Tips for Smart Investing in Any Economy

investingWondering where to invest in today’s complicated economic and market environment? That’s no surprise. While the United States isn’t formally in a recession any longer, there are plenty of reasons to be concerned. Wavering economic data make many analysts concerned about the prospects of the dreaded “double-dip” recession, and inflation data is worrisome because it can hurt the performance of many asset classes.

You may need to invest—now, as always

Investing now is a frightening idea, with the economy and inflationary environment so uncertain. You just don’t know which asset classes will perform well and which ones will perform poorly.

That said, giving up on investing altogether may not be a wise idea. If you decide to invest solely in cash equivalents because you’re uncomfortable with market volatility, you must accept the fact that inflation could eat away at most of your investment return—particularly in today’s environment of rising inflation.

How bad is it? While core inflation, as represented by the consumer price index (CPI), is below the US Federal Reserve Board’s (Fed’s) target and the rates prevailing before the most recent recession, it’s still worrisome. In fact, newer methods of calculating CPI that have been in place since 1983 mean inflation may be significantly understated. As of 3/31/11, for example, one-year CPI was 2.7%; that number would have been 10.2% using calculation methods in place prior to 1983.(1)

What does that mean? You may need to invest to help realize your long-term financial goals.

But what about the risks, you may ask? Certainly, investing is full of risks, so it’s normal to be concerned. But it’s also important to remember that investing always entails risks—but over time, stocks and bonds have performed well, even when adjusted for inflation. For example, $1 invested in stocks in 1802 would be worth $788,308 today, and $1 invested in bonds in 1802 would be worth $1,215 today—after adjusting for the effects of inflation.(2)

Other asset classes may also be worthy of consideration, such a real estate investment trusts (REITs) and commodities (including gold and precious metals).

Five strategies

To help you get started, below we offer five tips for investing in troubled times.

Strategy #1:

Avoid market timing. You may want to get back into investing, but have some concerns about getting started now. Why not wait, you might ask, and time your investment to when the market hits its low? While that’s an intriguing idea, but you probably won’t guess correctly. By keeping your portfolio on the sidelines, you could be missing another downturn—but also a rally.

Strategy #2:

Diversify. When you have a mix of different types of investments—that is, when your portfolio is well-diversified—you can better weather the ups and downs of the market. As the values of some types of securities decline, the values of others may increase. This may provide you with an overall return with which you are comfortable. So, when you re-enter the market, you may want to have an allocation to the three basic investment types: stocks, bonds, and cash.

You may also want to remember that diversification doesn’t end there; there are many investment sub-categories. You may want to have a mix of growth and value stocks, stocks of companies with different market capitalizations, and stocks from different countries, for example. (Of course, diversification cannot ensure a profit or protect you from a loss.)

Strategy #3:

Be sure to allocate enough of your portfolio to stocks. Let’s say that today you start investing $400 a month (a total of $4,800 a year) for retirement in a tax-deferred account such as a 401(k). You’re terrified of investing, so your money is earning a hypothetical 5% a year in a lower-risk investment vehicle.

Flash forward 25 years. You’re on the doorstep of retirement, and you have $235,248. Will it last another 25 years or so? Probably not. After 25 years, $235,248 is equivalent to about $112,432 today (assuming annual inflation of 3%). And when you take out what you owe in taxes, your total dwindles even more. Investing in stocks may help you earn a greater return.

Strategy #4:

Dollar-cost average. Let’s say you’re convinced that you need to get back into the stock market, but you’re not comfortable taking the plunge. Why not consider getting back into stocks in stages? Investing a little at a time is a strategy called dollar-cost averaging. While it doesn’t shield you from a market crash, it does let you take advantage of lower stock prices as the market declines. Because the amount you invest remains constant, you are able to buy more shares when the price is low. As a result, over the entire purchase period, your average cost per share could be lower than the stock’s average price per share.

Strategy #5:

Rebalance. Finally, after investing, you can help manage risk by paying attention to your asset allocation. After all, not doing so is exactly what got people in trouble during the dot-com boom of the late 1990s. Technology stocks rallied, becoming a larger percentage of investors’ portfolios. Instead of rebalancing—i.e., selling off some of these stocks to maintain their target asset allocations—many investors were swept up in the technology frenzy and failed to rebalance. When the bubble burst, they were hit hard.

Putting it in perspective

We’ve discussed five things you can do to help cushion the risk of investing in today’s troubled environment. But it also helps to remember that the markets can be volatile, with each year, month, and even week filled with ups and downs. Avoiding the downs means you’ll also be avoiding the ups. So we recommend you invest but do so wisely.

1 Source: Shadowstats.com, BLS and S&P as of 3/31/11.

2 Source: Dreman Foundation and Jeremy J. Siegel, Stocks for the Long Run (McGraw-Hill, 1994). Performance is historical and does not guarantee future results. Stocks and bonds are presented by a compilation of data designed by Jeremy Siegel to represent the asset classes going back to 1802. Equity index returns assume reinvestment of all distributions. Index returns do not reflect fees or expenses, and it is not possible to invest directly in an index. This data is for illustrative purposes only and does not represent any product.