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Paralysis by Analysis

By Don Kuehn


Okay, I’ll admit it, I panicked when the markets tanked and I converted some pretty reliable mutual funds into cash. I see where you have been talking about getting back into the markets, but I can’t make a decision about what to do. Help me.

—Deer-in-the-headlights

 

Dear Deer,

Yeah, you and millions of other people who watched the markets fall faster and farther than they ever could have imagined “went to the mattresses” in the face of the recession. Truth be told, I trimmed back some of my holdings, too. But that’s behind us. The question is what to do now.

If you are convinced that the economy has stabilized (that doesn’t mean there won’t be down periods in the future) and are ready to reinvest some of your cash holdings, you’ve got to shake the “paralysis by analysis”. Here are some of the things I would look for:

First, you have to have a philosophy of investing. That means you know why you are getting in and have a pretty good idea why you might sell at some point in the future. Panic (by the way) is not a good reason to sell.

Your circumstances, such as family size, age and tolerance for risk are all factors that will make your investing decisions different from mine. As a general rule, before dollar-cost-averaging all of your stash back into the market, I’d want to have an emergency reserve of at least six months’ living expenses set aside in a money market, bank or credit union account. You need that emergency fund in case one of the kids falls off his bike, an appliance goes on the blink or you face a lay-off or furlough.

Second, you know I preach investing exclusively in no-load, low cost mutual funds. It’s a way to take advantage of professional money managers who are armed with up-to-the-second information that you and I may not see for days or even weeks.

There are many places you can go to research mutual funds. All of the major fund families have information on their web sites, but one of the best is Morningstar.com. It’s the big research firm that grades mutual funds on their oft-quoted one- to five-star scale. Besides finding great information about investing in general, the site will allow you to compare funds and eliminate those that don’t meet your personal criteria: how have they performed in the past, how risky are they, what’s in their portfolios, who’s in charge and how long have the managers been there, how much do the funds cost per share and what are the minimum investments?

Third, I always choose to reinvest dividends and capital gains into more shares. Dividends are the profits companies pay back to their stockholders. Capital gains result when the fund sells some of the shares it owns for a profit. Mutual funds pass them along to shareholders.

Dividends provide a few percentage points in earnings advantage and are a hedge against falling prices in a down market. There is plenty of research to show that stocks and funds that are committed to paying dividends hold up better in tough times than those that don’t.

So, “Deer”, I’m looking for a no-load fund(s) with a low expense ratios and management fees (annual cost of doing business) with a four- or five-star rating from Morningstar and I’m going to reinvest all dividends and capital gains back into my account so my holdings will grow faster than just through price appreciation.

The next decision I have to make is what kind of fund I am going to look for.

Start with a “core” holding. That may be one or more funds that reflect the general economy. An index fund that tracks the Standard & Poors 500 holds the stocks of the largest, most broadly based companies traded on the stock exchanges. You can also buy funds known as “total market” or “extended market” which are even more diversified holding several thousand companies of all sizes.

As your investments grow and the more you save, the more money you will have to invest. Then you’ll have to pay attention to asset allocation and diversification.

Asset allocation is a simple way of saying how much of your money you are going to invest in stocks, how much in bonds and how much will you keep in cash. As a general rule, the younger you are the greater the percentage of your assets should be invested in stocks. As you age, the balance shifts gradually toward bonds.

This just reflects the fact that time is your greatest ally in growing your investments to meet your goals. The younger you are the more time you have to recover from the inevitable swings in the markets, and an aggressive mix of stock funds will grow faster and recover sooner than any other option.

Once a year you should review your allocations to be sure they are still appropriate to your age and circumstances and that they are still moving you closer to your goals.

As for diversification, you want to select a mix of funds that expose you to small- mid- and large-capitalization companies (just jargon for the size of the companies included in the fund’s holdings). You can also mix value funds that try to find companies that have taken their lumps but whose fundamentals remain strong, with growth funds. Growth funds try to identify companies positioned to benefit from whatever the current economic conditions present.

Since we have entered a post-American world economy, I want to have some of my money in foreign markets. Until recently you could say that the center of the world economy was here, in the U.S. But today, we are seeing more economic activity from Asia, India and South America... the so-called emerging markets.

Like the famous comment of Willie “The Actor” Sutton, the notorious bank robber of the 1930’s and 40’s, when asked why he robbed banks, he reportedly said, “’cause that’s where the money is.” If you are investing to make money today you have to be invested in international markets.

And finally, look at sector investments. By that I mean specific areas of the economy that seem poised to do well in the future. These days an investor can put money into any of hundreds of narrow niches of the market through mutual funds that invest only in energy companies, for example, or pharmaceuticals, health care or technology.

These “sector plays” can produce significant returns if you correctly guess which industries or segments of the economy will out-shine others. They can also be more risky because they do put all of their eggs in that one basket of stocks. So limit your exposure in sector funds to ten- to fifteen percent. That way you can take advantage of good opportunities, but avoid a catastrophic loss in the event some unexpected outside force hits the industry you thought was a sure winner.

Up to this point I have said very little about bonds. Well, there is a place for bonds in every portfolio. Just how much weight you should give to bond funds depends on several factors: your age, your need for immediate income and your forecast for interest rate fluctuations.

Let’s get basic for a minute. Unlike stocks, where you buy a small sliver of ownership in a company, when you buy a bond (or put your money in a bond fund) you are making a loan to a company or to a branch of government, like a U.S. Treasury Bill or a water utility, for example.

In exchange for your investment/loan, the company or utility agrees to pay you an agreed upon interest rate over a set period. These monthly payments (sometimes called coupons) are the interest on the loan. If you keep the bond to maturity you get your initial investment back (but no more).

There is a perception that bond investing is more conservative than stock investing. To some extent that’s true, but don’t be lulled to sleep thinking that if you keep most of your money in bonds you’ll be fine. In fact, an all-bond portfolio will lose ground to inflation at a fairly fast clip, eroding your buying power and threatening your retirement.

Bonds have their own risks. The most obvious is the risk that interest rates will change. If rates go up, the price of bonds goes down (and vice versa). So, in an era of declining interest rates investors have to pay more to get the same yield as on older bonds. It’s complicated, “Deer” so just trust me on this one.

Over the past year rates have plunged about as low as they can go. That means there is really only one direction for interest rates to go: that’s up. Even after some measure of recovery from the depths of the recession, many experts feel the economy is still so fragile that we are unlikely to see much change in rates for at least a year.

Typically, short-term bonds pay less interest, but also fluctuate less in price, than their longer-term cousins. Long–term bonds fluctuate the most in price but reward you for those swings by paying higher interest rates.

Lately, the yield curve (the difference between what short term, intermediate-term and long-term bonds pay) has been fairly normal, which means there is a premium for tying your money up in long bonds. For example, the recent rate on two-year U.S. Treasuries was 0.67 percent while the yield on thirty-year T-bonds was 4.26 percent.

The good news is that bond mutual funds are buying and selling bonds all the time, so they mitigate some of the price fluctuations as interest rates change. When doing your research on bond funds take a look at the price per share charts to see just how much the price of the fund has changed over the past one- three- and five-year periods.

If you lost money when the markets crashed and got conservative by hoarding cash planning to get back in when the time was right, it’s probably time, “Deer”. I know, it’s your money, but unless you have enough dough to stay out of the markets without jeopardizing your retirement or other goals (and I don’t know anyone who can), there is only one way to go – the stock market. End the paralysis. Do your homework. Proceed cautiously and diversify your investments.

 


Don Kuehn is a retired AFT senior national representative. For specific advice relative to your personal situation, consult competent legal, tax or financial counsel. Comments and questions can be sent to dkuehn60@yahoo.com.