What investors should know during the downturn

As we work our way through this current recession, it's clear that it has affected a broad section of investors. Stock investors and bond investors have seen declines in the value of their investments. Even cash investors have seen yields on their cash investments drop to practically zero and have had their implied guarantee of principal called into question.

Some investors have been hit harder than others. Certainly those investors with a large percentage of their assets in the stock market have seen a greater decline in value than those with less invested in the market.

Fortunately, there are some things that the average investor should know that will both help mitigate losses during the next downturn and enhance returns during the next boom in the stock market. For example:

* Don't fool yourself into thinking that you are diversified if you own five different bank stocks or three different large-cap growth funds. Diversification works when the investments chosen to make up your portfolio are very different from one another. A portfolio consisting of large-cap, small-cap, growth, value and international investments is a better diversifier than owning all bank stocks or all large-cap growth stocks. Even better would be one that includes bond investments in addition to stock investments, and maybe even a little cash.

* Do not try to time the market. Everyone seems to agree that trying to time the market is hard to do, but many continue to try. Put simply, market timing is the practice of buying when you think the market has hit a bottom and selling when you think the market has reached a high and is about to fall. The problem is that markets do not go straight up or down. There can be big moves up or down even as the market trends up or down.

From Aug. 28, 2008, through April 17, 2009, for example, the S&P 500 was down a total of 33 percent. At one point during that time frame, the S&P 500 had dropped as much as 49 percent. However, twice during that same time frame the S&P 500 rose by more than 24 percent. Market timing involves making two correct decisions; that is, buying at the right time and selling at the right time. Swings in the market as described above make it virtually impossible to get both the buying and selling timed right.

However, the real danger with market timing is when both the buying and selling decisions are wrong. Someone who rode the market down when the Dow Jones Industrial Average went from a high of just over 14,000 down to a low of 6,547 on March 9 and then sold everything in early March, and is still sitting in cash, is faced with an interesting dilemma. Certainly he did not time the selling side correctly and is now faced with a buy decision. As of mid-April, the market had recovered more than 25 percent since the lows in early March. The investor then has already missed out on the recovery back to the levels of April 19. If he buys now and the market goes up from here, then he will have locked in a permanent 25 percent loss, but share in future gains. However, if the market continues to go down from now, then the urge to sell again will become great and, if acted upon, will cause more loss on top of the already large loss. The worst thing about both scenarios is that whatever the loss is, it will be permanent, next to impossible to make up for, and certainly avoidable.

* Do not hold onto an investment solely because at one time the price of the investment was much higher than it currently is. It is no secret that most people are too emotional when it comes to dealing with their money and investments. Just because you owned Citigroup at $55 a share does not mean that it will eventually sell for $55 a share again. It may, but then the Washington Nationals may also win the National League pennant. Holding on to the stock just in the hope of it going back to where it once was is no different than a gambler doubling down on his losses in order to get back to even again.

* Do not hold onto an investment that has done very well simply because you do not want to pay income taxes on the sale. Last time I checked, the tax on the sale of an investment was never more than the proceeds received in the sale. Furthermore, for investments held for more than a year, the tax is even less, and in certain circumstances zero. If the investment is no longer appropriate for your portfolio or as a percentage of your portfolio exceeds 10 percent, then by all means sell the investment, pay your taxes and re-invest the proceeds in a more appropriate investment.

A Do not invest money in the stock market that you may need within the next five years. People saving for their teenage child's college education or to buy a house within the next few years should invest all that money in low-risk types of investments such as bonds or cash. The risk of principal fluctuation is just too great to take a chance with the money.

This does not mean, however, that individuals less than five years away from retirement should not invest in the stock market. These people most probably will need to invest some of their assets here. The mistake most people make is failing to properly identify the time period for which the money will be needed. A 55-year-old person may be retiring in five years, but will need their money to last much longer than that.

Following the above suggestions won't ensure that in the next downturn your investments won't lose money. They will, however, go a long way towards helping you understand what needs to be done to avoid making those major mistakes that can result in permanent losses and major damage to your portfolio.

Howard Hook, CPA, is a Certified Financial Planner with the money management firm of Access Wealth Planning in Roseland and Princeton, N.J.

(c) 2009 Accounting Today and SourceMedia, Inc. All Rights Reserved.

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