News Analysis date published New: 
Tuesday, September 18, 2012 - 09:30
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Tuesday, September 18, 2012 - 12:53
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Tuesday, September 18, 2012 - 09:30

Don't Put a Penny into the Stock Market Until You Read This

Tuesday, September 18, 2012 9:30 AM

While the overall economy is still on shaky legs, one thing's hard to deny: The stock market has been doing great.

By the stock market, I mean the Standard & Poor's (S&P) 500, the well-known index that tracks the combined performance of the 500 largest U.S. stocks. Many investors refer to the S&P 500 as "the market" because it encompasses about three-fourths of all U.S. stock market activity.

Well, "the market" is up 18% this year. And, as the table below illustrates, it has had quite a nice run since the nasty 2008 crash that occurred at the height of the housing crisis.

S&P 500's Performance for the Past Five Years

On average, you'd have made about 15% a year if you'd gotten into the market on Jan. 1, 2009. At that rate of return, an initial investment of $10,000 would now be worth almost $17,000.

Not surprisingly, these results have many people wondering whether they should start investing and accumulate some wealth of their own for retirement and other goals. To me, the answer is unequivocally yes. We all know it's wise to start building a nest egg as soon as possible.

And the way to do it is simply to invest in something that tracks the stock market, right?

Well, not necessarily.

Although stocks have delivered excellent returns the past four years, the market's a tough place in the short-term, as always. So before you commit a single cent into the market, you should carefully consider three key investment points so you know up front into what you're getting. This way, you don't end up walking away in disgust with less money than when you started.

1. Your tolerance for risk
As you may know firsthand, the market can be quite a source of stress in the short-term. It can go on a fritz for any rate of time. Think about how much daily market volatility you can comfortably handle. Also consider whether you'd be selling at a loss when the market's in a panic -- because I strongly believe the bottom will drop out again sooner or later. If you find market fluctuations and crises unnerving to the point of constantly feeling stressed, then it's a sign you should limit the proportion of stocks in your portfolio.

2. Your optimal asset allocation
Asset allocation is just a fancy-sounding term financial advisors use to describe the proportion of stocks and bonds in an investment portfolio, and it's based mainly on your risk tolerance. For instance, if you have moderate risk tolerance and can endure a fairly decent amount of market volatility, then you might consider an asset allocation, such as 60% stocks and 40% bonds. That way, stocks can still strongly influence the performance of your portfolio, yet you'd cut down a lot on volatility since bonds typically fluctuate less than stocks.

3. Your expectations about the behavior of stock prices
While most investors probably have a sense of the difference between stocks and bonds in terms of price fluctuations, you'll know exactly what to expect if you put a number on it. For this type of comparison, I like to use a number called standard deviation -- a measure of an investment's price behavior during a specific time period.

The S&P 500 has a pretty hefty three-year standard deviation of 16, meaning the value of the index usually fluctuated up or down by 16% during the past three years. But the bond market, as measured by the Barclays Capital U.S. Aggregate Bond Index, only has a three-year standard deviation of three.

In other words, the bond market was about one-fifth as volatile as the stock market during the past three years. So you see how the overall risk of an investment portfolio can decline as you increase the amount of bonds. Using the two indexes I've described, a portfolio of 60% stocks and 40% bonds would have a standard deviation of 11 during the past three years, whereas a 40/60 portfolio would have a standard deviation of eight.

Risks to Consider: These are examples of typical price behavior during the past three years. In times of extreme economic turmoil, you could see typical standards deviations of two or even three times the normal. If you invest in stocks, be sure to give plenty of thought about what investment approach best suits you. Be prepared for ongoing volatility, even if you plan to make stocks a small part of your portfolio. Consider your time horizon, too. If the goal you're saving for is less than five years away, then you should think twice about putting any money aside in stocks since they're apt to be riskier in the shorter-term.

Action to Take --> You can create a custom portfolio using whatever asset allocation and investments you prefer. But if you'd like to keep things simple, avoid foreign stocks. To really dampen the risk, I would consider the Vanguard Wellesley Income Fund (Nasdaq: VWINX). This fund has a 40/60 allocation, a standard deviation of only five and just 16% of stock holdings in foreign equities.

For greater stock exposure, including more foreign stocks, consider Vanguard STAR (Nasdaq: VGSTX), which I profiled in detail here. Vanguard STAR has a 60/40 allocation, a standard deviation of 11 and 36% of stock holdings in foreign equities.

Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.