November 18, 2014
November 18, 2014
(As printed in Worth Magazine: October- November 2014 Issue)
You’ve missed the rally. Perhaps you pulled out of the stock market during the financial crisis, or you never took the initiative to invest in the first place. What should you do now?
Don’t kick yourself. The financial crisis was as severe as anything we’ve seen since the Great Depression. When markets seemingly are falling on a daily basis and there is no end in sight, it is difficult to criticize anyone for wanting to protect what they have. However, recognize that persistently failing to keep up with the sum effects of inflation is going to be like termites eating your foundation. And, while losses were severe during the financial crisis, disciplined investors with appropriate diversification tended to recover within a year or two.
Although inflation has been extremely low and may remain so for a while longer, it has the potential to rear its ugly head in the future. The Federal Reserve’s unprecedented policies over the past few years may have unintended consequences, including the possibility of higher inflation down the road. With interest rates on bank deposits, money market funds and high quality bonds at historic lows, it seems unlikely that an ultra-conservative investment portfolio consisting of these vehicles will keep up with inflation over time. Allocating at least a portion of an overall portfolio to a globally diversified mix of equities has traditionally given investors a far better chance of staying ahead of inflation.
Given that the stock market has increased substantially and valuations in the stock market are not necessarily cheap based on historical measures, how should you go about obtaining the necessary exposure to equities that you need?
First, it’s important not to feel obligated to jump back into the market immediately because everything seems rosy. Volatility has been extremely low, and there have been few declines of any significance in the past few years. It seems highly unlikely that this period of relative calm will persist indefinitely. Various studies show that investors have a knack for buying and selling at exactly the wrong time.
Second, once you’ve developed the courage to re-enter the market, it may be psychologically damaging to experience losses right away. Thus, it’s not recommended that you pile into stocks all at once. Rather, develop a plan for systematically easing into the market over a defined period of time. Dollar-cost-averaging, or investing a specific amount of money at periodic intervals, is one possibility. Another is value-averaging, or buying to specific stock allocation targets (e.g., 20 percent, 30 percent, 40 percent and so on) at periodic intervals (e.g., monthly, quarterly). This has the advantage of allowing you to buy less when markets are high and more when they have fallen. Whatever approach you choose, it is prudent to develop a schedule and stick to it, as it will be very difficult, if not impossible, to predict the perfect time to invest.
Third, it can be extremely helpful to assess what levels of return and risk are needed to achieve long-term financial objectives. Determining how much you can safely spend during your lifetime under various conditions and portfolio allocations can give you the clarity and confidence necessary to identify and stick with a particular investment portfolio strategy.
The returns you earn over the next six months-to-a-year are likely to be far less impactful than the returns you will earn over the next 20 to 30 years. A patient approach that carefully considers your objectives and resources is the first step toward reaching your financial objectives.