When you don't have a steady paycheck, the market's daily swings can drive you crazy. If the market hits an air pocket, you can't wait 40 years for returns to average out. Here's what you can do to keep your sanity and keep your investments working hard for you.
Ten years ago it was common practice to assume that stocks held for the long-term would average about 10% a year, and that bank deposits would earn at least a 5% interest rate. As it turned out, the S&P 500 returned about 7.5% and for the last 8 years, and the Federal Reserve kept interest rates at essentially zero. As a result, many retirees have found that their portfolios have not performed as well as they were projected to. Here's what you can do to get things back on track.
Two Buckets Of Money
Divide your money into two mental buckets. One for the money you need for the next 5 years. The other for the money you can invest for 5 years.
One of the biggest risks of investing in stocks is that you might need the money before the investment comes to fruition. In a crash, there might be tremendous bargains around, but if you have to raise cash, you'll be selling at the worst possible time. By making sure that you have the next 5 years covered, you can give your fund managers a mandate to buy when things are cheapest knowing that they have 5 years for their stocks to come to fruition.
Investing With A 5 Year Horizon
In general, the market goes up when capital is allowed to flow to more productive uses. Government policies that slow the pace of capital movement to more productive uses tend to reduce market returns. Similarly rising interest rates also reduce market returns by making it more expensive to borrow capital.
Within a 5 year period the direction of the market will be driven to a large extent by the current mix of fiscal and monetary policy. Index funds like the Vanguard Index 500 Fund (VFINX) and ETFs like the SPDR S&P 500 (SPY) have made it easy to invest in the stock market. However, to invest in funds like these that mirror a broad market, you have to believe that things are headed in the right direction. After all, if you don’t think the stock market is going up, you are better off holding onto cash.
However, even if the market is down, there will be plenty of stocks that can still do well. Unfortunately there is no way to create an index fund for such stocks because it requires stock selection and index funds don’t do stock selection.
If you want to good stock selection, look for a manager with an excellent track record at least until you have developed your own investing skill if you are so inclined.
Good managers cost more than an index fund. But if they deliver better returns after fees than the index fund over your investment horizon, they are well worth the cost.
Here are two questions to help you to evaluate whether a change in investment strategy is warranted:
Do you believe current fiscal and monetary policies are conducive to a strong market?
Do you believe interest rates will be lower 5 years from now than they are today?
If you answered no to both questions, I think it makes sense to allocate a portion of your portfolio and let the best managers find a way to make money until fiscal and monetary policies change.
The Greatest Managers
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