Learning to weather market's highs, lows

PERSONAL FINANCE

June 11, 2006|By EILEEN AMBROSE | EILEEN AMBROSE,SUN COLUMNIST

When it comes to investing, we may be our own worst enemy.

Afraid of losing money, some of us bail out when the market drops. That turns paper losses into the real thing. Then we sit on the sidelines until the market recovers, missing out on the early gains of the rebound. Or, we are so confident in our skills as investors, that we ignore some of the basics that would protect our portfolio.

"Investors certainly lose more because of their own actions than the market's," said Louis Harvey, president of Dalbar Inc., a Boston research company.

The typical investor earned an average annual return of 3.9 percent in the past 20 years, according to a recent Dalbar survey that measures stock fund values and monthly cash flows in and out of funds. In comparison, the S&P 500 index gained an average of 11.9 percent annually. Harvey places a lot of the blame on an aversion to losses.

"The aversion to losses means that if the market declines we tend to withdraw funds. When the market is at its high and becomes euphoric, we invest," Harvey said.

Still, investors are savvier than they were 20 years ago, Harvey said, and sometimes our actions pay off.

In the past three years, the typical stock fund investor earned an average yearly return of 15.3 percent, compared with 14.4 percent for the S&P benchmark. Investors stayed in the market that steadily climbed overall from 2003 through 2005, Harvey said. And though the market had gentle ups and downs during those years, by the time investors reacted, they ended up buying shares when prices were low and holding off when prices were high, Harvey said.

Last month was one of the worst for the S&P 500 index since late 2002. This month is starting out rocky, too. Now is a good time to review bad investing habits and improve on ways to avoid them.

Here are some things to consider:

Overconfidence. So sure of their skills as investors, some people come to believe that bad things happen - but only to other people. Or, if the market only goes up, investors forget that it can go down. This can lead them to heavily concentrate their portfolio in one stock or fund. Even with the example of Enron, where employees lost their life savings after the company went bankrupt, workers elsewhere continue to hold huge amounts of their employer's stock.

To combat this, choose an asset allocation - a mix of stocks and bonds - geared toward your tolerance for risk and when you'll need the money. Maybe yours is, say, 60 percent stocks and 40 percent bonds. Then stick with it.

"There is really no good or bad investor. There is disciplined and undisciplined," said Robert Mewshaw, chief investment officer at Van Sant & Mewshaw in Lutherville.

Lack of diversification. You might have several funds, but if they hold the same type of stocks you're not diversified. Diversify a stock portfolio, for instance, through a mix of domestic and foreign; growth and value; and large-, small- and mid-cap stocks.

Diversification doesn't get you the highest return. But it helps reduce wide swings that could cause you to bolt the market.

Overwhelmed by choice? Consider a life-cycle mutual fund. Typically, the fund is based on an investor's target date for retirement, say, 2030. The more years to retirement, the higher the proportion of stocks. As retirement approaches, the fund shifts more money into bonds.

An added benefit of life-cycle funds: "People tend to hold them longer," Harvey said.

Anxiety acts. Sometimes market news fosters anxiety among investors, and they can't bear standing on the sidelines waiting to find out if a portfolio will be pummeled, said Sue Stevens, director of financial planning for Morningstar in Chicago. "It's human nature to want to do something." But a rash move when you're anxious could end up doing more damage to a portfolio.

If you want to take action, Stevens said, "Check what you are spending. That is something you can control. You will feel better that you are actually doing something."

Market timing. No one has perfected the ability to get in and out of the market at the right time, all the time.

Of course, sometimes a stock or fund deserves to be jettisoned because of some specific underlying problem. But selling off, say, all your large-cap stocks or funds because they have fallen out of favor means you stand a good chance of not owning them if they suddenly recover.

"Nine out of 10 times it's better to hold it than dump it," Harvey said.

Avoid the temptation of market-timing by dollar-cost-averaging, which is investing the same amount on a regular basis. You end up buying more shares when prices are low; fewer when the cost is high. It can smooth out a market's bumpy ride, and encourage people to stay invested in volatile markets.

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