Dow, S&P Records: What to do now

For the 26th time this year, the Dow finished at an all-time nominal closing record and the broader S&P 500 saw it’s 20th record close of the year. This year, stocks are up about 18 percent – an amazing performance, but (buzz-kill alert) we there is still quite a ways to go to reclaim new highs, when adjusted for inflation: the Dow has to rise above to 15,730 and the S&P 500 has an even steeper climb to over 2,000. Don’t even start to calculate the NASDAQ, which needs to add another 1425 points to get back to the nominal closing high. We all know that Ben Bernanke’s Federal Reserve is responsible for the lion’s share of the stock market’s move higher. Without low short-term interest rates (0 to 0.25 percent since December 2008) and $85 billion worth of monthly bond buying, it’s hard to build a case where stocks would be at these levels. That’s why all eyes have been on Bernanke over the past 8 weeks, as he has tried to explain under what circumstances the central bank would taper its bond purchases.

There will be another chance for a taper-tantrum this week, when Bernanke provides his semi-annual testimony to the House and Senate. That means you have a couple of days to force yourself to rebalance your investment accounts.

Remember that just because stock are up, does not make them safe. If you are the kind of person who simply cannot handle the ups and downs of the stock market, then your inclination is probably to avoid stocks at all costs. But what if you kept your stock allocation to a level where they gyrations didn’t cause you to lose sleep? Maybe a stock allocation of 10 to 20 percent of your portfolio would allow you partially participate over time, but not get your hat handed to you if/when the bottom falls out.

Even if new records don’t really mean too much, I am happy to use them as an opportunity to remind you to review where you stand, create a target allocation and force yourself to rebalance according to your goals.

Here's what smart money has known forever--the quicker you learn these rules, the better:

Don’t let your emotions rule your financial choices. There are two emotions that tend to overly influence our financial lives: fear and greed. At market tops, greed kicks in and we tend to assume too much risk. Conversely, when the bottom falls out, fear takes over and makes us want to sell everything and hide under the bed.

Maintain a diversified portfolio. One of the best ways to prevent the emotional swings that every investor faces is to create and adhere to a diversified portfolio that spreads out your risk across different asset classes, such as stocks, bonds, cash and commodities. (Owning 5 different stock funds does not qualify as a diversified portfolio!)

Avoid timing the market. Repeat after me: “Nobody can time the market. Nobody can time the market.” One of the big challenges of market timing is that requires you to make not one, but two lucky decisions: when to sell and when to buy back in.

Stop paying more fees than necessary. Why do investors consistently put themselves at a disadvantage by purchasing investments that carry hefty fees? Those who stick to no-commission index mutual funds start each year with a 1-2 percent advantage over those who invest in actively managed funds that carry a sales charge.

Limit big risks. If you are going to make a risky investment, such as purchasing a large position in a single stock or making an investment in a tiny company, only allocate the amount of money you are willing to lose, that is, an amount that will not really affect your financial life over the long term. Yes, there are people who invest in the next Google, but just in case things don’t work out, limit your exposure to a reasonable percentage (single digits!) of your net worth.

Ask for help. There are plenty of people who can manage their own financial lives, but there are also many cases where hiring a pro makes sense. Make sure that you know what services you are paying for and how your advisor is compensated. It’s best to hire a fee-only or fee-based advisor who adheres to the fiduciary standard, meaning he is required to act in your best interest. To find a fee-only advisor near you, go to NAPFA.org.

For those who want to protect their portfolios against the eventual rise in interest rates, you may be tempted to sell all of your bonds. But of course that would be market timing and you are not going to fall for that, are you? Here are alternatives to a wholesale dismissal of the fixed income asset class:

Lower your duration. This can be as easy as moving from a longer-term bond into a shorter one. Of course, when you go shorter, you will give up yield. It may be worth it for you to make a little less current income in exchange for diminished volatility in your portfolio.

Use corporate bonds. Corporate bonds are less sensitive to interest-rate risk than government bonds. This does not mean that corporate bonds will avoid losses in a rising interest rate environment, but the declines are usually less than those for Treasuries.

Explore floating rate notes. Floating rate loan funds invest in non-investment-grade bank loans whose coupons “float” based on the prevailing interest rate market, which allows them to reduce duration risk.

Keep extra cash on hand. Cash, the ultimate fixed asset, can provide you with a unique opportunity in a rising interest rate market: the ability to purchase higher yielding securities on your own timetable.