By John Wasik
CHICAGO, Feb 1 (Reuters) - Whenever there is an extended rally in the stock market, blazing lights go on in the heads of Main Street investors, signaling that it is time to join the party.
As the S&P 500 reached a five-year peak at the end of last week, on top of a 13 percent gain for the index last year, enthusiasm for stocks approached fever pitch. More than $55 billion in new cash flooded in to stock mutual and exchange-traded funds in January, according to TrimTabs Investment Research. That is the biggest monthly inflow on record, beating the previous record set in February 2000.
What to make of this exuberance? Investors are seeing a clearer horizon after the "fiscal cliff" came and went without hurting the market. Pending home sales took a dip in December, but were up nearly 7 percent for the year, according to the National Association of Realtors. Corporate earnings also look relatively strong, with earnings growth of 2.5 percent expected in the fourth quarter of last year, reports Factset Research. A renewed prospect of personal wealth is piggybacking this positive news.
But it may not last.
Main Street apparently has not received the message that more troubles for the U.S. economy and federal budget may lie ahead and derail the stock rally. While U.S. economic activity is generally rebounding, the economy actually contracted in December as government spending dipped, the Federal Reserve reported on Wednesday. It could recede even more if the planned sequester budget cuts go through.
That is why investing in the stock market should be less of an on-off switch and more of a dimmer. You can gradually ease in, making sure you are getting in the right way. It is all too easy to set yourself up for a fall again.
How do you temper risk while ensuring that you are not missing a rally? Stop looking at past returns and look at volatility instead. I like portfolios that spread out the risk, yet you always have to consider where your risk is concentrated. If you are a growth-oriented investor and have decades until retirement, then most of your risk is in stocks.
Income-oriented investors near or in retirement should be laser-focused on inflation, which hurts bond prices. When eyeing a greater portion of stocks, consider what it will do to your overall portfolio.
You can experiment with any number of portfolio planners online - every mutual fund company has them - that will show you expected ranges of returns and losses. But you may have to dig through the "risk" tabs on sites like Morningstar or Yahoo Finance to find volatility information - expressed as standard deviations, which generally cover a three-, five- and 10-year period, if available. I prefer the five-year measure because it includes the 2008 meltdown.
Standard deviation numbers are not perfect gauges of risk, but they give you some idea on how much prices can vary. They are pretty simple to read: The higher they are, the riskier the asset in terms of how much the price can fluctuate. Generally, a benchmark like the S&P 500 index ranges from 15 to 19 over the past half decade. Broad-based bond index funds are almost always under 5.
Here is a template portfolio of five funds to hold, originally suggested by David Swensen of Yale University with a minor alternation (I have dropped an overlapping non-U.S. stock fund):
* Vanguard Total Stock Market ETF, 19.74 (standard deviation)
* Vanguard FTSE Emerging Markets ETF, 29.41
* Vanguard REIT Index ETF, 32.71
* iShares Core Total US Bond Market ETF, 3.62
* iShares Barclays TIPs, 7.32
Notice how low the volatility is for the bond funds, which are five-year measures through 2012. That should be your fail-safe in creating a portfolio. You can weight more toward the iShares funds if you are concerned about preserving capital: 40 percent in AGG, 20 percent in TIP and the rest divided among the stock funds. Disclosure: I hold AGG, VNQ and VTI in my portfolios.
Moderate-risk investors can flip the allocation to put 20 percent in each of the stock funds and the remainder in bonds. Aggressive investors can put 70 to 80 percent in stocks, although this would clearly be the riskiest portfolio mix and one most likely to lose the greatest amount of money in a downturn.
Those who are extra-cautious or especially concerned about inflation should consider adding to the mix the SPDR Gold Trust , which tracks spot gold prices, at 10 percent of the portfolio. You would reduce the holdings in one or both of the bond funds to make way for the gold ETF.
At the very least, take a close look at the risk concentration you set up. Historical volatility is highest for stocks of real estate investment trusts - represented by the Vanguard REIT Index - and emerging markets. So in the event of a broad sell-off, these two funds may take the biggest hits.
There is nothing wrong with taking advantage of the market's upward movement, but never take your eye off the downside. When the lights go off, you will still need to find your way home.