How to Be a Confident Investor

Don't let short-term market hiccups distract you from your financial plan.

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A lot of people got whipsawed in the bear market of 2008-2009. They had money in stocks, but panicked when prices kept falling and sold most or all of their stocks or stock funds. Since hitting bottom at 676 on March 9, 2009, the S&P 500 index has almost doubled.

Some people didn't get back in the market because they couldn't figure out the best time to buy, and they were still afraid of losing money. That lack of confidence and sitting on the sidelines not only prevented investors from recovering money that was lost as stocks rebounded, it kept them from earning potential gains from new investments.

Here are a few ways you can stay calm and be a more confident investor:

[See 5 Reasons Investors Shouldn't Bail on Japan.]

Understand your investments. Some investors don't understand their investments and how to invest. Unfortunately, the financial services industry has deliberately made investing seem more complicated than it really is. If you get a 100-page prospectus for a product you're considering, it's likely to be filled with jargon and disclosures that are hard to understand. It almost feels like financial companies are forcing you to rely on them and pay for their advice.

In addition, financial firms have developed complicated securities that are probably not suitable for most investors. For example, auction-rate preferred securities were sold as a safe alternative to money market funds. While these securities worked fine for many years during normal market conditions, they turned very risky when the credit crisis hit in 2008. While investors were looking for extra yield, they didn't expect money in these accounts would be frozen for a few months when market conditions turned against the auction-rate securities.

[See Investors Continue to Chase Short-Term Performance.]

If you don't understand how an investment works, avoid it. Don't be tempted by "new and improved" investments or complicated strategies using exchange-traded funds, options, or other securities if you're not comfortable with them. Think of it this way: If a pair of beautiful boots or four-inch heels hurt your feet when you try them on, would you buy them anyway just because they look good? The same holds true for your portfolio—skip the products with bells and whistles and only buy investments that you understand and know will help you reach your financial goals.

Don't be emotional about your money. Whenever there's turmoil in the markets, many people let fear take over and make bad decisions. Investors should accept that prices do fall from time to time, and figure out how to stay calm when the market swings.

[See 4 Ways to Cure Emotional Investing.]

Everyone reacts differently to volatility in their portfolio. When you're setting up your financial plan, determine your ability to tolerate risk and how you would react to swings in prices in your accounts. For instance, ask yourself what you would do if the value of your portfolio fell 10 percent in one month. If you think you would sell everything, then you probably don't like to see volatility. If you say you'd be concerned and just monitor your investments, you're probably more calm and would not take any action right away. If you think this would be a great buying opportunity, you can handle swings more easily and are willing to take more risk.

When you understand your emotional response to volatility, you can choose investments you'll be comfortable with. If your feelings about price swings change over time, you should re-evaluate your tolerance for risk.

[See What Happens After QE2 Ends?]

Establish an asset allocation. Once you've figured out your appetite for price swings and risk, you need to diversify your portfolio by asset class. Generally, stocks are considered the growth part of your asset allocation, while fixed-income and cash investments are safer and provide stable income. If you're not comfortable picking the best mutual funds and other investments by asset class on your own, hire a fee-based investment adviser.

Many people have collected various investments in different accounts over the years. Review each investment and decide if you should continue to own it. Also, set up a proper account for each of your goals. For example, house your retirement savings in an individual retirement account (IRA), Roth IRA, or 401(k), rather than in a taxable account or savings account at your bank that offers little or no interest.

[See Is Your 401(k) Riskier Than You Think?]

Also, make sure your holdings fit in the asset allocation you've established to meet your investment goals. Most people should check their accounts twice a year to maintain their desired allocation. Adjustments may be necessary when your desired allocation changes and when market or investment performance has moved your investments from their desired weightings.

Stay disciplined and stick with your financial plan. Now that you've considered your tolerance for risk and established your asset allocations for each of your accounts and goals, you have to stick with your plan. Sure, it's hard to tune out the noise of the markets, especially when there's a big news event that's affecting prices. Try not to check your accounts every day. That will tempt you to make unnecessary changes. If there's a significant change in your life, like losing your job or serious illness in your family, you can modify your plan. Otherwise, stay focused and continue putting money into your retirement accounts and other investments. Over time, your well-planned investment strategy and discipline will pay off.

Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.