Don't be a market opportunist
Since you can't predict which investments will yield the highest returns, you're better off setting up a long-term diversified portfolio than chasing a quick buck.
NEW YORK (Money) -- Question: I believe that last year's upheaval has created some terrific opportunities if you're willing to be an opportunistic investor. You can already see that lots of money is being made in the market. So I'm considering investments that I would hold not for the next 10 years, but ones where the upside far outweighs the downside for the next 12 to 18 months. Do you think this is a prudent approach? --David, Brooklyn, New York
Answer: In a word, no.
Don't get me wrong. I'm all for taking advantage of opportunities. But my idea of the prudent way of doing that is quite different from yours.
You seem to think that it's possible to predict which investments will outperform in the short-term, snap them up, make a killing and presumably plow your profits into the next opportunity in a never-ending chain of prescient moves.
But I'm doubtful about that approach for a number of reasons, the main one being that there's not much evidence that investors are good at such timing.
Since the market low in early March, for example, stock prices have soared more than 50%. But according to Morningstar, more than 90% of the $226.4 billion that's flowed into mutual funds this year through the end of August has gone not into surging stock funds, but bond funds, which for the most part have lagged their stock counterparts by a wide margin this year.
You may see this as evidence that these investors aren't acting "opportunistically" (although I notice you didn't say that you started buying stocks back at the March low either). My guess is that they probably thought they were, but believed the opportunistic move was to get into bonds in case stocks spiraled downward again.
My point is that it's easy to identify wonderful opportunities in retrospect, but much harder in real time. For example, you could have pulled off a major coup last year if at the end of 2007, you had sold stocks and plowed your money into long-term Treasury bonds. You would have sidestepped a 37% decline in stock values and racked up a gain of about 34% in long Treasuries.
But come on, how many people had the foresight to do that back in late 2007 when the market was riding high and the idea that firms like Lehman Brothers or AIG would implode seemed absurd?
Even if you had somehow divined that stocks were heading for a fall and that bonds were the place to be, there's still the issue of which type of bonds you would have bought. If instead of Treasuries, you'd opted for investment-grade corporates, you would have done fine on the move out of stocks, but not as well with the bonds, as investment-grade corporates lost 5% last year. And if you had gone for high-yield corporates, you would have lost 26% in 2008.
Fact is, there are just too many moving parts in the economy and the financial markets, too many possibilities and too much uncertainty for anyone to know today what investments will be the winners 12 to 18 months from now.
Oh sure, you might guess right once in a while. But to earn competitive returns over the long run jumping around from one investment to another the way you propose, you've got to get the moves right consistently. And that's just not likely. What's more likely is that you'll go from one hot sector or investment to another, buying in after the big gains have been made and the sizzle is about to fizzle.
How can you take advantage?
My view is that you put together a reasonable mix of investments based on how long you intend to keep your money invested and how much risk you're willing to take.
The longer you have until you need your money, the more of it you want to keep in stocks, since stocks tend to offer the highest long-term returns. That's not a guarantee, of course. As we all know, the bond market has beaten the stock market over the past 10 years. But that's an anomaly. History shows that over long periods stocks are much more likely to generate higher returns, especially if you're buying after they've had a big setback as they did from the end of 2007 through early 2009.
The sooner you think you'll need to tap your investments, the more you should have in bonds and cash, since they're far more stable than stocks.
This isn't rocket science. You can find easy-to-follow instructions on how to build a portfolio that makes sense for your goals by checking out our Money 101 lesson on asset allocation. And if you'd like to see how different mixes of stocks and bonds might perform over different time periods, you can rev up Morningstar's Asset Allocator tool.
By the way, when I say stocks, I mean a diversified blend of large-, mid- and small-caps that essentially replicates the entire stock market. By owning the whole market, you avoid having to guess which industry or sector size of stock is going to excel. You own them all. The same cover-all-the-bases approach applies to bonds.
Theoretically, you can put together such a broadly diversified portfolio on your own with individual shares or mixing and matching different mutual funds. But you can do it a lot more easily with a total stock market and a total bond market index fund or ETF, versions of which you can find on our Money 70 list of recommended funds.
You can diversify more broadly, of course, adding some international shares, perhaps some TIPs or REITs as an inflation hedge. But don't go overboard, or be one of those investors who justifies buying into the hot asset class du jour (think gold) in the name of diversification, but is really just chasing performance.
You don't need a dozen different types of investments to have a well-balanced portfolio. In fact, the more asset classes you own, the harder it will be to periodically rebalance your portfolio and keep track of how it's doing.
So if you really want to be opportunistic, I suggest you forget about this quixotic notion of hunting for short-term gains and instead take the opportunity to build a portfolio that makes sense for the longer haul. It may not be the most exciting approach. But it's definitely the more prudent way to go.