On Tuesday, the Dow Jones industrial average, one of the most popular measures of how the stock market is doing, closed at an all-time high. Then it kept going up on Wednesday. And on Thursday. And again on Friday, catalyzed by a better-than-expected jobs report.
Get started with a free financial assessment.
Get started with a free financial assessment.
The headlines were screaming. The pundits were chattering. But, what does the stock market being on a tear mean? As one reader puts it: “When the market surges, a lot of people think they're supposed to … do something.”
If you want more insight on why the markets are doing so well, we have background on the Dow’s record-breaking surge. In the meantime, we want to explore: When markets go drastically up (or down), how should you react?
We spoke to Carl Richards, author of "Behavior Gap: Simple Ways to Stop Doing Dumb Things With Money" and regular New York Times contributor, as well as LearnVest Planning Services certified financial planner Sophia Bera for advice.
Your Starting Point
“First of all,” Richards says, even before the market reached these new highs, you should “have an investment plan that was carefully thought out when you were thinking rationally.” This will include a mix of, for instance, stocks of large companies, stocks of small companies, stocks from international companies, bonds and other types of investments. And the amount you have of each would be tailored to your goals and time horizons—or the amount of time you can leave your money alone to grow. (Wondering what mix is right for you? Check out our risk tolerance quiz.)
RELATED: Saving for Retirement 101
Second, this plan of yours should be not be based on short-term targets, but on goals at least five years out. (We’ve talked before about why day trading is a bad idea.) If you’re constantly adjusting your investments for what’s going on around you—i.e. "oh, emerging market stocks are doing well, I should get more of those"—you’re likely to run into problems.
For the sake of this article, let's assume that you have an investing plan that’s well-thought-out, and that you’re in the markets for the long haul, whether for retirement or another distant goal.
What You Should Be Doing
"If you have a plan, the question becomes, ‘Should I change my plan based on what’s going on with the market?’ The answer is no," Richards says. "Should you keep making contributions to your 401(k)? Yes." After all, your plan isn’t any less good just because the market is doing well. Richards adds, "Generally speaking, we should make changes based on changes in our lives, not based on changes in the market.”
When a person decides to trade because of a stock market surge, it's because he thinks he can predict where things will go in the future. For example, he might want to cash out before stocks plummet, or get in now because he thinks they’ll only go higher. But any such decision assumes he knows something no one else does.
If you find yourself thinking this way, Richards recommends pushing yourself: “Okay, if you know the market is going to go down, when will that happen?” You probably can’t answer with any real certainty. “The only thing we know is we had a plan that reflected our goals, and our goals haven’t changed.”
What About Being Strategic Within My Investing Plan?
You might be a long-term investor, sure, but if you’re just buying an index fund that reflects the stock market, shouldn’t you try to buy it on an optimal day if you can?
As a thought experiment, American Funds, a family of mutual funds managed by Capital Research and Management Company, ran the numbers on a hypothetical character (named Louie the Loser, of all things) who invests $10,000 every year. Each time, he puts his money in on the absolute worst day. After 20 years, from 1992 to the end of 2011, the study compared his returns to those of someone who always invested on the best possible day.
While the better investor earns an average of 6.9% annually, Louie still does well, earning an average of 5.5% annually. How much does this net out to? While both the better investor and Louie put in $200,000, the better investor ends up with $421,604, while Louie still finishes with a respectable $353,295.
The moral? Sure, it’s great if you managed to invest on the best day ever, but the most important thing is to jump in there at all, even if it's on the "worst" day.
[lv_share_bricks]If you despise the idea of investing a big chunk of money and then watching the market dip, you can simply invest the same amount every month, regardless of the market. As Bera notes, contributing this way is similar to a regular 401(k) contribution—you even out the highs and the lows, mitigating some of your risks: “People should keep contributing to their accounts like they have been. If you have a 401(k), money’s going in there with every paycheck, which is great," she says. "You're buying things when they’re low and when they’re high.”
One Thing You Should Do: Rebalance
In a good investing plan, you know what percentages you want to allocate to which kinds of investments (i.e. 30% international stocks, 30% bonds, etc.) based on your goals and needs. For instance, one person might be comfortable taking on risk and losing in the short-term for the chance of a higher reward later on, while another might want to avoid losing anything because he or she is nearing retirement.
Rebalancing is like giving your investments a haircut to set your percents back to where they should be.
Say you decide to split your money 50/50 between stocks and bonds. At the end of the year, your perfect balance will be off because some of your investments will have done better than others. Rebalancing is like giving your investments a haircut to set your percents back to where they should be. One upshot of a runaway market is that it’s a good opportunity to rebalance.
Let’s use our 50/50 example. Maybe you started off halfsies, but the stock market has been doing so well that now your stocks are more like 60% of your total portfolio because they gained in value. Even though it may feel wrenching to sell some precious stocks and buy bonds that you consider less valuable investments, Richards insists this is important. “Yes, it means taking some of the money off the table,” he says, “but you’re not doing it because you think the market’s going to go down—you’re doing it because 50/50 was the right plan, and it’s still the right plan.”
If a change in your own life means your allocation is no longer right for you, then yes, change your investments. But be careful about getting excited about how much the value of your stocks have increased and saying, “Oh, 60% is fine enough.” Don’t change your roadmap just because the market’s looking good.
Richards, a certified financial planner himself, admits: “Every time I’ve changed my long-term plan based on short-term noise, I’ve been wrong … and I’m pretty good at this!” If professionals can’t do it right, it doesn’t make sense for regular people to take the risk of trying.
Bera reminds us that the absolute most important thing is simply to invest at all, and to do it regularly: “Just consistently putting money in every month is going to help you,” Bera says. If you’re saving for retirement, the most powerful tool at your disposal is time, which will even out short-term hiccups—the highs and the lows, alike. “So many people are hesitant to start investing, or if they’re older, they think, ‘I should have started years ago and it’s no longer worth it.’ But even that $100 or $200 a month could turn into $100,000 in 10-15 years, which may be the difference between living off Social Security income or not.”
If all this advice has you convinced, don't forget that you still have until April 15, 2013 to contribute up to the $5,000 limit to your Roth IRA for 2012. Also, the contribution limit has increased to $5,500 for 2013. So, if you haven’t contributed to either yet, you have the opportunity to sock away up to $10,500 with some serious tax advantages.
RELATED: Top Retirement Mistakes to Avoid
Richards leaves us with parting wisdom if you're seeing dollar signs in the market's high: “Come in off the ledge and ask yourself if anything has changed about your goal. Nothing? Okay, then go back to riding a bike or taking a hike—to living your life.”