The Dow Jones Industrial Average recently hit a new high on an inflation-adjusted basis for the first time since the dot-com bubble. Such a long run of mediocre returns is nothing new: Investors in the early 1960s had to wait nearly 20 years for new highs to be set.
Think about this for a second: The well-trod maxim about buy-and-hold investing is undercut by the fact that the stock market has suffered (and will continue to suffer) long periods of listlessness where share prices struggle to regain their former glory. Depending on your time horizon, your portfolio will spend a large part of its time merely recouping prior losses instead of actually growing wealth.
Sure, in the long arc of time, stocks have done very well, posting exponential growth. But it’s not like it’s realistic for most middle-class Americans to look at the Dow’s return since the early 1900s and expect a similar performance.
Instead, if you’re trying to figure out how to invest, a new strategy is needed; one that more closely mimics the strategies of Wall Street’s professionals. These are the folks who understand that the typical buy-and-hold, fire-and-forget strategy will result in an exercise in extreme patience if not outright disaster spending on your timing.
How to Invest Like a Pro: Set Realistic Goals
Step one is setting realistic risk tolerance and asset allocation limits for yourself spending on your wealth, your obligations, your income, debts, retirement needs and your ability to tolerate losses.
An easy rule of thumb is to subtract your age from 100 to get your portfolio’s equity allocation. If you’re 40 years old, 60% would go into stocks, while the rest would be allocated to bonds and cash. If you’re 50, 50% would go into stocks, and 50% would be in bonds and cash.
As for what you can expect stocks to deliver, about 8% a year in total return (both capital gains and dividends) is reasonable. This is the S&P 500’s average inflation-adjusted annual total return since 1871, using data from Yale economist Robert Shiller.
How to Invest Like a Pro: Forget Buy-and-Hold
Click to Enlarge But remember that there is an incredible amount of variability and volatility in that average annual return number we just discussed. The S&P 500’s standard deviation from that average since 1871 is more than 18%. And, as mentioned at the start, there are long segments of market history where a buy-and-hold strategy would be just as effective as putting your cash under the mattress after using some as a fire starter.
If you started investing in the S&P 500 in August 2000, and setting aside dividend payments (which total about 1% to 2% a year over this time), on an inflation-adjusted basis, you would be in the red for your trouble. More than 14 years of buy-and-hold, with all the stomach-churning volatility that’s ensued over this time, to lose money.
A simple buy-and-sell discipline is needed to try and reduce your portfolio’s exposure to the market’s inherent volatility. One simple idea is to use the 10-month moving average on the S&P 500 as a trigger. When the index closes below that number, sell. When it crosses above, buy.
While this will subject your holdings to some trading churn, it will insulate you from the big declines in the market that drive so much of the historical volatility in average annual returns.
How to Invest Like a Pro: Pay Attention
Obviously, if you’re going to follow the 10-month moving average strategy, you’re not going to be able to sit back, relax and wait for your quarterly brokerage statements to arrive in the mail.
Instead, you’re going to have to (at the very least) pull up a chart of the S&P 500 using a basic charting tool at the end of every month and plot it against the 10-month moving average.
Just a few extra minutes of work, taking increased responsibility of your financial future, will pay dividends in reducing exposure to bear-market selloffs.
How to Invest Like a Pro: Dig Deeper
As you grow increasingly comfortable taking a more active role in managing your portfolio, consider focusing on individual sector groups within the market instead of just buying the whole market with a S&P 500 index mutual fund or ETF.
One way to do this is to use to the State Street Select Sector SPDRs, which are ETFs tied to the individual sector groups within the S&P 500 index. Using their Sector Tracker tool, which you can find here, I recommend keeping an eye on one- and three-month relative sector performance to limit your exposure to underperforming areas or increase your exposure to areas of strength.
If, say, healthcare is performing well, you could add a marginal position in the Health Care SPDR (XLV) to complement your S&P 500 Index fund holdings as a way to boost returns.
How to Invest Like a Pro: Add Leverage
Depending on your risk appetite and tolerance, if the 10-month buy-and-sell signal is in the clear and you’ve identified sector groups that look attractive (or are underperforming), consider increasing your exposure, for the dollar amount invested, using leveraged and inverse leveraged sector ETFs.
The ProShares family of ETFs is a good place to start, using their collection of short sector and ultra sector funds such as the ProShares Ultra Health Care (RXL) and ProShares Ultra Short Health Care (RXD) funds.
Just be aware that many of these funds are thinly traded, and leveraged funds can increase your potential for losses, not just gains. Thus, they should be used very sparingly in most average portfolios.
How to Invest Like a Pro: Branch Out
Just as diversification makes holding the entire market via an index fund like the S&P 500 attractive since a basket of stocks helps insulate company-specific risks, adding some foreign market exposure adds further diversification benefit by reducing country-level risks.
Maximum bang-for-the-buck for the average U.S.-based investor can be had by holding an allocation in the iShares MSCI Emerging Markets (EEM) since it provides quick and easy exposure to the shares of more than 800 companies domiciled in emerging economies like China and Brazil.
You could hold a developed-market fund, such as one focused on Europe or Japan, but for someone holding the bulk of their portfolio in U.S. equities (which is a developed-market economy), this is doubling up on rich-world exposure.
How to Invest Like a Pro: Look at Alternatives
Outside of stocks and bonds, consider holding alternative assets such as industrial commodities and precious metals to provide some inflation protection against a decline in the purchasing power of the U.S. dollar.
For instance, the United States Oil Fund LP (USO) would be attractive in a situation where oil prices were screaming higher since the S&P 500 is more exposed to companies that use crude oil as a cost rather than a revenue source. The gains in the USO would offset any negative impact higher energy costs had on the overall stock market.
Gold and silver exposure, such as that provided by the SPDR Gold Trust (ETF) (GLD), insulates against both inflation and political risk.
How to Invest Like a Pro: Consider Derivatives
For the more sophisticated investor, options and futures could be an appropriate way to maximize your exposure to market trends.
For instance, the low-cost call and put options I recommend to Edge Pro subscribers are high-risk/high-reward opportunities that can boost portfolio returns if limited to “play money” within the overall asset allocation strategy.
For example, during the market’s decline into the Oct. 15 low, call options on the iPath S&P 500 Short Term Futures ETN (VXX) — an ETF tied to the CBOE Volatility Index — gained more than 550% during a one-month holding period. Puts against Ford (F) gained more than 515% between September and early October.
How to Invest Like a Pro: Don’t Believe the Hype
And finally, it’s important to remember to keep your eyes and your mind open as the stock market is merely an amalgamation of millions of individual investor decisions.
And these decisions are often dictated by emotions like fear and greed instead of cold logic. Memes like the infinite profit potential of dot-com companies or the “you can’t lose” nature of Las Vegas condos spread like a contagion during bubbles just as irrational fear does during market declines.
Try to approach any given time period from a contrarian’s perspective, looking for opportunities away from the herd where possible and realizing that, in the long arc of market history, nothing is new and the cycle of ups and downs will inevitably continue.
When people are discussing hot stocks at cocktail parties, or your local pizza guy says he wants to trade currencies as mine is, then it’s time to start thinking conservatively.