When it comes to scoring big returns for big-ticket goals -- a fat retirement nest egg or tuition for the kids -- stocks are still the stars.
Yes, they've had a rough couple of seasons -- the Standard and Poor's 500 index is still more than 25% below its high two years ago -- but over the long-haul, stocks have historically outperformed other types of investments. On average, stocks have returned 10.4% a year since 1926. By comparison, long-term government bonds are less likely to decline in value, but have returned just 5.5% over the same time period. And short-term cash and Treasury bills returned about 3.7%. So, the more risk you are willing to take, the bigger the reward.
The key to winning with stocks is to stay focused on the long-term, avoid common errors and maintain a well-diversified portfolio.
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Think buy-and-hold
Stocks are risky, no doubt about it, but time is literally on your side. The more time you have, the easier it is to wait out the declines and ride the rebounds. If your goals are six or more years away, and you can stomach the occasional dips, then all of your portfolio should be in stocks. Test your risk tolerance to see how much of your portfolio should be in stocks.
As your savings goals near, however, you'll want to remove some of that risk by moving money out of stocks and into safer bond or cash investments.
Before getting started in stocks, however, make sure you have enough cash on hand to cover emergencies, lay-offs or big near-term expenses, says Steve Garrett, a financial planner for A.G. Edwards & Sons. "If you get into a nasty bear market," he says, "the last thing you want to have to do is liquidate your stocks" to pay the bills.
Diversify, diversify, diversify
Money managers and advisers can't say it enough -- don't put all your eggs in one basket. "It's the golden rule of the business," says Garrett.
Enron is a notorious object lesson for investors who feel compelled to bet it all on one stock. And it's not just one bad-apple stock that has the potential to spoil your savings goal. For example, if one energy company reports major losses and its stock takes a hit, a lot of other energy stocks will go down with it. "It's guilt by association," says Garrett. If your portfolio is too heavily weighted in the one particular sector, you'll feel the pain more sharply.
Start by spreading out your investments among at least six (ideally eight) sectors. Look at stocks of companies involved in basic industries like manufacturing, communications, health care, defense, technology and retail among many others. Briefing.com provides free sector ratings on its Web site, and they're updated at least once a month.
Garrett recommends that no more than 20% of your stocks be from any one sector. Once you have the sectors nailed down, it's time to start picking some stocks (see "Four Questions to Ask Before You Buy"). You'll want to buy at least 12, and possibly as many as 25, different stocks. In an ideal world, says Garrett, "you want to make sure that that holding is no more than 3% or 4% or your total portfolio."
Know when to get out of the game
One of the most common mistakes investors make is getting too attached to their stock picks. "It's great to ride a winning horse as long as you can," says Garrett, but you have to know when to get out. See "Learning to Say Sell" for a list of signs that might signal when it's time to part with a stock and move on to something else.
One final note: To get your stock portfolio going, you should have at least $30,000 that you're willing to do without for the next ten years. You can do it for less, but Garrett wouldn't advise it.
If that's more than you have on hand, consider mutual funds.
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