By John Wasik
CHICAGO Feb 1 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
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
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.
DO NOT FORGET RISK MANAGEMENT
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
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
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
* Vanguard Total Stock Market ETF, 19.74 (standard
* 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
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
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.