NEW YORK (CNNMoney)
Trying to time your entry into or exit out of the stock market is a guessing game you can't win. It's just impossible to divine where stock prices are headed.
Given recent volatility, doubts about global growth prospects and the fact that last week stock prices closed 5% lower than their level just three weeks ago, investors are understandably worried that we could be on the verge of a major meltdown.
But it's not as if investors haven't been skittish before or haven't seen worse declines from which the market has recovered and gone on to new gains. Prior to this most recent setback, the market dipped between 4% and 6% three times this year, as it did the year before. In 2012 there was a near-9% setback, while in the summer of 2011 stock prices dropped almost 17%.
That doesn't mean the recent turmoil will be followed by another surge. But it does show that volatility and setbacks don't necessarily mean a downturn is imminent. Fact is, while we all know this bull market will end someday, no one knows when that day will be.
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As for your plan to wait until prices decline and then get in on the next bull market, well, that sounds nice. But how will you know whether prices have truly bottomed out or are likely to fall even more?
It's easy to pinpoint market turning points with the benefit of a stock chart and 20/20 hindsight. There will always be doubt and ambiguity in real time.
My advice: Don't even get into this should-I-or-shouldn't-I conundrum. It will get you nowhere. Instead, I suggest you develop a strategy that allows you to reap the advantages of the financial markets in a sensible way. Here's how to do that.
1. Don't even think of investing in stocks until you've established an emergency fund.
History shows that stocks can provide superior long-term returns. But to reap those long-term gains, you've got to be willing to ride out some short-term setbacks along the way. So you don't want to put money in the stock market that you might need to meet emergencies, unexpected expenses, or funds you'll need to sustain you in the event of a layoff.
Which is why I recommend that before you start investing in stocks and other investments whose value can fluctuate, you first set aside at least three months' worth of living expenses in a savings or money-market account that's insured by the FDIC.
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Today, such accounts pay only a pittance. But maximizing yield is not the main goal for this portion of your savings. Your aim is to have a stash of ready cash you know you can always draw on, so you don't have to liquidate stocks at an inopportune time.
2. Assess your risk tolerance and then create an appropriate stocks-bonds mix.
The real key to investing in stocks is to remember that you shouldn't be investing only in stocks. Rather, you want to create a portfolio of stocks and bonds that reflects the amount of risk you can stomach and the returns you'll need to achieve your goals.
Let's start with how to gauge your risk tolerance. Investors face a variety of risks. But here I'm mostly talking about estimating how much of a downturn you can stand before you start selling off stocks and moving into more stable investments.
One way to do that is to fill out a risk tolerance questionnaire, like the one in RealDealRetirement's Retirement Toolbox that helps you gauge what size loss you can stomach and then suggests an allocation of stocks and bonds that jibes with that tolerance. Once you have that recommended stocks-bonds mix, you can then see how it has performed in past severe downturns and see whether you would be comfortable sticking with it.
Related: Asset allocation: Fix your mix
In the financial crisis of 2008, for example, stocks lost 37%, while a broad portfolio of investment-grade taxable bonds gained 5.2%. So a mix of 75% stocks and 25% bonds would have lost roughly 27%. If a loss of that size would have had you dumping the stock portion of your portfolio, then you may be better off in a tamer blend, say, 50% stocks and 50% bonds, which would have declined 16%.
Here's the tricky part, though. While a more conservative mix may be more emotionally acceptable, it may not generate the returns you'll need to build a retirement nest egg or provide reasonable assurance that your savings will support you throughout a long retirement. So before settling on a portfolio, try plugging it into a retirement calculator that can show you how different blends of stocks and bonds can affect your chances of having a secure retirement.
What you'll probably find is that you'll have to balance your desire for protection from market setbacks with your long-term need for returns high enough to allow you to reach your goals.
3. Resist the urge to abandon your plan when the market sinks (or soars).
This third step may be the toughest. It's one thing to calmly and rationally create a portfolio. It's quite another, however, to avoid abandoning it when every news headline or cable TV pundit is screaming that Armageddon is at hand and investors should flee the market -- or, alternatively, crowing that the market's ready to surge and that real investors should have all their money in stocks.
That's why a crucial part of a long-term investing strategy is to avoid becoming overly pessimistic when the market is flailing or overconfident when all is going swimmingly and stock prices hit and surpass new highs. In short, you've got to learn to ignore the hype and hoopla -- what I refer to as the investment circus -- and have the confidence to stick to your plan.
Bottom line: Focus on creating a stocks-bonds portfolio that jibes with your risk tolerance and goals. Because if you continue to obsess about whether this is a good or bad time to start investing or what the stock market is going to do in the short-term, you may find yourself still on the sidelines years from now, regretting that you never got into the game.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com.
More From RealDealRetirement.com:
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How to build a $1 million IRA
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First Published: October 14, 2014: 7:53 AM ET
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