Is Now the Time to Get Back Into Stocks?

Oct. 14, 2008 — -- Brutal. That's the only way to describe last week's stock market rout.

There's no getting around the pain triggered by the worst single week in the history of the Dow Jones industrial average. It has millions of Americans worried about their financial futures.

Despite recent events, however, I stand with countless other financial planners who have advised individual investors to resist panic and the urge to liquidate entire portfolios in favor of all cash. A 100 percent cash portfolio simply is not going to build the retirement nest egg most of us need to accumulate, and not one of us can say when the right time to jump back into the market will be.

Still, it's understandable many small investors feel a need to take action rather than watch our financial futures wash down a Wall Street drain. The good news is that there are a number of positive steps you can take even if stock prices continue to decline.

Here are five steps you might consider:

Buy, yes, buy stock funds. That's because the key to successful investing is quite simple: You want to buy low and sell high. And right now stocks are available at a lower price than they have been for quite some time.

If you have the cash on hand, look to fill gaps in your current asset allocation, whether those gaps are in large caps, small caps or even international. In my view, the best way to do this is through either index mutual funds or exchange traded funds.

If you're worried about the potential for further declines, then make a series of moderate purchases rather than one large buy.

Rebalance. With the 40 percent plus drop in stock prices this year, there's a good chance the target allocation for the stock portion of your portfolio is down while cash and bonds have assumed larger positions.

For instance, the asset allocation target I've set for my own portfolio is 85 percent stocks, 10 percent bonds and 5 percent cash. The stock market nose dive, however, brought my allocation to 79 percent stocks, 11 percent bonds and 9 percent cash at the start of this week.

Good Time to Buy Low

That means I need to take some money from cash and maybe a little from the bonds to buy some stocks to bring that portion back up to 85 percent.

You rebalance by selling the asset classes that have taken on a larger-than-desired position in your portfolio and by buying those that have shrunk below where they should be.

These moves run counter to our instincts, but once again it's a way to ensure we buy low and sell high.

Rebalancing is a way to take advantage of today's low stock prices even if you don't have extra cash on hand.

Keep contributing. The worst possible reaction to the recent market slide would be to stop contributing to your 401(k) plan or other retirement savings vehicle. That is because the drop in stock prices means you are able to buy more mutual fund shares at a lower price than you could a couple of weeks ago.

For example, suppose you contribute $200 of each paycheck to a 401(k) plan. If a month ago, a share of Mutual Fund X cost $50 each, you could buy 4 shares. Now, if the share price of that fund is down to $40, you can buy five shares each pay period.

Armed with that extra share, you will be sitting pretty when prices recover. And if the market continues a downward spiral for some time, you will be buying future shares at an even lower price.

Meanwhile, your coworker who stopped contributing to the company 401(k) is missing out on sale prices and will end up paying more -- and earning less -- when he decides it is "safe" to contribute again.

Convert to a Roth: One way to make up for losses in your retirement portfolio is to lock in future tax savings by converting from a traditional IRA to a Roth IRA. As you may know, retirement-age withdrawals from a traditional IRA are taxed as ordinary income and are required after age 70½. Withdrawals from a Roth IRA, however, are tax free and not required at any age.

The federal tax code allows retirement savers to convert a traditional IRA to a Roth IRA and avoid taxation on those funds in retirement. That conversion, of course, comes with a cost. Income taxes are due on the conversion amount for the year the conversion takes place.

About Roth Conversions

The stock market collapse means you can now convert to a Roth IRA at a lower tax cost than you could at the beginning of the year as your conversion amount will be smaller.

Be aware there are income restrictions on Roth conversions. The limit is $100,000 in modified adjusted gross income for most taxpayers.

Conversions from a former employer's retirement plan, such as a 401(k) account, are also allowed starting this year.

If you converted early in the year and now are looking at paying a tax bill on a diminished account, you may want to consider what's called a Roth IRA recharacterization.

The rules for both Roth conversions and recharacterizations are too complicated to provide in detail here, but they are worth your time researching. For larger accounts, it's probably worthwhile to seek the help of a financial planner or tax accountant.

Pay down debt. Finally, no matter what happens next with stock prices, there is one way to earn a guaranteed rate of return that will beat what you can earn on an FDIC-insured bank account or CD.

And that is to pay down debt, whether it's high-cost credit card debt or even a tax-deductible home mortgage.

Paying off a loan carrying a 6 percent interest rate amounts to a guaranteed 6 percent rate of return in the savings you realize. If it's tax deductible debt, then the actual rate of return may be less. But in times like these it's still a good move, particularly if you're too frightened to put available cash in stocks right now.

Any time you pay down debt, you improve your financial position and put yourself in a better position to withstand any economic shocks that await us.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.