First-timer in a fitful stock market
Before jumping into a volatile market, a beginning investor needs to ask a few key questions.
NEW YORK (Money) -- Question: I'm 28 years old and looking to invest some extra money that's come my way recently, $10,000 to be exact. Any suggestions? - Brandon, Charlotte, NC
Answer: It's always a challenge trying to figure out the best way to invest a windfall. But the task is even more daunting when you're dealing with a rollercoaster market like the one we've had in recent weeks, where big sell-offs are followed by hopeful rebounds that give way to more unsettling downdrafts, creating a climate of fear and uncertainty all around.
So I'm happy to weigh in on this issue. I'll try to answer in a way that can also give guidance to others out there who are unsure how to navigate a market like this, whether they're investing new money like you or considering what to do with the money they've already invested.
The first thing I think you need to do is be wary of some of the advice that's already floating around out there. I don't want to say much of it is flat-out bad. But I do think a lot of it is misguided.
I'm thinking not just of the obligatory stories recommending you move your money to "safe harbors" like money-market funds and bonds or that you buy "defensive stocks" that are supposed to shelter you from losses, but also their opposite counterparts. You know, the ones that say now is the time to start scooping up bargains by buying on the dips.
In both cases there's a presumption that you know what lies ahead - that is, that the market is headed down further and thus you need to protect yourself or that most of the damage has been done so you'll be buying in just in time to ride the rebound.
Let me be clear about this. Nobody knows where this market is headed over the short-term. And nobody can know because that will be determined not just by how things shake out in areas ranging from subprime mortgages to company earnings to inflation and interest rates, but also how investors react to those developments.
So how does one invest in the face of such uncertainty at a time when investors are also clearly on edge? I recommend you start by asking yourself the following three questions.
1. How long will it be before I need the money? This is always the first question you should ask before investing money, but it's especially important to ask it in a volatile market like today's. If you're going to need access to some of your $10,000 within, say, two to three years, then you should invest that portion of your stash in money-market funds or short-term CDs where it will be immune from the ups and downs of the financial markets.
After all, if you're depending on your money as an emergency reserve, or if you're going to need it in a few years for a house down payment or college tuition, you want to be sure the funds will be there. You don't want to risk that it will be tied up in stocks that are worth 20 percent less than you paid for them, even if those stocks may eventually rebound to big gains.
On the other hand, you can afford to take a little more risk in pursuit of higher gains if you're investing longer term, since you have more time to recover from market setbacks. The way to go after those higher long-term gains is by building a portfolio of stocks and bonds (or, more likely for most individual investors, stock and bond funds).
The key, though, is that it's your time horizon that determines the investment choice. Not some notion of what the market is or isn't likely to do in the near future or where you might find the highest returns.
2. Do I have the right stocks-bonds mix? Once you know you're investing funds you won't be touching in the short-term, you can start thinking about how to divvy up that money between stocks and bonds in a way that makes sense for you. The first issue, again, is time horizon.
The longer the money will be invested, the more you can afford to put in stocks. If you're in your 20s and you're putting money into an IRA you won't touch until you're retired, you might want to put upwards of 90 percent in stocks.
Forty years from now, a market correction that occurs today will seem like little more than a blip. If, on the other hand, you're investing money you'll need in, say, five to 10 years, you still want some stocks for growth, but not nearly as large a stake.
In deciding on a stocks-bonds mix, you also want to factor in what I call a "gut check" - that is, you want to realistically gauge how you might react if your portfolio takes a hit of 20 percent or more. There's no sense in keeping 90 percent of your money in stocks if a market meltdown would have you shedding your stock funds at fire-sale prices.
At the same time, you don't want to be such a wimp that your portfolio earns only lackluster long-term returns. Our Asset Allocator tool can give you some guidelines on how to handle this balancing act. Just answer a few questions, and you'll get a recommended portfolio mix that can serve as a starting point for creating your own blend.
You can then go to the Asset Allocator tool in the Investment Guidance & Tools section of T. Rowe Price's web site to see how different stocks-bonds allocations might do in the future. (You don't have to be a T. Rowe Price customer to use the tool, but you do have to register for the site.) Once you've settled on an asset mix, you can check out the Money 70 for fund recommendations.
If you want ease and convenience, you can simply opt for a target retirement fund that has a date that roughly corresponds to the year you'll retire. You'll get a pre-mixed portfolio with a blend of stocks appropriate for someone your age investing for the long term. If you prefer to create your own mix, I suggest you consider doing it with low-cost index funds, or at least make them the core of your portfolio and supplement the index funds with a few good actively managed funds.
3. Am I acting on reason or emotion? While at my gym last week, I was watching one of the cable TV financial shows as the market was in the midst of a steep decline. Based on the frenzied rapid-fire report of the correspondent on the trading floor, you could easily get the impression that you'd better quickly dump your stocks before you get caught in a bloodbath.
Of course, just weeks before, the same show was so upbeat when the market was hitting new highs that you could have gotten the impression you were an idiot if you didn't take out a home equity loan and plow the proceeds into the market. All of which is to say that you've got to be careful about getting caught up in undue pessimism during bad times and irrational exuberance when things are going swimmingly. It's almost always a mistake to invest in the heat of the moment. Better to step back, calm down a bit, even let a day or two go by and then make sure that you're making a decision that reflects a long-term strategy, not some passing passion.
If you answer these three questions in a thoughtful and honest way, I think you'll come away with a good sense of how to invest any new money. And you'll also be able to assess whether you're doing the right thing with whatever funds you already have invested.
I can't guarantee, of course, that this approach will immunize you from losses. There's no way to do that, if you want to earn decent returns. But at least you'll know you're making your decisions in a consistent and rational way, and that you're lowering the chances of compounding the losses from a market setback by inflicting even more damage of your own.