in your short-term bucket should be in safe and accessible, though admittedly low-return, investments such as bank accounts and Treasury bills. Your medium-term money can be in corporate and government bonds that provide a set return and a maturity date that corresponds with your need for the proceeds. Long-term money can go in a mixture of domestic and international stocks, as well as longer-term bonds and real estate investment trusts. These long-term assets are volatile, subject to sometimes violent swings in value. But, over the long haul they tend to appreciate far faster than the rate of inflation, which boosts your buying power over time.
Mistake: Failing to diversify
Bucketing your savings and investing in appropriate investment categories – i.e. stocks, bonds and cash — is just the first step. Each of these investment buckets needs to be widely diversified within its category, too. For instance, your bond portfolio might hold Treasury bonds, corporate bonds, tax-free municipal bonds and even international bonds. Your stock portfolio should have shares in big companies, small companies, international concerns and REITs, which invest in rental properties. The more diversified your holdings, the less chance that the woes of one company or one industry will derail your strategy.
“You see people load up on their own company’s stock – or with half of their portfolio in Facebook,” says Danaher. “One stumble and they’re stuck.”
Solution: Index funds
Although it’s fine to own some individual stocks, no one stock – nor single industry group – should make up more than 5 percent to 10 percent of your portfolio. If you don’t want to spend the bulk of your free time evaluating whether your investments are too concentrated, an easy way to diversify is to buy index funds in several investment categories. For instance, to diversify the stock portion of your portfolio, you could buy just three funds — the Vanguard Total (US) Stock Market Index; the Vanguard Total International Stock Index; and the Vanguard REIT Index. In total, that gives you shares in more than 9,900 different companies, spanning virtually every industry around the globe. A three-fund strategy could likewise diversify your bond holdings.
Mistake: Investment xenophobia
Even as U.S. stocks were going gangbusters, financial markets in other parts of the globe – from Europe and Asia to Brazil – were undergoing political and economic upheaval. That’s caused international investments to drastically underperform U.S. investments over the past decade and has convinced some that they’re better off keeping their money at home. But international securities are a necessary component of a diversified investment portfolio. Why? Let’s put it this way: Do you drive a Honda, Toyota, Volkswagen, Volvo, Mercedes, BMW or Saab? Do you cook your food – or wash your clothing — with appliances made by Samsung or LG? Eat fruits and vegetables imported from Mexico? Drink coffee from Brazil? Sit on furniture that was manufactured in China? Take overseas vacations?
Chances are, your day-to-day life is full of products manufactured in other countries. Since investing is about maintaining your buying power now and later, it makes sense to have a portion of your portfolio invested in the companies you do business with here and abroad.
Solution: Slice international into your investment pie
More than half of the goods and services produced in the world are produced outside of the U.S. That would suggest that as much as half of your investment portfolio should be dedicated to international investments, says James Paulsen, chief investment strategist with The Leuthold Group. However, according to the Investment Company Institute, the average U.S. investor has only half of that international exposure, which would suggest that many investors ought to lighten up on their domestic holdings to bolster the money they have in international funds.
“I think international markets are going to beat the U.S. market from here on out,” Paulsen adds. “International markets are in younger recovery cycles and have more potential for growth.”
Mistake: Letting inertia tip the scales
Even if you did all the right things at the start – matched money to your goals, divvied your assets up among different investment classes, and diversified widely – if you haven’t “rebalanced” lately, your portfolio could have fallen out of whack. Rebalancing simply involves selling a portion of your winners and/or buying more of the investment losers to make sure that your plan stays true to your goals.
Indeed, U.S. stocks have done so well in the past few years that they’re likely to overwhelm your portfolio. Let’s say you decided that the right investment mix for your retirement portfolio was 50 percent stocks and 50 percent bonds, for instance. If you invested in March of 2009 and just left your money alone, stocks would now account for 73.65 percent of your portfolio, bonds a mere 26 percent, says Michelle Swartzentruber, senior research analyst at Morningstar Inc. That dramatically hikes your risk.
“After several years of bull markets in stocks and bonds, you absolutely must rebalance,” says Ed Yardeni, president and chief investment strategist at Yardeni Research. “That simply means that you lighten up on some of the winners that have become too big a piece of your portfolio and move money into your laggards – or look for other opportunities that you haven’t considered.”
While it’s always tough to let go of a winning investment, rebalancing forces you to follow the old market adage that summarizes the best way to make money in the financial markets: Buy low; sell high.
Kathy Kristof is the author of Investing 101 and editor of KathyKristof.com
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