I know cooler heads prevail when the stock market takes a turn for the worse, but I’m finding it hard to resist the urge to cut my losses and pull out of all my investments. Talk some sense into me, please!
We’ve been going through an economic cycle that challenges the fortitude of even seasoned investors. When people make investing decisions based on emotion, they make mistakes. Just when things are at their worst and emotions are raw, they capitulate and sell — either at or near the bottom. Then, as the market anticipates improving economic activity (even as we still feel gloomy) and begins to recover, we stay on the investment sidelines. That’s a double whammy. We lose big on the way down and miss the rebound, too.
There is a better way for the average investor that takes the emotion out of investing decisions. It’s simple and it consists of three practices: dollar-cost averaging, asset allocation and rebalancing.
With dollar-cost averaging, you commit the same dollar amount on a recurring schedule to purchase investments. A simple example is making a 10% contribution to your 401(k) plan every pay period. The biggest benefit of this approach is that it provides the discipline you need to invest. Rather than spending all of your income on consumables, you are regularly saving and investing for the future.
Dollar averaging also avoids attempting to time the market, but rather provides a way to purchase stocks at an average price over time. Many individuals get burned by trying to outsmart the market. Even if you choose to invest part of your portfolio by timing the market, I encourage you to use dollar-cost averaging for a reasonable portion of your investment activity.
Diversification is an important investment principle that simply means you shouldn’t put all of your eggs in one basket. It’s a scriptural principle, as well. Ecclesiastes 11:2 says, “Give a portion to seven, or even to eight, for you know not what evil may happen on earth.”
Asset allocation, another term for diversification, recognizes that different asset classes behave in different ways. By allocating your investments among basic investment categories, you can achieve a balanced return with reduced risk.
Common asset classes include equities (including small, large and foreign), bonds, real estate and commodities. Visit with your investment advisor to discuss an appropriate asset allocation for your stage in life. As retirement approaches, it typically makes sense to reduce the level of investment risk in your asset allocation.
Finally, because asset classes don’t tend to perform in tandem, the percentages you have chosen in your asset allocation will shift over time. Assuming your allocation strategy still makes sense, you should periodically “rebalance” your portfolio to the original percentages. Rebalancing is a smart way to systematically sell high and buy low and should be done at least annually.
Of course, following these principles doesn’t mean that you won’t experience ups and downs with your investments. But the principles do provide a methodical way to save and invest for the future that provides a reasonable balance between risk and return.
God love you!
Phil Lenahan is president of
Veritas Financial Ministries (VeritasFinancialMinistries.com)
and author of 7 Steps to Becoming Financially Free: A Catholic Small Group Study (OSV).