Investing in a Bear Market

On 09 October 2007, the Dow Jones Industrials hit a record high, closing at 14,279. What a difference a year makes: Last Friday, the Dow closed at 8451, and there's a good chance it will drop even further.

Unsurprisingly, my inbox is filled with e-mail from people who wonder what they should do. Here are some typical questions from readers like you:

• “Originally we had planned to open Roth IRAs this weekend, but with the stock market being so unreasonable, we have lost our confidence. Wouldn't it be wiser to leave the money in our savings accounts for several more months?“
• “I am 30 years old and since reading your blog, I realize how important it is to get a Roth IRA fired up. However, now that I'm financially ready, the market meltdown has confused me completely. Should I hold tight and just keep saving while I see how this rides out?“
• “I have two 401k plans. However, the last time I looked at my quarterly reports, I noticed I am losing money. I know that the US economy has been pretty bad lately, but is there anything that can be done or planned for?“

These are fantastic questions. Unfortunately, there are no fantastic answers. Nobody knows what the market will do. Nobody.

I watched a news program today in which a pundit predicted the market has hit bottom and is ready to make a recovery. But there are others who believe stocks will continue to fall. I am by nature an optimistic guy, but even I start to feel gloomy and scared for the future when I read and hear some of this stuff. (Peter Schiff, especially.)

Unfortunately, neither I nor anyone else can tell you whether now is a good time for you to invest in the stock market. Only you can make that decision. I can, however, suggest four fundamentals to help guide your thinking.

Know your risk tolerance
The first thing you should do before you invest — now or at any other time — is to gauge your risk tolerance. When you buy stocks, there is always an element of risk, the chance that the value of your investment will fall.

Some investors can tolerate more risk than others. I used to believe I could stomach a lot of risk. I thought I was bold and aggressive. Then I made a couple of dumb investments, culminating with the loss of my entire 2007 Roth IRA contribution when The Sharper Image went bankrupt.

I've learned that I don't actually have a high risk tolerance. I've funneled all of my money into index funds, mutual funds that track the broad movement of the market. These still contain an element of risk — the “broad movement of the market” has caused my index fund to drop 17.3% over the past two weeks! — but it's risk I can tolerate. I know that my investment is doing no worse than the market as a whole.

There are several online tools that can help you assess your own risk tolerance:

• Rutgers investment risk tolerance quiz
• MSN Money risk tolerance quiz (and an article on the subject)
• Kiplinger: Test your risk tolerance

If your risk tolerance is high, you can put more money into stocks. If your risk tolerance is very low, the stock market may not be right for you. Remember, a more risky type of stock has greater potential for gain as well as greater potential for loss. Lower risk stocks have smaller swings over the long term. If your investments are geared toward retirement, you should lower the overall risk level of your portfolio as you age.

Set investment goals
It's important to know why you're investing. What is your purpose? What are your goals? Do you need the money in a few years, or do you still have 40 years before you'll need to draw upon it? Are you looking for the maximum possible growth? Or do you simply want to protect your capital — to not lose money?

• The stock market is not the right place for short-term investments, or for those who cannot afford to lose capital. If you're saving for next year's vacation, you're better off putting your money into a high-yield savings account or a certificate of deposit.
• Are you saving for a medium-term goal, like a down payment for a house? Again, the stock market is probably too risky for holding this money.
• But if your investment horizon is long-term, if you're saving for retirement in 15, 20, or 30 years, then the stock market's historical performance makes it an attractive option, especially when it's down 43% from its peak.

That's not to say that the stock market is always the best choice, even for long-term investments. Coupled with your risk tolerance, your investment goals can help you determine the proper asset allocation — the best way to divide your money among possible investments.

Diversify
Diversification is one of the cornerstones of Modern Portfolio Theory. Though it seems counter-intuitive, research indicates that owning investments of different types offers higher returns at lower risk. Diversification is simply the practice of owning many investments, of not putting all your eggs in one basket.

There are several ways to approach diversification, including:

• Diversification among stocks — When you own a single stock (or a handful of stocks), you are subject to a lot of risk. But when you own a mutual fund — a collection of stocks — you are practicing diversification, spreading the risk among many securities.
• Diversification among asset classes — Only the most risk-tolerant investors place all of their money in the stock market. Most spread it around into other “asset classes”. For example, I have my retirement in stocks, but I also have an emergency fund (in cash), and am accelerating my mortgage payments (real estate). I have friends who have diversified into precious metals, such as gold and silver.
• Diversification over time — Some investors practice dollar-cost averaging as a means to mitigate risk. This can be an excellent way to invest in the market if you're nervous about putting all of your money in at once. (Please note that dollar-cost averaging has critics with valid points.)

This asset allocation wizard from CNN Money poses a few basic questions about your goals and your risk tolerance to determine a framework for diversifying your investments. I told it that I needed my money in 20+ years, could handle some risk, was okay missing my target by a couple years, and view market sell-offs as a time to buy more stocks. The calculator's recommendation? Almost exactly the same asset allocation as FFNOX, the index fund I've selected for my 401k.

Diversification can't prevent stock market losses, but it can certainly reduce them. (Note that it also reduces market gains, however.)

Educate yourself
The final fundamental concept is also the most important. I believe that education is the most essential component of any investment plan.

Often, fear is a product of ignorance. When we don't understand something, it scares us. But ignorance can be overcome through education. If the market meltdown makes you anxious, I urge you to do some research. Visit my collection of financial literacy resources and watch the video series about saving and investing. Go to the library and borrow one of these books:

• The Four Pillars of Investing [my review]
• The Random Walk Guide to Investing [my review]
• The Only Investment Guide You'll Ever Need
• Why Smart People Make Big Money Mistakes (and How to Correct Them) [my review]

I wish I could make all new investors set aside a few hours to read The Four Pillars of Investing. There's a good chance it won't make today's investors any less nervous, but at least they'll have a basis for making informed decisions.

Investing in real life
In The Only Investment Guide You'll Ever Need, Andrew Tobias writes, “Buy low and sell high. You laugh. Yet most people, particularly small investors, shun the market when it's getting drubbed…It's precisely when the market looks worst that the opportunities are best.”

We all know this, but although the market is currently getting drubbed, the average person isn't buying. The average person is panicked. The average person is selling. Friday's edition of Marketplace featured some shocking stats. Last week, investors pulled $43 billion out of mutual funds. Two weeks ago, that number was $6 billion. The week before that it was only $5 billion. Why is the market dropping? One reason is that the average investor has panicked.

If the average person is selling, then who's buying? Who's crazy enough to buy when everyone else wants out of the market? I asked some of my colleagues about their recent money moves. Here's what they said:

• Trent from The Simple Dollar recently maxed out his Roth IRA for 2008 (placing the money in Vanguard's Target Retirement 2045 fund)
• Nickel moved some money into a Total Stock Market Index fund last Friday.
• Jeremy from Gen X Finance told me: “Buying opportunities like this don't come around that often, so my only regret is that I don't have a lot of free cash on hand so that I can pick up a lot of beaten down individual stocks.”
• Ryan from Cash Money Life says: “I plan on opening a self-employed retirement account soon with my web income, and will probably also put more money in equities where I can. I've been hoarding cash for several months and I think it is a great buying opportunity right now. I've got 30 years before I reach retirement age.”
• Blunt Money writes: “I'm continuing automatic investments as well, although I did allocate a portion of new money for those to a fixed income fund. I also put additional money into single stocks.”
• JLP at All Financial Matters, a financial planner by trade, writes that for a long-term investor, the current market is a gigantic sale.

What about me? I recently took as much money as I could it and pumped it into FFNOX. I bought in at $24.20. Its current value is $20.01. It's down 17.31% since I bought it. So what? If I had bought it a year ago, I would have paid $32.71. If I get a chance to buy more FFNOX in the next few months, I will. Yes, it's scary to buy as the market is falling, but I know that I'm purchasing a broad-based diversified index fund. Also — and this is key — I believe that the market will turn around.

Now maybe all of us personal finance bloggers have been drinking the same Kool-Aid. Maybe we're suffering from mass delusion. If so, we're not the only ones. Warren Buffett, the world's richest man, is on a buying spree. So are Mark Cuban and many others.

But you don't care about all those other people, do you? You care about yourself and your money. Rightfully so. What should you do? You are the only one who can make that call. You are the only one who knows your own risk tolerance, your investment horizon, and your savings goals. Educate yourself about investing, and then make decisions based on your own objectives and your own assessment of the market.

If you're still uncertain, seek professional advice. Find a fee-based financial advisor to help guide your decisions.

Conclusion
In Benjamin Graham's classic The Intelligent Investor, he writes:

The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored. He should never buy a stock because it has gone up or sell one because it has gone down. He would not be far wrong if this motto read more simply: “Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop.”

If you believe stock prices are still high, then steer clear of the market. If you think they're low, then buy. And remember: Unless you sell your stocks, you haven't lost anything at this point — it's all on paper.

During the tech bubble, I was part of an investment club. The other guys and I chortled with glee as we bought tech stocks (Celera Genomics, Home Grocer, Triquint Semiconductor) near the top of the market. We thought we were going to be rich. We weren't laughing so hard when the bubble popped; we closed the club and sold the stocks at huge losses. What lesson did I learn? The time to buy is when prices are low, not when they're high.

I believe that for the average long-term investor, the best course of action right now is to make regular scheduled purchases of low-cost diversified index funds. That's what I've done, and that's what I intend to keep doing.