Snub Stocks at Your Peril

Nervous investors are voting with their feet. We think you should sit tight.

These days, a bull on Wall Street is as out of place as a bull in a china shop. Bearish sentiment among individual investors has been above the historical average for the better part of four months. It's more than just a mood. Nearly $12.4 billion exited U.S. stock funds in July; investors have taken out more than $28 billion since the start of the year. Even brokerage analysts, known for falling in love with their stocks, are doubtful. In a recent compilation by Bloomberg, fewer than 29% of ratings were "buys," the lowest percentage since the financial-data firm started keeping track in 1997.

Blame a lot of the dark mood on fear that the fragile economic recovery will relapse into recession. Some investors are capitulating after three bear markets since 2000. Returns on stocks in Standard & Poor's 500-stock index were flat for the ten-year period that ended in 2009 and down slightly for the ten years that ended in 2008, according to investment-research firm Morningstar. You'd have to go back to 1974 to see a ten-year swath of similarly disappointing performance.

But nothing has shaken investors' faith like last spring's "flash crash," which delivered crushing losses in a matter of minutes, for reasons that remain mysterious (see What You Need to Know About Stock Markets Today). "May 6 was a trigger event," says Chris Nagy, managing director of brokerage TD Ameritrade. "But it's a blessing in disguise for the little guy." With regulators' attention now focused on our complex, fragmented and computer-driven markets, investors can expect unprecedented and fundamental changes in coming years, aimed at giving individuals a fair shake (see Lessons from the May 6 Flash Crash).

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While reforms take shape, it's still a good idea to own stocks. Corporate earnings, which ultimately drive stocks, are outgrowing the sluggish U.S. economy. Meanwhile, emerging markets should bolster the global economy -- and S&P 500 companies derive 40% to 50% of profits from overseas. Cash-rich companies should boost dividends in 2011.

Now is the time to think long-term, focus on asset allocation and adjust your portfolio periodically, says Charles Rotblut, of the American Association of Individual Investors. A decade ago, investors expected too much of stocks. Today, bonds might account for too big a chunk of portfolios.

It's easier to hang tough if you're insulated from volatility. Small and midsize stocks may be less buffeted by machine-to-machine trading than more-liquid large-caps. Use limit orders when you trade. Like market orders, they're filled at the best available price but let you set limits on how much you'll pay or how little you'll accept -- so your trade isn't executed at an absurd price that happens to be the best a crazy market has to offer. Use limits on stop-loss orders, too.

Consider hedging with put options, which give you the right to sell shares at a specified price within a period of time. Since the flash crash, TD Ameritrade has seen a 30% uptick in such derivatives trading, meant to hedge against market swings. Says Nagy: "You insure your life, your health, your home and your car -- why not your portfolio?"

Anne Kates Smith
Executive Editor, Kiplinger's Personal Finance

Anne Kates Smith brings Wall Street to Main Street, with decades of experience covering investments and personal finance for real people trying to navigate fast-changing markets, preserve financial security or plan for the future. She oversees the magazine's investing coverage,  authors Kiplinger’s biannual stock-market outlooks and writes the "Your Mind and Your Money" column, a take on behavioral finance and how investors can get out of their own way. Smith began her journalism career as a writer and columnist for USA Today. Prior to joining Kiplinger, she was a senior editor at U.S. News & World Report and a contributing columnist for TheStreet. Smith is a graduate of St. John's College in Annapolis, Md., the third-oldest college in America.