Stock Market Rebound: What Investors Should Do

Sept. 15, 2009 — -- Over the past year, many investors insisted on pulling out of the stock market and vowed to return only when they concluded it was "safe" to do so.

Now, with stocks up nearly 50 percent since a market bottom in early March, I'm sure many of those same investors are thinking this is the time to jump back in, that it is safe to invest in stocks.

I say, think again.

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I'm more worried about future stock prices now than when the Dow Jones industrial average scraped bottom at 6,440 on March 9. I'm not forecasting another big drop; I'm just a bit skeptical that the current six-month rally can be sustained at its recent pace.

Just as I doubted in March the stock market would fall an additional 40 or 50 percent, I now doubt the Dow will rise skyrocket another 50 percent over the next six months.

It is important to note that it is impossible to predict the short-term direction of stock prices. Few investors, if any, predicted the stock market would begin its recovery on March 10 and that it would make such impressive gains in such a short period of time. I certainly did not see it coming and won't claim that I did.

But for long-term investors able to demonstrate patience, in mid-March stocks seemed to be screaming, "Buy me, I'm cheap."

Now, that screaming has stopped and stocks seem to be whispering, "Careful."

What does this all mean for small investors?

It means go slow.

Investors Should Exercise Caution

By no means is it time to abandon stocks. Further price gains could be ahead in the short term, but there's just no way of knowing.

For now, I'd exercise some caution, particularly by those at or near retirement age. These folks might want to consider breaking up any planned stock or stock-fund purchases into a series of smaller buys at regular intervals.

For example, if you have $10,000 to invest, you might want to make four $2,500 purchases at one-month intervals instead of a single, lump-sum investment. This approach reduces your risk by lowering your exposure to sudden market decline immediately after making your investment.

Of course, it's also true this approach increases your chances of missing out on a quick upward market burst.

For a younger investor, the lump-sum investment is fine if the funds being invested are not needed for a number of years.

A second way to demonstrate prudence is to rebalance your portfolio by selling securities that have made big gains and directing those funds in other areas that have not done as well.

This means you're selling high on one side of the portfolio and buying low on another. Ideally, you want to do it with a target allocation in mind for the major asset classes: stocks, bonds and cash.

An asset allocation target set out ahead of time, combined with a disciplined commitment to regular rebalancing, helps an investor buy low and sell high. Those who panicked around the market low on March 9 and now think it's safe to invest again would be doing the exact opposite, selling low and buying high.

Finally, investors can demonstrate caution by including bonds in any upcoming investment purchases. This will help mitigate the risks associated with any stock purchases you might make at the same time.

SUBHEAD

There is no guarantee against a decline in the value of bonds despite their more conservative nature. In fact, an investment in even the most conservative bond mutual fund or bond exchange-traded fund quite often will drop in value over short periods of time. But if the bonds are of high quality and short-to-intermediate duration, they will often bounce back quickly.

And when do they drop, the price declines in bonds tend to be much less severe than what can be seen with stocks.

That's why it's smart to combine conservative bonds with riskier stocks when making investment purchases, particularly when stocks have burst upward in a short time and continued gains appear difficult to achieve.

There's never a truly safe time to invest, but steps like these can make it safer.

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.