Economic doubts at home, debt crises abroad, a sickly job market and volatility in the stock market have combined to make Americans uneasy about their financial future. At times like these, it's worth taking stock of some of the investing basics that can make investing a less-fraught proposition.
Consider the following as a checklist for staying sane when markets seem to be anything but friendly:
1. Don't pay too much
High fees can cut into a fund's overall returns.Recent data from Morningstar underscore the importance of fees in predicting the success of mutual funds. The investment research company looked at the expense ratios of funds in various asset classes from 2005 through 2008, then tracked their progress from 2008 through March 2010. Bottom line: The cheapest funds outperformed the highest-cost funds in each asset class over every time period.
For instance, the cheapest quintile of U.S. stock funds returned 3.35%, on average, over the five-year period, versus 2.02% for the highest-cost quintile of funds in the category.
When selecting funds, keep in mind that some asset classes are pricier than others. Large-cap funds are generally cheaper than small-cap or international funds, for example. It's a good idea to compare your funds' expense ratios with those of their peers.
Christine Benz, Morningstar's director of personal finance, says most investors shouldn't pay more than 1% in annual fees for a domestic large-cap fund, about 1.2% for international stock funds and between 0.65% and 0.75% for bond funds.
2. Keep it simple
Index funds and exchange-traded funds, or ETFs, track indexes, so they're generally cheaper than funds that rely on stock-picking managers.ETFs, which look like mutual funds but behave like stocks, offer a simple, low-cost way to invest and gain instant diversification. When you invest in an ETF or an index fund, keep in mind that your fund won't likely underperform its index, but it won't beat the index either.
Index funds that provide exposure to U.S. stocks include Schwab Total Stock Market Index Fund (SWTSX). Investors seeking overseas exposure might consider the Vanguard Total World Stock Index Fund (VTWSX).
3. Dollar-cost average
In a volatile market, it can be difficult to stick to your investment plan. Many investors pull money out of stock funds when the market gets bumpy. One way to stay on track is by practicing dollar-cost averaging -- investing a set amount of money on a regular basis instead of investing a large sum at once."It can provide discipline, and it can give you the courage to invest in what could, in hindsight, turn out to be a good time," Benz says.
Dollar-cost averaging ensures that you'll continually invest in the market regardless of how it's performing. You can begin by setting up an automatic investment plan through a fund company. T. Rowe Price, for example, will allow you to invest in more than 90 of its no-load funds if you agree to contribute at least $50 per month to a fund.
One offering is T. Rowe Price Spectrum Growth Fund (PRSGX), which provides broad-market exposure through 11 underlying T. Rowe Price stock funds.
4. Diversify within asset classes
The so-called lost decade for stocks makes a good case for diversification. If you had invested only in an index fund that tracks the Standard & Poor's 500 Index ($INX) from Jan. 1, 2000, to Dec. 31, 2009, you would have earned virtually nothing. The culprit? Large-cap stocks that performed poorly.Meanwhile, other asset classes provided solid returns. For instance, over the past 10 years, the Russell 2000 ($RUT), a small-cap index, has returned an annualized 4%.
5. Keep an eye on cross-asset allocation
Large cap? Small cap? Those distinctions matter but not nearly as much as the mix of classes of assets in your portfolio.No longer does a diversified portfolio consist of just stocks and bonds. Equities and fixed-income instruments should be held alongside such assets as real estate, commodities and other alternatives to prevent just the sort of damage that hit portfolios during the 2008-09 crisis, when wide swaths of assets -- homes, stocks, bonds -- lost value at the same time.
Research shows that almost all investment volatility is driven by asset-allocation decisions. A classic study (.pdf file) of pension funds showed that 91.5% of investment variation in quarterly returns is explained by investment policy rather than stock picking or other factors.
"It's not so much what you put in your account, it's how you allocate what you put in your account that's going to help reduce volatility," says Brian Rimel, an adviser with Raymond James.
Continued: Rebalance periodically
