By JONATHAN CLEMENTS
It is a risky time to be a stock-market investor. It always is.
After Monday's market mayhem, the Dow Jones Industrial Average is off 3% from its April 21 high, the doom-and-gloom crowd is in full chorus, and tales of easy profit are giving way to much talk of risk.
But this notion of risk can be slippery. It is usually associated with volatility, as measured by gauges like beta and standard deviation. The more volatile an investment or a portfolio is, the riskier it is deemed to be.
Yet these short-term price swings don't capture my sense of risk. Instead, I worry about investment losses that could have a lasting impact.
Falling Short. When investing, the greatest danger is failing to meet your financial goals, because you save too little or earn lackluster returns.
The need to save is obvious. What about returns? If your portfolio is to grow, you must outperform inflation, taxes and investment costs. And the best way for long-term investors to do that, I believe, is to buy and hold stocks.
Risky? It sure seemed so Monday. If you compare the short-term performance of stocks with that of bonds and money-market funds, the traditional link between risk and reward seems alive and well. The greater returns of stocks are accompanied by greater short-term gyrations.
But over the long haul, this risk-reward relationship isn't quite so simple. Indeed, stocks actually seem safer because they are more likely to make you decent money, while bonds and money funds find it tougher to stay ahead of inflation, taxes and investment costs.
Compelled to Sell. Investing is delayed consumption. We tuck money away with the notion that, somewhere down the road, it will get spent. But what happens if the future arrives -- and the stock market is underwater? You could be forced to sell at dirt-cheap prices.
To avoid that risk, look to unload your stocks when you are within five years of needing the cash, preferably making your sales when the market is buoyant. And yes, I would still consider the current market buoyant. Even after Monday's losses, stocks are up 13% in 1998.
Unrequited Love. Too many investors bet too heavily on just one or two stocks. Sure, that may mean handsome gains. But if you bet wrong, you could suffer losses you will never recoup.
The solution is simple enough. Use mutual funds to spread your money among a good number of stocks in a variety of market sectors, including large, small and foreign stocks.
Left Behind. If you jump in and out of stocks in an effort to catch bull markets and sidestep market declines, you run the risk of being out of the market when stocks are bulldozing ahead. That is a real danger, because big stock-market gains are often concentrated in a few weeks or even days.
To avoid this particular pothole, decide what portion of your portfolio you want in stocks and then stick with this percentage no matter what is happening in the market.
Relatively Miserable. Even if you stick with stocks through thick and thin, you could still suffer lackluster results, thanks to market-lagging performance by your stocks and funds. Because of that danger, consider using index funds for at least part of your stock portfolio.
Index funds buy the stocks that constitute a market index in an effort to match the index's performance. By keeping a portion of your money in these funds, you guarantee that whatever the market delivers, that is what you will get.
Closed for Business. My fondness for index funds comes with one reservation. With an index fund, you are locked into a particular market or markets. What if one of these markets ceases to exist?
It has happened. Finance professors Philippe Jorion and William Goetzmann examined 21 national stock markets that date back to the 1920s. Over the next seven decades, eight shut down temporarily and seven suffered a long-term closing.
It is hard to imagine the U.S. market closing. But it is entirely conceivable that this could occur in some of the smaller foreign markets found in international index funds.
If a closing were threatened, an index fund might get out before the market shutters, though probably at a steep loss. By contrast, at least some actively managed funds would no doubt prove nimble enough to bail out at decent prices.
Friendly Fire. Yeah, individual stocks fall apart. But the danger is greatest for those who foolishly bet too much on any one company. True, the market can take a sudden dive. But that has grim consequences only if you sell in a panic or have money in stocks that you will need to spend in the near future.
The stock market often goes haywire. Monday reminded us of that. But it is the way investors react that causes the real damage. Keep that in mind in the days ahead.