Scared to wade back into stock market? 3 steps for investors

Make no mistake about it: The news for investors is really rotten this quarter. The average stock fund fell 9.1% the past three months.

And it gets worse: A $10,000 investment in the average stock fund has lost $3,789 the past 12 months. You could have had more fun using your money to light the barbecue.

But sooner or later, you're going to have to tiptoe back into the stock market. You can't afford not to, given today's savings rates. If you're terrified, we'll give you three ways to tiptoe back into stocks.

Compared with a 9.1% loss, a money market mutual fund or bank CD looks pretty tempting. But here's the problem: Savings rates are so low that you can't afford to park your money on the sidelines. The average money fund, for example, yields 0.23%, according to iMoneyNet, which tracks the funds. At that rate, you'll double your money in a bit more than 300 years.

How about a bank CD? The average one-year bank CD yields 2.3%. You'll double your money in 31 years at that rate. But even that won't mean much: Inflation and taxes will eat your earnings down to a nub.

So if you have a long-term investment outlook — 10 years or more — then you'll probably earn more in stocks and bonds than you will in money market funds or bank CDs. Ironically, given the losses you may have taken in the past five years, the stock market is probably your best bet at getting even.

Market experts often talk about "reversion to the mean," which means that periods of good or bad performance generally drift back to average. In the 1990s, for example, some analysts warned that ultra-high stock returns would revert to the mean — meaning that, sooner or later, a long period of bad performance would follow, bringing the long-term average back to normal. And that's pretty much what happened.

The stock market's 10-year performance is the worst since the Great Depression, says Ibbotson Associates, a Chicago research group. If there is a reversion to the mean, the next long-term move could be up.

Step 1: Rebalance

If you started the year with a mix of 60% stocks and 40% bonds, your portfolio is probably no longer at the same balance. You probably have a higher percentage of your portfolio in bonds than you did at the start of the year, and a lower percentage in stocks.

When you rebalance, you take money from your winning investments and invest it in your losing ones. The goal is to get back to your target allocation — in this case, 60% stocks and 40% bonds.

Rebalancing every month or quarter usually isn't a great idea. On Wall Street, you're supposed to sell your losers quickly, and hang on to your winners. When you rebalance every month, you're selling your winners too soon. And if you have to pay transaction fees or taxes for buying and selling funds, frequent rebalancing is a loser's game.

You should, however, rebalance when your portfolio is 5 or 10 percentage points away from your goal. In this example, you might rebalance when stocks are 50% of your portfolio.

If you rebalance according to target percentages, you won't have to move money very often. A mix of stocks and bonds is a fairly self-balancing mechanism. Stocks often rise when bonds fall, and vice-versa.

Using the 10-percentage-point rule, you would have rebalanced three times in the past decade: Once in October 2002, once in January 2007 and once in November 2008.

Step 2: Consider a balanced fund

If rebalancing seems like too much work, consider a fund that does the work for you. Balanced funds, for example, are traditionally a mix of 60% stocks and 40% bonds. The past five years, balanced funds have gained 0.7% while the average stock mutual fund has fallen 21%.

You might also consider an asset allocation fund. These invest in a mix of stocks, bonds and money markets. Asset allocation funds come in two flavors. A more old-fashioned approach simply targets investor risk appetites: conservative, moderate or aggressive. Conservative asset allocation funds have less of their assets in stocks than aggressive ones do. Nevertheless, even conservative ones have about 30% to 40% of their assets in stocks.

Other funds, called target maturity funds, try to match their asset allocation to the date you plan to retire. When your retirement date arrives, the funds often convert to income funds — after all, retirees tend to be more interested in generating income than capital gains.

Target maturity funds tend to be more broadly diversified than asset allocation funds or balanced funds. In the past year or so, however, this has simply meant that they have lost money in a variety of different ways. The average target maturity fund that matures in 2030, for example, fell 36.2% the past 12 months.

Nevertheless, the funds' basic theory is correct. Broad diversification, over time, should smooth out some of the market's downdrafts. And if you're worried about getting into the market, a balanced fund — or an asset allocation fund — should make the ride a bit less scary.

Step 3: Consider a dividend fund

If you're feeling brave enough for a pure stock fund, but not an aggressive one, consider a fund that invests in stocks that pay steady dividends. Although you'll still get a rough ride from time to time, dividends will cushion some of the bounces.

A dividend is a cash payout from a company's profits. Essentially, the company is sharing its earnings with its investors. "During tough times, the only way an investor can get a cash return from the stock market is through a dividend," says Judy Saryan, portfolio manager of Eaton Vance Dividend Builder fund.

Companies that increase their dividends regularly have several virtues. First, they tend to have loyal shareholders. And, because cutting a dividend is pure poison on Wall Street, a company that raises its dividend is signaling that it can afford to continue paying that dividend indefinitely. "Growing the dividend is the best signal they can give," Saryan says.

A word of caution: Because of the tough economy, an unusual number of companies have been cutting their dividends. Through February, 40 companies in the S&P 500 have cut their dividends, Saryan says. Nevertheless, 48 companies have increased their dividends during the same period.

If you're worried about getting back into the market, you're not alone: The bear market has sent even the bravest investors hiding. But sooner or later, you're going to have to tiptoe back in. Any one of these three steps will help you inch back.

TELL US: Do you plan on getting back into stocks?