(MONEY Magazine) -- I'm a long-term investor, but I worry that the financial issues facing Spain and Greece could send the U.S. market into a significant slide. Does it make sense to pull out of the market and leave my nest egg in cash until this is sorted out? -- John J., Tampa, Fla.
Moving to the sidelines in order to assess the impact of Europe's woes on the U.S. market may seem like a reasonable strategy, but it's not.
If you think about it, there's almost always something that has the potential to send the market into a tailspin. Last year, it was worries about the U.S. debt ceiling. A month ago, it was a rising tide of investor distrust in the wake of Facebook's (downgrading the credit ratings of 15 major banks.) screwed-up IPO. Last week, it was Moody's
Today, Europe's economic problems are taking center stage but there are plenty of other issues that could just as easily make the market swoon: the looming "fiscal cliff" the U.S. faces if tax increases and federal spending cuts take effect as scheduled next year; the growing threat of an economic slowdown in China; persistently lackluster job growth and high unemployment here at home.
If you start yanking money out of the market every time there's some potentially threatening economic news, you could end up sitting in cash for a very long time.
Besides, you're kidding yourself if you think you can adequately protect your portfolio by fleeing the market when the economic outlook here or elsewhere darkens. Even if the coast seems clear, an unseen storm could be brewing somewhere. After all, as stock prices climbed more than 24% from the beginning of 2006 through mid-July 2007, most investors felt pretty sanguine about the market's prospects. It's not as if they saw the financial crisis coming and yanked their money out of stocks before the market tanked.
All of which is to say that jumping into cash every time you get worried, then moving back into stocks when you feel more optimistic isn't an investing strategy. It's a guessing game you can't win.
If you're considering getting out of the market, you not only have to decide whether or not to leave, but when to go. And where to go. And when to get back in. Your chances of getting all these calls right are pretty minimal.
By the time you sort through the possibilities, market prices have probably already adjusted. The result is that you may not get as much protection on the downside as you'd hoped by exiting. You may also miss out on a good portion of any rebound by the time you decide it's safe to reinvest. And, of course, you run the risk of getting it totally wrong, bailing out only to see the market hold up or jumping back in just before the market takes another dive.
If you're really the long-term investor you say you are, you need to develop a strategy that isn't based on emotion and guesswork.
Start by recognizing that your goal isn't to avoid market downturns. Rather, your aim should be to create a portfolio that not only has enough stock exposure to give your nest egg a decent shot at the growth it will need to support you in retirement, but also enough in bonds and cash to keep the damage during market downturns to a magnitude you can tolerate.
So instead of moving to cash, I recommend you review how your nest egg is currently invested. The fact that you're so nervous now makes me wonder whether you've been investing more aggressively than you should. Since the market's March 2009 low, stocks have gained about 90%. It's not unusual during such run-ups for investors to get overconfident and overestimate their true appetite for risk. Perhaps your jitters are a wake-up call.
For tips on how you might divvy up your nest egg between stocks, bonds and cash, you can check out our Fix Your Mix tool. When you've decided a stocks-bonds mix that seems appropriate, you can plug that portfolio into Morningstar's Asset Allocator to get a sense of how it might perform over the long-term as well as during market corrections.
Once you've settled on a basic blend of stocks and bonds -- and I mean basic, you don't want to overdo it -- leave it alone except to rebalance periodically. As you approach retirement and become more concerned about conserving than growing capital, you'll also want to gradually shift more towards bonds and cash.
This strategy won't immunize you from short-term losses altogether. Nothing outside of sitting in an FDIC-insured savings account can do that. But it should limit your setbacks to ones you can handle -- and save you from having to obsess over what to do every time you see a scary headline.
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