From bear market to bull market.
If the proverbial visitor from Mars had headed our way four years ago, this traveler might have beamed up the news reports from Earth and decided to keep on going to a more promising destination. Why land on a world that apparently was coming to an end? Stock markets had crashed, major brokerage firms were endangered, and the entire financial system seemed to be in jeopardy.
Today, that extraterrestrial traveler would be getting a very different message. Headlines announce that "Mutual Funds Are Breaking Records" and "S&P 500 Closes at Five-Year High." Reports indicate that the average diversified U.S. stock fund is 10% higher than at the previous peak, reached in 2007.
Does this mean that stocks are heading still higher? Or that every bear market will be succeeded by a more powerful bull run? Not necessarily. The future is unknown, and that's certainly true when it comes to investing in stocks.
However, reliable stock market records now go back about 85 years. Those decades have seen booms, busts, recessions, the Great Depression, wars, terror attacks, inflation, rising debt levels, natural disasters, and countless other crises. Yet, the U.S. stock market has continued to reward patient investors, despite this litany of setbacks.
Absorbing future shocks
As mentioned, future investment returns are unpredictable. That said, you can learn some lessons from the recent and distant past. Basic, prudent steps include the following:
* Diversify. Holding different types of assets can reduce overall portfolio risk. An investor with a 50-50 portfolio, for example, between stocks and bonds, would have fared better than a 100% stock investor during the 2008-2009 crash. The diversified investor might have been more likely to stay in stocks, and then benefitted from the subsequent rebound. Adding more asset classes may help to smooth out long-term volatility.
* Invest regularly. Some financial advisors advocate a strategy of dollar cost averaging, in which you invest a fixed amount periodically, perhaps every month. If you save for retirement by investing in your company's 401(k) plan, you probably are using this approach.
With dollar cost averaging, you buy more fund shares or stock shares when prices are down, fewer shares when prices are up. Over time, this will lower your cost per share and can lead to higher profits.
* Allocate and rebalance. You should have a plan for your investing, rather than relying on tips and rumors. Studies show that asset allocation is vital to a successful investment plan--you might aim to have certain portions of your portfolio in stocks, bonds, foreign securities, and perhaps in other asset classes as well.
From time to time, revisit your allocation and bring it back into line. If you want 60% exposure to U.S. stocks, for example, but a bull market brings that allocation up to 75%, you might sell some stocks and reinvest in other assets to get back to your desired position.
* Use tax tactics. Selling securities that have lost value can produce capital losses, which offer tax benefits. Those losses can offset capital gains you take, whereas net losses up to $3,000 can be deducted on your tax return each year. Excess losses carry over to future years, where they'll deliver the same tax benefits. Be sure not to reinvest in the security you've sold at a loss within 30 days. That's considered a wash sale, which will deprive you of the tax benefit.