Jan 24th, 2008
Doing the Smart Things in a Down Market…
…are not any different than doing the smart things in an up market.
The stock market in the United States has a long, successful track record, but it’s never going to go straight up and not occasionally come straight down. Clearly, after the all time highs in the S&P 500, Dow Jones Industrial Average, and Wilshire 5000, we are in correction territory (yes, at some point there will be a Working Backwards post on corrections, as well as on bull and bear markets). The stock market is a marathon, not a sprint. If you’ve been in it long enough, you realize that sometimes things go great, and sometimes not, but over the long run, the results have been positive–and better than other investments.
What are the smart things to do when you’re investing? They’re simple, and importantly, they’re the same if the market is headed up or headed down.
1) Take advantage of the perks offered by the government and your employer
Does your employer offer you a match on 401(k) or 403(b) contributions? Take every cent. That’s free money! If you’re offered a 401(k) or 403(b) or other equivalent plan at all, take advantage of it. Those are pre-tax dollars which can lower your tax burden considerably. Do you qualify for a Roth IRA? Go for it! How about catch up provisions for IRAs or 401(k)s if you qualify with age? Do those too! If it’s free money or a tax break, go ahead and take advantage of it.
2) Keep your costs low
Use a quality discount brokerage. I have a couple of accounts at Firstrade.com and love their low trading costs (not that I trade more than one day a year) and lack of maintenance fees and inactivity fees. Buy mutual funds with no loads, low turnover, and low expense ratios (Vanguard’s family of index funds comes to mind), or their exchange traded equivalents with marginally lower costs. Costs are one of the few variables an investor can control, and over the long term the higher costs, taxes, and fees of high cost funds and brokerages can make a huge difference in your bottom line.
3) Understand the importance of asset allocation
How much money you have in stocks, how much money you have in bonds, how much money you have in cash: that’s what asset allocation is. It’s tough to give a recommended asset allocation for everyone, but I try anyway: for most folks, my model portfolio of 50% domestic stocks, 25% international stocks, and 25% high quality bonds is what I think makes sense; if I was in retirement or had low risk tolerance, I might do something like 35% domestic stocks, 15% international stocks, and 50% high quality bonds. In any case, understand that asset allocation is important because some years one of your investments will do better than others and it’s not the same investment every year. This is yet another way of not putting all of your eggs in one basket.
4) Dollar cost average
Buy into your investments with the same dollar amount at regular intervals; that’s what dollar cost averaging is. Fortunately, most 401(k) plans allow this to happen automatically. Every month, a certain amount of money is invested.
The theory behind dollar cost averaging is that it reduces the risk of buying when the market is at a peak by spreading the investment over a long period of time. The statistics don’t necessarily back this theory up. However, the real purpose in my mind of dollar cost averaging is to get people into the habit of investing regularly. Just make it part of your monthly budget.
5) Diversify
The overall trend of the market is up. The risk of buying an individual stock is underperforming the index. The way to avoid that is to diversify; if you have a thousand shares of a single stock you have a lot more risk than if you have one share of a thousand different stocks. You can easily diversify by buying into (all together now) low cost, no load, passively managed mutual funds or their exchange traded equivalents.
The nice part of these five smart things to do with investing is that they’re smart no matter if the market is up, down, or going ’round and ’round. They’re simple, they’re low cost, and they’ve worked for many, many investors–including myself.
[...] keith wrote an interesting post today onHere’s a quick excerptHow much money you have in stocks, how much money you have in bonds, how much money you have in cash: that’s what asset allocation is. It’s tough to give a recommended asset allocation for everyone, but I try anyway: for most folks, … [...]
I agree. As long as you’re investing wisely and diversely…and you don’t need the money right away.
Another way to lower your risk is to thoroughly know and understand the business you’re investing in. If you do decide to invest in individual stocks, a complete knowledge of the industry, its players, trends, and tendencies will significantly lower your risk when investing in an individual stock. Always invest in a business, not a stock.
And thank you for saying that DCA doesn’t always work like some magic formula. I’ve been saying that for years.