How to Safely Ease into the Market or Increase Your Stake
Is it too late? Have you waited too long to pour a little—or a lot—of your money into the stock market? Surely you’ve been tempted as you continue to get extremely low yields on cash in bank accounts, CDs and bonds…while the stock market has nearly tripled since it bottomed in 2009.
Perhaps you’re still haunted by past market crashes. Or maybe you just keep waiting for a so-called correction—a pullback of 10% or more—before you jump in. However, the last time the Standard & Poor’s 500 stock index had a correction was in August 2011, and there may not be another for a while as the economy keeps chugging along.
If you’re nervous about investing more, or perhaps any, of your money in stocks, here’s a simple strategy that I use with clients. It gets you off the sidelines (or lets you increase a small stake) but also guards against the risk of large losses so that you can sleep at night.
First, decide on the total amount you want to invest in stocks. Perhaps you have a total of just $50,000 and it’s all in savings and bonds and you’ve never invested anything in the stock market. Or maybe you have $250,000, or even a few million, but pulled out a large amount of money when times got scary.
For most investors, the basic process to decide how much to invest is the same. Divide your available cash into three categories…
Emergency cash. This amount should typically equal three to six months’ worth of your bills and living expenses. It should be held in safe, immediately accessible accounts such as money-market or savings accounts even if it means getting little or no yield. You need this money to remain liquid in case you lose your job or suffer some unexpected costs, such as a major car repair or a medical crisis.
Savings you may need in the next five years. That includes money intended, for example, to pay for a child’s college education, go on a special vacation or make anticipated home repairs. Consider keeping this money in low-risk, fixed-income investments that offer better yields than bank accounts—such as CDs and short-term bonds—especially if you don’t need immediate access.
Savings you don’t need to touch for at least five years. This is the money that you can invest in the stock market. Historically, five years is the length of a typical stock market cycle encompassing both a bull and a bear market. Of course, you don’t have to put all of this long-term savings in stocks…but you should not put in more than this.
Decide How much
Your horizon for needing cash is just one factor in deciding how much to invest. Other factors to consider…
What kind of investment return do you need to meet your long-term financial goals? Over the past century, stocks with dividends reinvested have returned about 10% annually, on average, compared with about 5% for bonds, but stocks have entailed much more risk along the way. If you don’t have to achieve a high return to meet your particular needs, you may not have to invest much, if any, in stocks.
How much risk can you tolerate, especially during market drops? Long-term investors need to be able to maintain the money that they allocate to stocks through both bull and bear markets. If you have invested before, you may already have a long-term asset-allocation plan dividing your portfolio between stocks and bonds.
If not, you can evaluate your risk tolerance and determine how much of your cash to allocate to stocks with the help of free tools at Individual.ML.com (click “Start” under “Risk Tolerance Evaluator”) and/or Personal.Vanguard.com (search for “Investor Questionnaire”).
How to Invest
Once you decide how much money you want to invest, move into the market based on this strategy…
- Immediately invest 30% to 50% (depending on how comfortable you are with market ups and downs) of the total amount of cash you plan to put into stocks. This makes sense because the lion’s share of the stock market’s long-term gains are made in a few big “up” days. Over the past 20 years, if you missed the five days of biggest gains, your annualized returns dropped from 9.2% to 7%. If you missed the 10 biggest days, they dropped to 5.5%…and the 20 biggest days, 3%.
- Add the rest gradually. Divide the remaining cash that you want to put into the stock market into 10 equal portions. Invest one of these portions at the end of each calendar month. So if you start with $30,000 and invest $10,000 immediately, you are left with $20,000, or 10 portions of $2,000 each, to invest over the next 10 months.
- Invest an extra 5% of your cash each time the market pulls back by 5%. This is smart no matter how gradually you decide to invest because it allows you to incrementally add to positions at lower prices and actually use market declines to your advantage. Historically, markets have averaged about three 5% pullbacks a year.
- Establish a system for how you divvy up cash among specific stocks and/or funds. This will vary among investors. For example, I spread new money evenly among the top three funds in my model portfolio based on having the best average performance over the past one, three, six and 12 months. As of June 2014, those funds were…
However, investing all your cash intended for stocks at once is just too unnerving for most people, so holding back 50% to 70% limits the pain in the event that there is a sudden market pullback.
If you are especially jittery, spreading out your investments rather than diving in all at once also might help you avoid panicking and pulling out your money at the wrong time if the market drops sharply. Very risk-averse investors may want to ease in even more slowly, putting in a 10% portion every other month, which would get you fully invested in 20 months.
Important: Discipline is the key to easing into the market. The least profitable strategy over time is to follow your emotions, leaping into the market when stock prices shoot up or hoarding cash as soon as the market pulls back.
Example: Say the market drops 5% in a particular month. Instead of investing a 10% portion, invest a 15% portion.
Dodge & Cox International Stock Fund (DODFX)
Janus Contrarian Fund (JSVAX)
Guggenheim S&P 500 Pure Growth Fund (RPG), an exchange-traded fund (ETF) that invests in the fastest-growing one-third of the S&P 500.
But there are many other valid approaches to choosing your stock investments. For instance, if you already have a portfolio that you like, you could simply add equal portions to all your stocks and funds. Or for investors who focus on buying bargain-priced stocks, you could add to holdings that lost the most (or gained the least) over the past year.
Finally, if all this still feels too scary or uncomfortable, consider using the above basic methods…but invest in a balanced mutual fund instead of stocks or stock funds. Balanced funds temper the ups and downs of the market by allocating a portion of the portfolio to bonds. Those that have done best in my model portfolio over the past one-, three-, six- and 12-month periods…
Dodge & Cox Balanced Fund (DODBX)
Fidelity Puritan Fund (FPURX)
Leuthhold Core Investment Fund (LCORX).