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P UNTIL OCTOBER 27, the markets' relentless bull run was commanding more and more attention. Folks who had never invested in anything but savings accounts and CDs were wondering if they should get in while those already in the market were wondering if they should get out. These extremes are the topics for this month.
After the initial publication of this page, there were several inquiries asking How do I Get Started?" It's not as hard as you might think, and it can even be interesting. At the other end of the spectrum, the guys at the barbershop were debating whether they should get out of the market. Oddly enough, they were asking the wrong question. To see why, check out "Should I Raise Cash?".
Do you have any questions or concerns? If so, send 'em in. An effort is made to respond to all and who knows, you may be the inspiration for the next update.
So why haven't you started? Well, it's probably for two reasons: You don't have the amount of money necessary to set up a stock portfolio, and even if you did, you aren't sure you'd know how to invest it anyway. Does that sound about right? If so, don't worry, both problems can be overcome.
First of all, you don't need a giant pile of cash to start a portfolio. In fact, systematic saving is a conservative and effective approach. We'll come back to that below. As far as the actual investment is concerned, all you need is a consistent plan of action. Here it is:
1. CAN I AFFORD TO INVEST? If you're considering investing in stocks (even conservatively), you've got to realize the value of your portfolio will go up and down. While equities have historically provided the greatest return of all investment classes, this is true over the long-term, not the short-term. In other words, you don't want to invest next month's mortgage in the stock market. Before entering the market, be sure you've set aside enough for emergencies.
What's a sufficient amount for emergencies? That's a good question. Some advisors say three months' gross income. Others say six months' living expenses. There isn't one right answer for everyone. What's right for you is the amount you feel comfortable with knowing that your other investments may not be there when you need them.
Your emergency money shouldn't just sit in a coffee can. While you don't want to tie it up or risk its value, you can do better than Bank of Maxwell House. The easiest option is a money market fund. Now don't confuse this with a bank money market -- that's a money market in name only. Real money market accounts are sold by mutual funds. Like bank money market accounts, they allow you to write checks and there's no "substantial penalty for early withdrawal". In the process, they pay about double a savings account and usually at least 1% over a bank money market. No, they aren't FDIC insured, but they're invested in such short-term instruments, risk is still almost negligible.
If you can't bring yourself to leave the safety of the bank, your other alternative is to use a ladder of CDs. To do this, break your total balance into several equal parts -- quarters or fifths usually work well. If you use quarters, invest one part in a three-month CD, another in a six-month CD, another in a nine-month CD, and the final quarter in a one-year CD. While you would suffer the dreaded early withdrawal penalty if you needed all of the money at once, you'll have one quarter coming due every three months. Even if you have an emergency, odds are you won't need to tap your entire balance at once.
By using the CDs, you'd be getting a higher return than if you simply left the total in a savings account or bank money market. In addition, if you don't need the money when one of the CDs matures, you can simply reinvest it in another one-year CD. That way, you're always reinvesting at the long end, and the highest rate in your ladder.
Now that your emergency funds are set aside and invested, you're ready to invest for the long-term. But before jumping in, you need to ask yourself:
2. WHAT AM I INVESTING FOR? Are you investing for retirement, for your children's education, to be able to pass something along to your heirs, or for some other reason? You can be a lot more aggressive if you're just trying to build up an estate than if your kid is depending on you when he heads off to college in five years. You might also want to be a little more conservative with your retirement savings if you're fifty-five rather than thirty-five.
The bottom line is this: The longer the time before you'll need the money, the more risk you can assume. Why do you want to take on risk? Because there's a direct relation between risk and return. The more risk you take on, the greater the return you can expect in the long-term. Return is kind of like your reward for assuming risk. The longer it is before you'll need the money, the safer it is to take on risk. (This is why your emergency money needs to be in a safe, liquid investment -- you can't afford to risk it.) If the market goes down when you're thirty-five, you have thirty years to make it up; but only ten years if you're fifty-five.
Your reason for saving will not only define your time horizon, it'll also help determine the amount you'll need. While a thirty-five year old has a lot longer to save than a fifty-five year old, she'll probably need more, if for no other reason, than inflation. Back when IRAs were first available, banks made a big deal of pointing out that a thirty-year-old could easily save $1-2 million by age 65. That's true, but even with inflation at a modest 3-3.5%, that $2 million would be worth roughly $250,000 to the thirty-year-old saver.
You need to set your goal and then invest accordingly. There are a number of computer programs and worksheets available to help you do this. Even if you just ballpark the figure, it's still better than shooting in the dark. Now, the next question:
3. SHOULD I ONLY INVEST IN STOCKS? Probably not. While equities offer the highest return for the long-term investor, they also carry the highest risk. In addition, there has historically been a benefit in using more than one asset class. Often when the stock market falls, the bond market goes up. Even if both move down in tandem, a cash (meaning money market or other short-term investment) position will hold steady. This diversification across markets may reduce performance in boom times, but will also reduce losses in downturns. It adds stability to your portfolio.
When your goal is still far away, you'll probably want to invest aggressively. The largest part of your investment portfolio will probably be in equities. As the time when you'll need your funds grows closer, you'll want to begin moving your investments into more conservative holdings. This will lock-in your gains. At this point you'll probably be more weighted towards fixed income and money markets. In between, you'll likely use a mix.
What's the right mix? Well, that differs not only with your investment time horizon, but also with your risk tolerance. If a thirty-five year old can't stand to turn on the TV and hear Dan Rather say, "The stock market fell 100 points today," then she probably shouldn't be too heavily invested in stocks. By the same token, if a fifty-five year old is comfortable looking at his brokerage statements once a year (whether he needs to or not), he's fine being 100% in equities.
As a general rule of thumb, advisors frequently recommend that the stock portion of your portfolio equal to a percentage derived by subtracting your age from 100. This means the thirty-five year old should have 65% in stocks (100-35), while the fifty-five year old should have 45% (100-55). As you can see, this approach makes you pare back your stock exposure as you get older. It doesn't, however, factor in your risk tolerance. For a more precise estimate, you might want to use Smart Money's asset allocator. (This is a subscription site, but may allow free access from time to time. The allocator is also available through the print edition of Smart Money).
OK, so all your investments won't be in equities, but let's continue to focus on the portion that is. We're now back to the original question:
4. HOW DO I GET STARTED? The answer is simple: Systematically. You don't have to start with a large sum of money. (It's a good thing, too, because very few of us would get started if that was the case.) No, you can start with as little as $100, $50, or even $25 a month. The amount isn't what's critical, the consistent additions are. If you start at a level that you're comfortable with, you'll stick with it. As your investments start to grow, it'll become even easier.
Not only does this make good savings sense, it makes good investment sense. Look at it this way: If you're putting the same dollar amount in the market each month, you're buying more when the market is down and less when it's up. Since you're buying more at the bottom, you have a greater potential for gain when the market reverses course. When you buy less at the top, you minimize your potential losses when it comes back down. But, you might ask:
5. HOW CAN I SYSTEMATICALLY INVEST EQUAL DOLLAR AMOUNTS IN EQUITIES? That's a good question. Stock prices change every day and even if they didn't, $100 or even $1000 each month won't buy many shares of most. No one wants to pay monthly trading commissions to buy one share of IBM or two shares of Coca-Cola.
But don't worry, there are ways to do this. The easiest way is through mutual funds. Mutual funds commingle the funds of their investors and purchase a portfolio of hundreds of stocks. Fund shares are often priced as low as $10 and most fund companies welcome systematic investors. They'll even draft your bank account so you don't have to write a check and pay monthly postage. Unlike purchasing stocks through a broker, you can purchase fractional shares of mutual funds. This allows you to put your entire monthly investment to work. An added bonus is the automatic diversification you get when you buy a mutual fund. It would be quite expensive for you to buy as many stocks as most funds hold.
Of course, only CDs are more boring than investing in mutual funds. Fortunately, there's another alternative that will allow you to have more direct management in your portfolio while systematically investing. There are almost 1000 companies that allow you to purchase shares directly from them through their Dividend Reinvestment Plans (DRP). As the name implies, all dividends are reinvested and you can purchase additional shares each month through your systematic additions. Since you're making your purchases within the plan, fractional shares are tracked allowing full investment of dividends and monthly additions.
Until relatively recently, you had to buy your first shares through a broker (and pay the associated commission) to be eligible to enter a DRP. Now, however, about 150 domestic and 50 foreign companies allow you to make your initial purchase directly through them, totally avoiding any sales commission...
So now, there's only one question left:
6. SHOULD I USE FUNDS OR INDIVIDUAL STOCKS? There's no easy answer to this one. It pretty much depends on how involved you want to be. Mutual funds are the easy way out. You choose your initial funds, periodically monitor their investments, and unless they dramatically underperform, hold onto them. The fund manager worries with what stocks to buy and sell, and the fund itself provides diversification.
On the other hand, if you have the time and inclination to create and monitor your own unique portfolio, individual equities are the way to go. While you'll never have the diversification of just one mutual fund, you can still balance your portfolio with as little as 11-15 stocks. You can easily do that from the list linked above. Each equity there has received one of Standard & Poors' three highest ratings for performance in the next six to twelve months. You'll need to do a lot more work than with mutual funds, but you'll probably also enjoy it more.
If you do feel the need to seek help from an investment professional -- a broker -- don't begrudge him or her the commission. Brokers can help you sift through the literally thousands of funds out there. And contrary to what the no-load fund disciples of Money magazine will have you believe, the 12b-1 fees and high management expenses of many no-load funds can quickly eclipse the effect the front-end load of a broker-sold fund. Many new investors appreciate the assistance a broker can provide in setting up their portfolios as well as the handholding they can provide when the market behaves badly. Like most things in life, you get what you pay for in investment advice. Remember what you paid for this!
Well, they could start by asking the right question. "Should I raise cash?" is not a question for long-term investors, but rather one for short-term traders. They're the folks who try to time the market -- buy in when it's down and jump out at the top. They rarely succeed, but they have to be prepared to move in and out at a moment's notice. As the Dow Jones approached 8000 and beyond, they had to consider raising cash.
On the other hand, it's just not an issue for long-term investors. The key for them is determining the proper investment objective and setting the appropriate asset allocation. (The previous essay addressed this process in boring detail.) Once this is done, the asset allocation determines when you buy or sell. It's a relatively mechanical process, but it usually beats the market timers.
Here's an example of how it works. Suppose you decided you wanted a portfolio of 60% stocks, 35% bonds, and 5% cash (money market). To make the point but keep the math simple, let's also suppose you had invested $100,000 in Now let's suppose your portfolio tracked the major market indexes in the first three quarters of the year. By September 30, your stocks would have risen 29.6% to a total of $77,760, your bonds would have increased a At this point, your portfolio allocation is messed up -- there's 65% in stocks, 31% in bonds, and 4% in cash. It's time to rebalance to get back in line with your objective. Notice what happened? As stocks ran up, rebalancing forced you to take profits. These profits were then redeployed in the assets that had underperformed and retained the greatest growth potential. Had you done this on September 30th, it would have worked perfectly. When the stock market fell in late October, bonds took off. You would have locked in equity profits and bought bonds at a relative low; all without deciding whether or not to "raise cash".
Obviously you wouldn't want to rebalance your portfolio too often since the benefit of moving small balances would quickly be negated by transaction costs. The best procedure is to wait until one asset is at least 5% out of balance. Alternately, you could rebalance on specified dates such as June 30 and December 31.
In any case, periodic rebalancing is a disciplined way for you, as a long-term investor, to reallocate assets and lock in profits. "Should I raise cash?" is a question best left to market experts -- corporate retirement plan committees and local barbers.
"The Hardest Part of Anything is Getting Started." -- J.C. Penney
RE YOU STARTING TO WONDER where your retirement income will come from? Do you need to have some tuition money warming up in the bullpen just in case Junior doesn't get that baseball scholarship to college? Do you want a better return on your investment than 2% in a savings account or 5% on a CD? Odds are, you have at least one of these concerns. You've probably also heard that equity investing is the best way to meet these long-term goals.
"If you have to ask, you'll never know."
HE STOCK MARKET CONTINUED to rise throughout the third quarter. The higher it got, the more concern it raised. The investment committee for a large company debated raising cash in their twelve million-dollar retirement plan. Down the road, the local barber was seeking advice from his customers as to the several thousand dollars he had tied up in mutual funds. He wondered if he should sell out and "lock in his gains." What should they do?
this mix as of January 1, 1997. Initially then, you'd have $60,000 in stocks, $35,000 in bonds, and $5,000 in cash.
more modest 5.4% to $36,890, and your cash would have grown to $5,180. All in all, your $100,000 portfolio would then be worth $119,830.
To do this, you have to sell $5,862 from your stock positions, put $5,051 in bonds and leave the remaining $812 in cash.
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