Ignore the Stock Market Pain

Right now I am feeling the stock market pain. Since my January Net Worth Update my investments have taken a beating. I am down a little over 4% in a week. That is on top of a 3.5% loss during the month of December. Pundits and prognosticators are predicting a recession, run away inflation, and a plummeting dollar. Is now the time to move money into bonds and cash to stop the pain? Absolutely NOT!

I follow a few simple rules that let me sleep at night even as the market nose dives:

1. Diversify
2. Buy the Market through Index Funds
3. Dollar Cost Average
4. Invest for the Long Haul
   

Diversification means to own assets (and asset classes) which tend to move in different directions. A non-exhaustive list of possible asset classes includes: foreign stock, domestic stock, corporate bonds, government bonds, real estate, and commodities. I have spread my investments over all of these categories so that when one drops the others may go up to keep the total portfolio stable. By always keeping a diversified portfolio, I won't feel the need to move all of my money in and out of stocks with market gyrations. Jumping between asset classes almost always means selling stocks after they have fallen and buying bonds after they have increased in value. That is the exact opposite of the buy-low-sell-high strategy that makes money in the market.

I own index funds rather than individual stocks. There are two benefits to this strategy, the first is diversification which comes from owning hundreds of different stocks so that one bad apple can not cause a large loss. For example, the S&P 500 includes the stock Courtrywide Financial Corp (CFC). This company is at the heart of the current subprime mortgage debacle which has created much of the recent pain in the US market. The stock has lost 57.54% of its value in the last 3 months. During this time the S&P 500 has only lost 3.33% (source). An index fund captures the growth of the whole economy while muting the damage done by the few stocks that crater.

The second benefit of owning the index is that it removes the requirement for active management also known as "stock picking" from the investing equation. While most of us like to think we are "smarter than the average bear," only a tiny minority of investors are able to beat the index for extended periods of time. Index funds gain most of their advantage by reducing the taxes, management fees, and turnover expenses that come from actively buying individual stocks. Check out this article from Consumerism Commentary for more about why index investors get better returns.

Dollar cost averaging is the process of investing in small amounts on a regular schedule. If you have money invested into your 401(k) with every paycheck, you are dollar cost averaging. This process helps me ignore the pain of my current losses because I know that when my next payday arrives I will be buying up more stocks for less money. If the market drops, it is a buying opportunity for me to load up on more shares for the same money. In effect, stocks have gone on sale.

Finally, I am investing for the long haul. I have roughly 38 years until I retire, which is a LONG time for stock prices to recover. In fact, I will probably see several long bear markets and maybe even a crash or two between now and retirement. However, because I know that my money will be left to grow for decades there will always be time to recover. I will also keep in mind that as my time horizon shrinks it will be time to gradually move my money to a more and more conservative asset allocation with more bonds and cash as my retirement approaches.
Use these four rules and you end up with a huge nest egg no matter what the market does this week, month, or even over the next couple of years.

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Automatic Rebalancing - A Lifecycle Fund Bonus

Today there was an article I came across on CNNMoney.com that caught my interest about the benefits and perils of rebalancing your portfolio. The article specifically mentions the Charles Schwab Lifecycle Funds that I talked about in my last post about one fund investing. It seems that I forgot to mention the important benefit of automatic, professionally directed rebalancing that is an inherent part of Lifecycle funds.

The idea of rebalancing is to keep the asset allocation close to its target. The benefits of this strategy are three fold, 1) it keeps your level of risk in sync with your tolerances, 2) it forces you to sell asset classes that have had a run-up in price and buy assets classes that are selling at a discount, and 3) your portfolio is on autopilot as it is regularly rebalanced automatically in line with a professionally determined asset allocation that is appropriate for the time horizon of the fund. In my case as I approach my retirement around 2040 the asset mix is gradually adjusted to be more conservative. The disadvantages of rebalancing are the potential capital gains taxes and transaction fees that you will incur. Both of these negatives can be completely avoided by using an tax sheltered account such as a 401(k) or IRA and investing in a fund like the Schwab 2040 (SWERX).

If you aspire to wealth like I do then starting a Roth IRA and investing in a Lifecycle Fund is a great way to start your on a path to wealth.

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