10 Lessons for Fund Investors

12/17/01 - 07:46 AM EST

Another year gone and what have we learned? Plenty, hopefully.

Even with its impressive recent rally, the Nasdaq Composite is still down a whopping 60% from its peak last year, and the many folks who slugged record billions into funds last year are a long way from break-even. The only thing worse than absorbing a drubbing is not learning from it -- picture someone slamming his hand in a car door four times a day, or tugging on a door clearly marked "Push."

Want to stay out of that dubious club? Here are 10 investing rules we should all keep in mind. Following these steps will help you bask when the sun shines on Wall Street again without getting burned -- or soaked if the weather turns inclement.

10 Lessons for Fund Investors

Build a six-month emergency stash before you invest a dime.

Keep money you'll need within five years out of the stock market.

Be a fund investor, not a fund collector.

Ignore bond funds at your peril.

Don't bet more than 5% of your money on your company's stock.

Taxes and expenses matter.

Only do it yourself if you're willing and able.

Consider the worst-case scenario.

Invest in tax-deferred accounts like IRAs and 401(k)s.

Know where your funds are investing your money.

1. Build a six-month emergency stash before you invest a dime.

You might recall this one from our list of things to do before you invest. It bears repeating. Not having enough money on the sidelines to cover at least half a year's expenses is like driving down a wet road at night with no brakes. Just a few years ago, the conventional wisdom was that you needed only three months, but the ongoing spate of layoffs makes six months sound like a better idea.

2. Keep money you'll need within five years out of the stock market.

This seemed silly when the S&P 500 rose more than 20% a year between 1995 and 1999 -- stocks' best five-year stretch ever. The line between the stock market and an ATM machine blurred, but consider that anyone who sunk $10,000 into a sensible S&P 500 index fund at the start of last year is sitting with some $7,500 today. If that money were put into the average tech fund after the category's 137% gain in 1999, that investor would be left with less than $5,000. While hanging on for at least five years doesn't guarantee you'll make money, it does lessen the chance of losses like those.

3. Be a fund investor, not a fund collector.

I borrowed this phrase from Chicago research house Morningstar because most of us simply buy funds that seem like a good idea at one time or another, instead of having a plan. If you learn nothing else from the past two rough years, make sure you diversify your stock investments among solid growth and value funds with broad exposure to small-, mid- and big-cap stocks. (Here's a blueprint.) This might not ensure that you'll make money in any environment, but it will keep you from losing your shirt when one sector or style craters, a la tech stocks and the growth style over the past 20 months.

4. Ignore bond funds at your peril.

Consider owning at least a modest bond-fund stake because it can smooth out your portfolio's performance without significantly sapping its returns. A portfolio invested solely in an S&P 500 index fund would've fallen 25% in the year ended Oct. 31, according to Morningstar. The same portfolio with 20% of its money in a bond fund would've fallen only 18%, but it would have lagged behind the stock-only portfolio by less than 1 percentage point over the past 10 years.

Why You Bother With Bonds Adding bonds does lower returns over time, but it whittles risk, too
	100% Stocks	80% Stocks, 20% Bonds
One-Year Return	-25%	-18.1%
Five-Year Return	10	9.9
10-Year Return	12.7	11.8
Best Year	52	42.9
Worst Year	-26.7	-19.8
Source: Morningstar. Returns through Oct. 31. Stocks represented by the Vanguard 500 Index fund, and bonds represented by the Vanguard Total Bond Market Index fund.

5. Don't bet more than 5% of your money on your company's stock.

It's good to want to own a stake in the place where you work, but it's also a titanic risk. Because your company already represents your paycheck and your future prospects, buying its shares raises an already outsize bet on its success. As we noted last week, 401(k) retirement plans that offer company stock as an investment have 30% of employees' money there. The sudden and breathtaking collapse of bankrupt energy trader Enron (ENE - Cramer's Take - Stockpickr) illustrates the risk of owning stock in your own company. Like many firms, Enron matched its employees' retirement plan contributions with company stock and required them to hold on to those shares until the employees turned 50 years old. If an employee had 30% of a $1 million retirement account in Enron stock at the start of the year and the rest in an S&P 500 index fund, he or she would have lost just shy of $400,000 by now.

6. Taxes and expenses matter.

A fund's taxable distributions and fees didn't matter much when we were all making money, but now they seem like what they are: a drag. For example, if you own 1,000 shares of a stock fund with a $10 share price, and it pays out a $1 per share capital gain, you get stuck with a roughly $200 tax bill. Similarly, every dollar you pay in fees is a dollar less you've made or a dollar more you've lost. A $10,000 investment in the (VFINX - Cramer's Take - Stockpickr)Vanguard 500 Index fund, which carries a low 0.18% expense ratio, costs $18 in its first year. The same investment in the average U.S. stock fund, which carries a 1.43% expense ratio, costs $143 in its first year. While a fund's tax efficiency and fees aren't reasons to buy it, they should be part of the decision-making process.

10 Questions With Utilitarian Bern Fleming

7. Only do it yourself if you're willing and able.

The past 20 months' losses are an advertisement for diversification. They demonstrate the value of having a good adviser who keeps your portfolio from leaning too heavily on the sector or style du jour. No-load noload funds, which are sold directly to investors, made up about 30% of fund sales in 1995, according to Boston fund consultancy Financial Research. Last year it was half of that, and it's expected to fall to 10% of overall sales by 2005. If you're comfortable with your plan and have the time to, well, invest in your investments, then do so. But if that's not the case, it might be time to join that long line of folks outside the local financial planner's office.

8. Consider the worst-case scenario.

If you built your portfolio during the 1990s, you saw precious little of stock investing's risks, and you might have seen more volatility than you expected in the past two years. Before you decide how to spread your money between stocks and bonds, make sure you're comfortable with the potential downside of the mix you choose. A stock-only portfolio, for instance, averaged a 12.7% annualized gain in the 10 years ended Oct. 31, according to Morningstar, but it did have a year when it lost some 27%. Maybe you're OK with that or maybe you're not. Either way, it's better to know that possibility or worse exists before it comes along.

Prepare for the Worst Make sure you know how bad things can get for your portfolio
Allocation	Five-Year Return	Worst Year
100% Stocks	10	-26.7
75% Stocks, 25% Bonds	9.8	-18
50% Stocks, 50% Bonds	9.4	-8.5
25% Stocks, 75% Bonds	8.8	-2
100% Bonds	7.9	-3.7
Source: Morningstar. Returns through Oct. 31. Stocks represented by the Vanguard 500 Index fund, and bonds represented by the Vanguard Total Bond Market Index fund.

9. Invest in tax-deferred accounts like IRAs and 401(k)s.

Ignoring this advice is like tossing money out the window. You should invest money in tax-deferred retirement accounts for two reasons: tax-deferred growth over time and lower taxes today. You don't have to pay taxes on any gains made in these accounts until you withdraw your money. As for lower taxes today, contributions to your retirement plan at work lower your taxable income. If you don't make too much money, your contributions to a taxable IRA are tax-deductible.

10. Know where your funds are investing your money.

Assuming a fund's name or classification tells you where it's investing your money can be a truly bad move. During the tech sector's eye-popping rally in 1999, many investors bought tech funds, not realizing that their "diversified" growth funds were stuffing the lion's share of their money in that mercurial sector, too. That added up to dramatic tech bets and dramatic losses. To avoid this, enter the funds you own into Morningstar's Portfolio X-Ray tool. It will toss them all in a pot and show you where your money is invested. As our I Own What?! feature has proved time and time again, you just never know where a manager will stash your cash.