Why You Should Stick With Stocks

Investors are just realizing that you don’t earn an average of 10% annually without taking some risk and suffering some pain.

Like fishing in a well-stocked pond, investing has been pretty easy in recent years. Imagine that at the end of October 2007, the month the bull market peaked, you put all of the money you had to invest into a fund that tracks Standard & Poor's 500-stock index. Even with such terrible timing, you would have more than doubled your money as the market produced positive returns in every year from 2009 to 2017.

In late January and early February, the stock market reverted to a pattern of extreme volatility, with the Dow Jones industrial average losing 1,175 points one day and rising 567 points the next. It was a vivid reminder that, as an investor, you don't earn an average of 10% annually without taking some risk and suffering some pain. But there are ways to mitigate that pain. Here is some advice for investors who are just realizing (or may have forgotten) that stocks don't always go up.

Be disciplined. Benjamin Graham, the late financier and scholar who was Warren Buffett's mentor, once wrote, "The investor's chief problem–and even his worst enemy–is likely to be himself." It is the "excitement and the temptations of the stock market," said Graham, that get investors in trouble. His answer was the discipline of value investing–that is, buying stocks that are so cheap in relation to corporate profits and other yardsticks that their low price provides a "margin of safety" even if the worst happens.

Invest regularly. The best way to tame those emotions is to take them out of the picture entirely by making the purchase of stocks mechanical. Rather than guessing when to buy shares, set up a program with a broker or within your company's retirement plan to invest the same amount regularly–every month, every quarter or every year. The process is called "dollar-cost averaging," and you can do it with individual stocks or funds.

Say, for example, that your entire portfolio consists of shares in Vanguard 500 Index (symbol VFINX), a mutual fund with an expense ratio of 0.14% that tracks the S&P 500. Every three months, you buy $2,500 worth of shares in the fund. For simplicity, let's assume that one share costs $250, so your $2,500 will purchase 10 shares. Now assume that over the course of three months, stocks tumble. The S&P falls by 30%, and a share in the Vanguard fund trades for $175. Your next quarter's $2,500 purchases not 10 shares but about 14 shares.

Dollar-cost averaging helps you think about stocks the right way. "Do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous," Buffett wrote in 1996 in an "owner's manual" for shareholders of the company he chairs, Berkshire Hathaway (BRK-B). "Instead visualize yourself as a part-owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family."

Automatic purchases allow you to accumulate a growing interest in the business over time. If you love the company, you want to own as much of it as you can, and when the price goes down, dollar-cost averaging lets you buy even more shares. The price doesn't matter until you sell, sometime far in the future.

Sell rarely. When should you sell? The simple answer: almost never. As my example of the investor with lousy timing illustrates, the best investing strategy is to buy and hold. Period. Certainly, sell if you need the money–for retirement, college or a house, for example. But don't sell because a stock (or a market) has gone up or down by what you believe to be too much. No one can time the market with any consistency, so don't try to time it at all.

Put your eggs in many baskets and pay as little attention as possible. In other words, diversify, invest automatically and sell reluctantly.

Other than cashing in to fund your goals, the only times you should consider selling relate not to price or economic environment but to the nature of individual companies themselves. Again, let's turn to a master investor–in this case, the late Philip Fisher, best known as the author of the investing guide Common Stocks and Uncommon Profits. You should sell, he wrote, when a company's business has developed trouble: "When companies deteriorate, they usually do so for one of two reasons. Either there has been a deterioration of management, or the company no longer has the prospect of increasing the markets for its product in the way it formerly did."

Keep your eye on the CEO. Jeffrey Immelt, who took over General Electric in 2000, was not as able as his predecessor, Jack Welch. If you have doubts about a new chief, the right move is to sell. As for deteriorating markets, just look at what has happened to brick-and-mortar retail chains as shopping has moved online.

Other good reasons to sell include mergers, the failure of a major product or a lack of integrity in management. The latter was the reason I withdrew my recommendation of Wells Fargo in 2016. A higher or lower price, or a prediction about the growth of the economy, is not a good reason to sell.

Rebalance your holdings. There is one more reason to sell: as a means of maintaining your target asset allocation–that is, the proportion of your portfolio devoted to different asset categories and subcategories, such as stocks and bonds or domestic and foreign shares.

Determine your allocation according to your age, your impending needs and your aversion to risk. Say you are in your fifties, intend to retire within 20 years and have moderate worries about volatility. A simple allocation might be 60% stocks and 40% bonds. Now imagine that over the course of five years, stocks double in value and bonds hold steady. An initial $100,000 portfolio, with $60,000 in stocks and $40,000 in bonds, will become a $160,000 portfolio, with $120,000 (or 75%) in stocks. To get back to 60-40, you should buy more bonds or sell stocks in your portfolio.

Rebalancing does not have to be an annual event, but you should check your allocation each year and, if it has drifted out of whack, make purchases and sales.

Diversify. When you construct your stock portfolio, and as you rebalance, be sure to diversify your holdings. A good strategy is to put at least half of your money into one or two broad mutual funds–an S&P index fund or a low-fee large-company fund, such as Dodge & Cox Stock (DODGX), for example–or exchange-traded funds. Put the rest into at least 10 stocks in a range of businesses, such as technology, energy and consumer goods. Although there is debate about how many stocks you need to own in order to achieve the protection of diversification, the minimum seems to be 10. I also recommend owning foreign stocks and small companies, either in funds or as individual shares.

Andrew Carnegie, the famously rich industrialist and philanthropist, once said, "Put all your eggs in one basket and watch the basket." That may have worked for him, but most investors should do the opposite: Put your eggs in many baskets (diversify) and pay as little attention as possible (invest automatically and sell reluctantly).

As Buffett said, "We continue to make more money when snoring than when active."

James K. Glassman chairs Glassman Advisory, a public-affairs consulting firm. He does not write about his clients and does not own any of the securities mentioned in this column.

You don't have to be a value-only investor to profit from financial discipline, but you do have to understand the dangers of human emotion when it comes to buying and selling stocks. When a sweater goes on sale, it attracts buyers. But with stocks, the buying urge works the opposite way. A falling price can throw investors into a selling panic. Similarly, investors are drawn to shares whose prices are rising. The logic goes: Hey, that stock must be a good one if everyone is buying it.

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