Cold Turkey: The Case for Not Quitting Stocks

They say a cat with scalded paws won't jump on a hot stove again, but it won't jump on a cold one, either. In a way, some singed stock-fund investors are acting downright feline.

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In the wake of 1999's tech mania, many fund investors got smug, stuffing record billions into sagging tech and tech-heavy growth funds. Feeling sucker-punched by the past year's losses, many have stopped buying shares of stock funds, preferring the security of bond funds, money markets and the bank on the corner.

While prudence has its place, if you're at least 10 years away from your investment goals, the lesson of the past year's drubbing isn't that you should invest in stocks when they've had a good year and flee when they've fallen. Rather, the take-away is that you need to simply decide how much money you want to invest in different types of stock and bond funds, and then dutifully add to your portfolio during both up and down markets.

Following the Herd

"The stock market is spastic," says Russ Kinnel, director of fund research at Chicago fund tracker Morningstar. "If you only invest when stocks make a concerted move up, you've probably missed out on much of the gains."

Fat returns breed arrogance, and the average tech fund's 137% gain in 1999 did just that. Tech funds are the riskiest breed of stock fund because they invest solely in the market's most mercurial corner. But in 1999 and 2000, they attracted some $82 billion, compared with a previous two-year record of $6.9 billion. Even when tech stocks traded at nosebleed valuations, inflows to tech and tech-heavy stock funds led to a record $309 billion gush into stock funds last year.

"People tend to invest their next dollar in whatever style or sector is working now," says Phil Edwards, director of Standard & Poor's global funds research unit. "It was too easy in 1999 because all you had to do was buy big tech companies."

With the average tech fund down 49% over the past 12 months, and the average large-cap growth fund down 27%, fund investors have curbed their enthusiasm. Redemptions from tech funds have outpaced investments by $5.4 billion this year through Sept. 30, according to Boston fund-consultancy Financial Research.

Some 95% of individual and institutional investors' fund investments have gone to bond and money market funds this year through Oct. 31, according to New York fund tracker Lipper. In the first 10 months of this year, stock funds have netted just $21.4 billion, compared with $291.4 billion in the year-ago period.

Even with the Nasdaq Composite's 13% rise last month, stock funds netted just $1.6 billion by Lipper's tally.

Dear Prudence

After many investors ended up with tech-sick portfolios, a little prudence is welcome. Staring at the prospect of steep losses and wilting job security, many investors are probably heeding the old saw that you should have enough money in the bank to cover three to six months' expenses.

But too much prudence is just as bad as last year's overexuberance. If you're years away from your goals and investing in bonds because they've performed better than stocks over the past year, or because you don't want to invest in stocks until they trudge north for a quarter or two, you should rethink your approach.

The case for owning stocks is that they tend to return about 11% annually over time. Of course, they don't rise 11% each year but instead rise and fall in bursts. The case for owning bonds, then, which tend to post about half of stocks' returns over time, is that they're usually less volatile than stocks. So rather than flitting between one or the other, most long-term investors should own both, spreading their assets broadly in each bin and buying shares every month, no matter which way the wind is blowing.

If you're investing for a goal that's at least 10 years away, consider taking these steps to help you focus more on your goals and less on the market's short-term moves:

1. Look at our Diversification Toolbox to figure out what a diversified stock-fund portfolio looks like.

2. Use Morningstar's X-ray tool to see what you own.

3. Set target allocations to different sectors and styles, like value vs. growth.

4. If you're looking for less risk, check out how a modest bond-fund stake can help.

5. Invest a set amount each month that will reach your goal, assuming a conservative 9% annualized gain. If you're wondering about the math, a dollar invested in a fund rising 9% a year will double every eight years.

The bottom line: It's always fascinating to try to figure out which stocks or sectors are going to rise, but the suffering over the past 20 months has illuminated the risks involved. Most of us will end up with more money if we spread our bets and ride out rough markets, rather than spend our time in either the fearful or greedy mode.

"A good strategy is just to invest systematically," says Morningstar's Kinnel. "Decide how much you want in growth or value stocks, large- or small-cap stocks and bonds, too. Then just stick with it."

I concur.

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