It has not been a relaxing summer for Wall Street. Economic blues at home and debt crises abroad, a sickly job market, and a general fearfulness among investors over the future direction of the market are still weighing heavily on the minds of many Americans. At times like these, it's worth taking stock of some of the investing basics that can make any portfolio a less fraught proposition. Consider the following a checklist for staying sane when markets seem to be anything but friendly.
Don't pay too much. High fees can really cut into a fund's overall returns. This week, Morningstar released new data showing how important fees are in predicting the success of mutual funds. Morningstar looked at the expense ratios of funds in multiple asset classes from 2005 through 2008, then tracked their progress from 2008 through March 2010. Bottom line: Research found the cheapest funds outperformed the highest-cost funds in each asset class over every time period. For instance, in 2005, the cheapest quintile of U.S. stock funds returned 3.35 percent, on average, over the five-year period, versus 2.02 percent for the highest-cost quintile of funds in the category. When selecting funds, keep in mind that some asset classes are pricier than others. Large-cap funds are generally cheaper than small-cap or international funds, for example. It's a good idea to compare your funds' expense ratios with the annual fees of their peers. Christine Benz, Morningstar's director of personal finance, says generally, investors shouldn't pay more than 1 percent in annual fees for domestic large-cap stock funds, about 1.2 percent for international stock funds, and between 0.65 and 0.75 for bond funds.
Keep it simple. Index funds and exchange-traded funds track indexes, so they're generally cheaper than funds that rely on managers to pick stocks. ETFs, which look like mutual funds but behave like stocks, offer a simple, low-cost way to invest and gain instant diversification. When you invest in an ETF or an index fund, keep in mind that your fund won't likely underperform its index, but it won't beat the index, either. "I'm a huge fan of simplification strategies, and I think indexing a broad-market segment is a great way to do that," Benz says. "It's possible to pick active funds that outperform index funds, but in terms of something that's low cost and hands-off, it's hard to beat indexing." Funds that provide exposure to U.S. stocks include Schwab's Total Stock Market Index Fund and its U.S. Broad Market ETF. Funds for a globally diversified portfolio include Vanguard Total World Stock Index Fund or Vanguard Total World Stock Index ETF.
Dollar-cost averaging. Many investors pull money out of stock funds when the market gets bumpy. In a volatile market, it can be difficult to stick to your investment plan. One way to stay on track is by practicing dollar-cost averaging—investing a set amount of money on a regular basis instead of investing a large sum at once. "It can provide discipline, and it can give you the courage to invest in what could—in hindsight—turn out to be a good time," Benz says. Dollar-cost averaging ensures that you'll continually invest in the market regardless of how it's performing at any given time. You can begin dollar-cost averaging by setting up an automatic investment plan through a fund company. T. Rowe Price, for example, will allow you to invest in more than 90 of its no-load funds if you agree to contribute at least $50 per month to a fund. One offering is T. Rowe Price Spectrum Growth Fund, which provides broad-market exposure through 11 underlying T. Rowe Price stock funds.
Diversify within asset classes. The so-called "lost decade for stocks" makes a good case for diversification. If you had invested only in an index fund that tracks the S&P 500 over the period starting Jan. 1, 2000, and ending Dec. 31, 2009, you would have earned virtually nothing. The culprit? Large-cap stocks that performed poorly during this time period. Meanwhile, other asset classes provided a solid return. For instance, over the past 10 years the Russell 2000 (a small-cap index) has returned an annualized 4 percent.