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Markets

7 Ways to Stay Cool

When we're nervous, we tend to make mistakes such as dumping good stocks at the wrong time. Here's how to keep your head.

These are scary times for investors. If the stock market takes another substantial dip, it's possible that the ten-year period ending this December 31 will be the first since the 1930s in which Standard & Poor's 500-stock index loses money.

The S&P ended 1998 at 1229; it closed the first quarter of 2008 at 1323. That's an increase of just 8%. Dividends count as returns, too, but they have averaged less than 2% annually. No wonder investors are testy.

When we're nervous, we tend to make mistakes, such as dumping good stocks at exactly the wrong time. Later, I'll offer seven suggestions on how to keep your head when all around you are losing theirs. First, let's get grounded by recalling the basics.

Shades of risk

Investing is an act of faith, a postponement of pleasure, an abnegation of desire. You take money you have earned and, instead of using it for here-and-now consumption, you invest it so that you can have more in the future. This process unavoidably involves risk.

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Putting cash under the mattress is a certain loser because inflation will destroy your buying power. No investment is completely safe, but Treasury inflation-protected securities come closest. When you buy TIPS, you make a loan to the U.S. government that carries a promise of repayment and interest that is linked to consumer price increases. The most recently issued TIPS bond, maturing in 20 years, carries an after-inflation interest rate of 1.8%. If inflation runs 3% (the average for the past 80 years), that's a nominal return of less than 5%.

If you invest $10,000 in 20-year TIPS and at maturity roll over the proceeds into new 20-year TIPS paying the same real rate, you will roughly double your purchasing power at the end of 40 years -- nearly an entire working lifetime. By contrast, the average inflation-adjusted return on stocks since 1926 has been more than 7%. If that average holds, then your $10,000 becomes $20,000 (in real buying power) in just ten years.

With TIPS, you aren't taking much of a chance. The U.S. government pays its debts, and the interest the bonds pay won't lose ground to inflation. With stocks, there are no such guarantees. Businesses go bankrupt. Share prices bounce up and down wildly. In less than five years, even a relatively stable stock such as Motorola has gone from $10 to $25 and back to $10 again. But when you hold a diversified portfolio of stocks and keep it for an extended period, the risk subsides. The longer you own a bundle of stocks that looks like the market, the lower the risk.

Standard deviation measures the way points of data vary around their average. If stocks produced the same return year after year, then standard deviation would be zero. But, of course, stock prices fluctuate dramatically in the short term.

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In a recent report, Vanguard Group's Donald G. Bennyhoff points out that between 1926 and 2006, the average standard deviation for U.S. stocks over each one-year period is 20%. That means that in two-thirds of the years, returns will range between a 31% gain and a 10% loss. Now, that's risky.

Time reduces risk

But over longer periods, the volatility of stocks falls dramatically. If you keep an S&P 500 portfolio for five years, the standard deviation is just 8.5%. If you hold stocks for 20 years, history shows that two-thirds of the time average annual returns will range between a high of 15% and a low of 8%. (The highest average annual return for the 65 such periods since 1926 was 18%; the lowest, 3%.) That's not risky at all.

Alas, investors don't behave as if they understand this powerful history. They focus on the near-term volatility. And why not? It's right in front of your face. "In large part," writes Bennyhoff, "it is this disconnect between the expected lower risk of an investment in stocks over the long run and the expected higher risk of such an investment in the short run that creates doubt and can foster poor decision-making under stress."

There's a paradox here. Say that at age 30 you get a windfall inheritance of $100,000 and put the money into a stock mutual fund. Viewed from age 30, the long-term investment in stocks seems sound. If history holds, your $100,000, growing at about 10% annually after expenses, will become $1.7 million by age 60 and risk will be minimal -- a standard deviation of only a bit more than 1%.

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The critical years

But when you view the same investment from the vantage point of age 50, the picture is quite different. Your nest egg has grown in 20 years from $100,000 to a little less than $700,000. The ten years that lie ahead are critical if you are saving for retirement. It's the time you are expecting your mutual fund to earn $1 million. Standard deviation is relatively low at 5%, but as I noted earlier, there have been ten-year periods when stocks have actually lost money.

Many investors find themselves in just this position today. They are five to 15 years from retirement, and they worry that their account may not grow much. In fact, it may even shrink. In a disturbing footnote, the Vanguard report states, "While the worst annual loss for the Standard & Poor's 500-stock index was -45% in 1931, the cumulative loss for the four years ended 1932 exceeded -80%."

Before you shoot yourself, let me offer you seven practical suggestions:

1. Buy stocks for the long term, but start to unwind your stock holdings and move toward bonds as you get closer to retirement. Horizon-based mutual funds -- also known as target-date funds -- will do the unwinding for you. For example, Morningstar's Ibbotson Associates found that a 50-50 portfolio of S&P 500 stocks and Treasury bonds has never lost money in any ten-year period since 1926. Vanguard Target Market Retirement 2015 fund (symbol VTXVX), designed for investors planning to retire between 2013 and 2017, currently allocates its assets this way: 51% U.S. stocks, 13% foreign stocks and 36% U.S. bonds. T. Rowe Price's Retirement 2020 fund (TRRBX) has a target allocation of 78% stocks and 22% bonds.

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2. Don't try to guess what the stock market will do tomorrow. No one can time the market consistently. Sell stocks only when a substantial change has occurred in the underlying company.

3. Go ahead and indulge your fears and hopes in a small account (absolutely no more than 5% of your stock holdings), trading to your heart's content. Sell in a panic, try to pick a bottom, let off steam. You may learn something. And if you make tons of money with great stock picks, take yourself to dinner.

4. Always maintain some cash in your primary investing account so that you can take advantage of the fear of others. At times like these, you can buy very good companies on the cheap. James Grant is a well-known bear but nonetheless waxes enthusiastic about American International Group (AIG), the giant insurer, whose price fell by more than one-third in the six months ending March 31. At $44 in mid April, AIG trades at a price-earnings ratio, based on year-ahead projected earnings, of just 6.

5. Favor stocks that pay dividends. Rising payouts are clear, tangible evidence of a company's good health. Using a proprietary system to study 2,600 companies, Dow Theory Forecasts concluded that dividend payers had an average relative risk score of 65; nonpayers, 34 (a higher score means lower risk). The newsletter recommended two low-risk dividend payers, each of which increased its dividend annually for 26 straight years: AFLAC (AFL), which sells insurance, and Energen (EGN), a utility. In the same category, but with less-spectacular consistency, Dow Theory likes Disney (DIS) and chemical maker Sigma-Aldrich (SIAL). The point is not how big the yield is but how regularly the payments rise.

6. If you must, chicken out. Just understand what you are giving up. If you want to play it safe, then buy a TIPS fund that carries a low expense ratio, or buy an exchange-traded fund, such as iShares Lehman TIPS Bond (TIP).

7. Keep your spirits high. Betting on the U.S. economy by owning shares of great companies has been a winning game for two centuries. But no one ever said that investing was easy. The hard part is weathering the terrifying storms without jumping overboard.

James K. Glassman is a senior fellow at the American Enterprise Institute.