Uncertainty
Any time you put money at risk for the chance of profit there is an inherent level of uncertainty. When new threats such as war or recession arise, the level of uncertainty increases significantly as companies can no longer accurately predict their future earnings. As a result, institutional investors will reduce their holdings in stocks considered unsafe and move the funds to other sources like precious metals, government bonds and money-market instruments. This selloff, which occurs as large portfolios reposition themselves, can cause the stock market to depreciate.

Effects of Uncertainty
Uncertainty is the inability to forecast future events; people can’t predict the extent of a possible recession, when it’s going to start/end, how much it will cost, or what companies will be able to make it through unscathed. Most companies normally predict sales and production trends for the investing public to follow assuming normal market conditions, but increasing levels of uncertainty can make these numbers significantly inaccurate. (For more, see Recession: What Does It Mean To Investors.)

Uncertainty itself can affect the economy on both the micro and macro level; a description of uncertainty on a micro level focuses on the effect on individual companies within an economy faced with the threat of war or recession, whereas the view of uncertainty on a macro level looks at the economy as a whole (To learn more, see Economics Basics.):

• From a company-specific point of view, uncertainty provides a major concern for those that produce consumer goods every day. For example, consumption may fall on the threat of a recession as individuals refrain from purchasing new cars, computers and other non-essentials. This uncertainty may force the companies in certain sectors to lay off some of their employees to combat the impacts of lower sales. The level of uncertainty that surrounds a company’s sales also extends into the stock market. Consequently, stock prices of companies that produce non-essential goods sometimes experience a selloff when levels of uncertainty rise. (For more, see The Impact Of Recession On Businesses.)
• On a macro level, uncertainty is magnified if the countries at war are major suppliers or consumers of goods. A good example is a country that supplies a large portion of the world’s oil. Should this country go to war, uncertainty regarding the level of the world’s oil reserves would grow. Because the demand for oil would be high and the supply uncertain, a country unable to produce enough oil within its own borders would be required to ensure that enough oil was stored to cover operations. As a result, the price of oil would increase.
• Another macro-level event that affects companies and investors is the flight of capital and devaluation of exchange rates. When a country faces the threat of war or recession, its economy is considered uncertain. Investors attempt to move their currency away from unstable sources to stable ones; the currency of a country under a threat of war is sold and the currencies from countries without the threat are bought. The average investor probably would not do this, but the large institutional investors and currency futures traders would. These actions translate into a devaluation of exchange rates.

What’s an Investor to Do?
When situations of heightened uncertainty arise, the best defense is to be as well informed as possible. Keep updated by reading the newspaper and researching individual companies. Analyze which sectors have more to gain and lose in a crises and decide on a long-term plan. Times of heightened uncertainty can lead to great opportunities for investors who position themselves to take advantage of it. Some investors might decide to be offensive and search for companies that provide goods or services that will lead to great returns when things turn around. It is difficult to commit capital during uncertain times, but it can often reap huge rewards in the long run. Those who want to mitigate uncertainty and risk might be content leaving their money where it is or perhaps moving it to safer securities.

Regardless of which strategy you decide to take (if any), you can’t go wrong over the long term by keeping yourself well informed and getting into a position so that you can take advantage of prices when the things reverse.

Types of Debt
Generally speaking, having debt can make it very difficult for investors to make money. In some cases, investing while in debt is like trying to bail out a sinking ship with a coffee cup. In other words, if you have a debt on your line of credit at 7% interest, the money you are investing will have to make more than 7% to make it more profitable than simply paying down the debt. There are investments that deliver such high returns, but you have to be able to find them knowing you are under the burden of debt.

It is important to briefly distinguish the different kinds of debt here:

1. High-Interest Debt – This is your credit card. High interest is relative, but anything above 10% is a good candidate for this category. Carrying any kind of balance on your credit card or similar high-interest vehicle makes paying it down a priority before starting to invest.
2. Low-Interest Debt – This can be a car loan, a line of credit, or a personal loan from a bank. The interest rates are usually described as prime plus or minus a certain percentage, so there is still some performance pressure from investing with this type of debt. It is, however, much less daunting to make a portfolio that returns 12% than one that has to return 25%.
3. Tax-Deductible Debt – If there is such a thing as good debt, this is it. Tax-deductible debts include mortgages, student loans, business loans, investing loans and all the other loans in which interest paid is returned to you in the form of tax deductions. Because this debt is generally low interest as well, you can easily build a portfolio while paying it down.

The types of debt we will cover in this article are long-term low-interest and tax-decductible debt (like personal loans or mortgage payments). If you don’t have high-interest debt or, better yet, all your debts are tax deductible, then read on. If you do have high-interest debt, you’ll need to pay it off before you begin your investing adventure. (To learn more, read Digging Out Of Personal Debt and The Indiana Jones Guide To Getting Ahead.)

Why Invest?
Debt elimination, particularly of something like a loan that will take long-term capital, robs you of time and money. In the long term, the time (in terms of compounding time of your investment) you lose is worth more to you than the money you actually pay (in terms of the money and interest that you are paying to your lender). You want to give your money as much time as possible to compound. This is one of the reasons to start a portfolio in spite of debt (but not the only one). Your investments may be small, but they will pay off more than investments you would make later in life because these small investments will have more time to mature. (To learn more, read Understanding The Time Value Of Money and Delay In Saving Raises Payments Later On.)

The Plan
Instead of making a traditional portfolio with high and low-risk investments that are adjusted according to your tolerance and age, the idea is to make your loan payments in the place of low-risk and/or fixed-income investments. This means that you will be seeing “returns” from the lessening of your debt load and interest payments rather than the 4-8% return on a bond or similar investment. The rest of your portfolio should focus on the higher-risk, high-return investments like stocks. If your risk tolerance is very low, the bulk of your investing money will still be going toward loan payments, but there will be a percentage that does make it into the market to produce returns for you. (To learn how to design your portfolio, read A Guide To Portfolio Construction.)

Even if you have a high risk tolerance, you may not be able to put as much as you’d like into your investment portfolio because, unlike bonds, loans require a certain amount in monthly payments. Your debt load may force you to create a conservative portfolio in that most of your money is being “invested” in your loans with only a little going into your high-risk and return investments. As the debt gets smaller, you can adjust your distributions accordingly. (To learn more, check out Rebalance Your Portfolio To Stay On Track.)

Conclusion
You can invest in spite of debt. The important question is whether or not you should. The answer is very personal. There is no denying that there can be benefits from getting your money into the market as soon as possible, but there is no guarantee that your portfolio will perform like it needs to. Such things depend on how adept you become at investing.

The biggest benefit of investing while in debt is psychological (as much of finance is). Paying down long-term debts can be tedious and disheartening if you are not the type of person who puts your shoulder into a task and keeps pushing until it is done. For many people who are servicing debt, it seems like they are struggling to get to the point where their normal financial life – that of saving, investing, etc. – can begin. Debt becomes like a limbo state where things seem to be happening in slow motion. By having even a modest portfolio to distract you from the tedium, you can keep your enthusiasm about your finances from ebbing. Knowing that the sun will come up and being able to see the dawn are very different experiences. For some people, building a portfolio while in debt provides a much needed ray of light.

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Like a great car, diversification is something that almost everybody wants but seems hard to get if you do not have a lot of money to spend. Luckily for investors, there are more options now than ever before for adding diversity to a portfolio. Better still, these options are not all that expensive. (For more, see The Importance Of Diversification.)

IN PICTURES: Learn To Invest In 10 Steps

Mutual Funds – Old, But Useful
An actively-managed mutual fund is still an excellent way to diversify a portfolio. By allocating even just one “slot” of a portfolio to a mutual fund, an investor can draw on the accumulated benefit of potentially thousands of stocks, as well as the skill of the management team making the selections. Although some funds still charge loads, many do not and it is not hard to find funds that are likewise efficient with respect to expenses and taxes.

Mutual funds are not just about adding diversity in numbers, though. They also allow an investor to diversify across investment styles. An investor with a natural affinity for value investing may find it useful to own a quality growth-oriented fund (and vice versa for growth investors) as a counter-balance to their own natural inclinations. There are periods when growth shines and other periods when value works best, but it is unlikely that a normal investor will be able to change with the times. Rather than attempting to be a good growth investor and a good value investor – something precious few people ever manage - it is much simpler and cheaper to buy a fund in an opposing style.

Funds also permit investors to diversify across asset classes. The argument over whether investors should always have some allocation to fixed income is a topic for another article, but those who believe the answer is “yes” often find that funds are a good option. Given the sizable cost of individual bonds, a well-diversified portfolio of government, corporate and foreign bonds is all but impossible for a small investor. A single fund, though, can give that investor most of those benefits at a much more reasonable price.

ETFs – When Autopilot Is Good Enough
Though some investors will regard the active management of a mutual fund as a virtue, others will point to the mountain of evidence that suggests most funds underperform their targeted averages. For them, exchange-traded funds (ETFs) may be the answer.

Although there are some actively-managed ETFs, the majority are passive vehicles designed to track a specific index like the S&P 500 or MSCI World Index. Within the realm of ETFs, investors can find options that mimic an entire country’s stock market (or even a global index), or a specific industry or commodity. In short, it is a huge menu of options for investors and the costs are generally low.

IN PICTURES: 10 Reasons To Add ETFs To Your Portfolio

Hard Assets and Property – Harder Than It Looks
Hard assets are also another option for achieving diversification. Unfortunately, this process can be harder than it looks. Owning the actual hard goods (bullion, coins, real estate, etc.) is expensive, time-consuming and can require a fair bit of specialized knowledge. Consequently, it is generally the case that coins are better for coin collectors and gold bars are better off left to the true gold bugs.

While futures contracts are an option for some investors, they too are expensive to hold in a small portfolio. Luckily, investors can fall back on mutual funds and ETFs to fill this gap. There are numerous securities out there that offer exposure to gold, real estate and other hard assets. Yes, technically these would represent allocations to equities and not hard assets, but given that the price is closely linked to the underlying assets, it is close enough for the individual investor’s needs.

Diversifying Across Space and Time
It was worth repeating that diversification can have multiple meanings. Geographical diversification, for instance, has been shown to boost returns and lower overall risk over time. While global equity markets are linked, they do not move in lock-step and a global (or region/country-specific) fund or ETF can boost the diversification of a portfolio.

Dollar-cost averaging can be thought of as a means of diversifying across time. History has clearly shown that there are good times to invest and bad times to invest, but it is devilishly tricky to know which one “now” is. If investors accept that they cannot reliably time the markets, it makes sense to consistently invest over a period of time – guaranteeing that the investor will be buying relatively more shares when the markets are low and fewer when the markets are high. (For more, see Chosing Between Dollar-Cost And Value Averaging.)

The Bottom Line
Ultimately, the best way for an individual investor to diversify a small portfolio of stocks and funds is to buy more stocks and funds. By allocating a few slots in the portfolio to other assets classes (bonds, hard assets, real estate, etc.), other styles (growth, distressed, etc.), and other regions, investors can achieve an impressive level of diversification without stretching their capital too far. However, remember not to diversify just for diversity’s sake – give the same level of careful attention and due diligence to any asset that you are considering as an investment. (For more tips, see Diversification Beyond Stocks.)

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Today we’re going to let you in on a hot tip for surviving a sinking stock market.

Industry players and pundits try to convince us that they can tell when the market will hit bottom. Knowing who to believe is just as difficult as it is for them to actually pick the bottom! What’s an investor to do? In this article, we’ll explain a little-known technique that will help protect you in a falling market and let you ignore the futile attempts of those who think they can predict the market’s behavior. There is only one proven investment technique that, regardless of economic conditions, can consistently get investors in at the bottom. Read on to find out what it is, and why it is important. (Learn more, in Dollar-Cost Averaging With ETFs.)

What is the Bottom?
When a security or market sinks to its lowest price level in a given time period, it means they have hit bottom. Whenever the markets plummet, people get excited about getting in, but they want to do so only after securities have bottomed out – when price levels begin a steady rise after hitting bottom. Since everyone wants to know when that will happen, CEOs, media types and analysts all try to forecast the upturn, which signifies that the bottom has indeed been established. Because no one wants to be the last to call the bottom in case price levels tank further, we are bombarded with confidence-building words from every level of industry, including the industry watchers, that prices are unlikely to continue their downward trend.

Much of this commotion comes from the “buying on the dip” mentality left over from the previous bull market in the 1990s when many made a lot of money buying cheap at every dip and riding the recovery. On the other hand, investors in a bear market feel “things can’t possibly get any worse” and that “logically”, the market can only climb up. (Find out more, in Dollar-Cost Averaging Pays.)

The Game
Calling the bottom has become such a worldwide pastime – it would make veteran investors like Warren Buffett, John Bogle and Peter Lynch chuckle – you’d think there was a cash prize for predicting it. To illustrate, here are a handful of past bottom calls as well as the figures that followed.

• Boston Globe, Aug 12, 2000 – “…at these undervalued prices…we’re not selling any stock at these prices”. (On Monday, Aug 14, the S&P 500 closed at 1491. Four years later on Aug 12 2004, the S&P fell a further 29% to close at 1063.)
  
• Wired Magazine, Dec 4, 2000 – “Fred Siegel, president of investment management firm Siegel Group, believes that it is unlikely that the Nasdaq will drop more than another 200 points.” (The Nasdaq fell over 1,000 points shortly after Siegel made his prediction.)
  
• Forbes, Aug 8, 2001 – Intel CEO Craig Barrett said “the computer industry has bottomed out”. (In less than a month the Philadelphia Semiconductors Index fell another 20%.)
  
• Market guru and former hedge fund manager Jim Cramer of TheStreet.com said it best in Jan 2001: “I get paid to call bottoms. I don’t see one yet, but in my 18 years of trading I’ve never called one exactly right yet. I don’t see why this time will be any different.” (Find out if DCA is right for you, in Choosing Between Dollar-Cost And Value Averaging.)
  

The Way In
The truth of the matter is that if hedge fund managers, mutual fund managers, private investment managers, market gurus, CEOs and analysts can’t pick the bottom, neither can we. But don’t despair, there is a means to protect yourself in the long run from the effects of a bear market as well as ensure your injection of capital into the market when it is extremely close to the bottom.

The technique is called dollar-cost averaging (DCA), and it is one of the simplest and most useful investing techniques around. DCA is simply putting a set amount of money each month into an investment such as a stock, index fund or mutual fund. Most banks will even set up a monthly automatic-withdrawals service. DCA is also ideal for the investor who doesn’t have that big lump sum at the start but can invest small amounts on a regular basis.

Why DCA is so Effective?

The markets, even though they have bad days or even bad years, tend to go up over time – during the past century, U.S. equities markets appreciated each year by a near 11% average. When you invest a set amount of your money each month, you buy fewer shares when the market is high and more shares when it’s low. For example, your fixed investment might buy 10 shares when the price is low and only five shares when the price is higher. DCA therefore lessens the risk of investing a large amount in a single investment at the wrong time (i.e. at an inflated price), and in a falling market, the average cost per share becomes smaller and smaller. This lessening average cost per share will help you gain better overall profits as the market increases over the long term.

What About Timing?

Many people ask, ”Isn’t it more profitable to buy as much as you can when the market is at its lowest and sell everything when it is at its highest?” Of course it is, but any professional investor will tell you that you pretty much need supernatural powers to get a correct prediction. No one knows when the bottoms and tops will happen exactly, and no one can stop surprises from happening. This is why so many professionals preach dollar-cost averaging as an optimal strategy regardless of what the market is doing: DCA smoothes out the bumps of the market over the long term. (Get more background info, in Fight The Good Dollar-Cost Averaging Fight.)

Conclusion
Next time you hear of a forecasted bottom, you can be confident that he or she is no more insightful than you no matter who the individual is. No person can predict market behavior. But you can be rest assured that if you use dollar-cost averaging, you are being prudent. DCA not only offers protection from market swings but also helps you can take advantage of the ever-elusive market bottom.

by Cory Janssen (Contact Author | Biography)

Cory Janssen is a co-founder of Investopedia.com and currently oversees the company’s internal operations.

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Investors have a knack for piling into investments at the top and selling at the bottom. Many investors get caught up in media hype or fear and buy or sell investments at the peaks and valleys of the cycle. Why does this type of emotional investing happen and how can investors avoid both the euphoric and depressive investment traps? Read on for some tips on how to keep an even keel – and keep your investments on track.

Tutorial: Understanding Behavioral Finance

Investor Behavior
The behavior of investors has been well documented; there are numerous theories that attempt to explain the regret and overreaction that buyers and sellers experience when it comes to money and the potential gains and losses on that money. Investors’ psyche overpowers rational thinking during times of stress, whether that stress is a result of euphoria or fear.

The typical non-professional investor is putting his hard-earned cash at stake and, while hoping for a gain, wants to protect that cash against losses. Investors get investment “information” from many sources, such as mainstream media, financial news, friends, family and co-workers. Oftentimes investors get enticed by the market during periods of market calm (low volatility) and prolonged bull markets.

Bull markets are periods when the market tends to go up indiscriminately. During such times of market exuberance, investors tend to listen to stories from friends or family members about how much money they are making in the market, creating a stir and compelling those not invested to test the waters. Likewise, when investors read stories about a bad economy or hear reports about a volatile or negative market period, fear takes over and they sell at the bottom. (Not all investors are mentally prepared for when a much-awaited bull market finally comes charging in. To learn more, check out Is Your Psyche Ready For A Bull Market?)

Bad Timing
The lag between when an event occurs and when it is reported is what typically causes investors to lose money. The media will report a bull market only once it has already hit; unless the trend continues, stocks will retract in upcoming periods. Investors, influenced by the reports, often choose these times of premium valuations to build up their portfolios. It is worrisome when the daily stock market report leads off the mainstream news because it creates a buzz and investors make decisions based on “opinions” that are often outdated. Market uncertainty creates fear and brings about an atmosphere of emotional investing.

Time Tested Theory
The theory that many market participants buy at the top and sell at the bottom has proved to be true based on historical money flow analysis. Money flow analysis looks at the net flow of funds for mutual funds. Over a period from 1988 through 2009, money flow analysis showed that when the market hit its peak or valley, money flows were at the highest levels.

Money continued to flow into funds until the market hit bottom, and only then did investors start to pull money out of the market and money flows turned negative. The net outflows peaked at market bottoms and continued to be negative even as the market moved into an upward trend. Because the market was shown to fall before funds were sold, and funds were often reinvested after the market had alreayd moved up, it’s clear htat investors often fail to time their trades in the most beneficial manner.

A Bright Spot
Despite the strong tendencies that investors portray at the peaks and valleys, they have gotten other periods correct. Throughout the 1990s, there was a steady flow of funds into the market during a period when the market was on a prolonged bull run. Likewise from 2004 to 2007, during another strong bull market, investors poured money into the market. So it can be hypothesized that during periods of very little volatility (such as prolonged bull markets), investors become more comfortable in the market and begin to invest. However, during periods of volatility, or when bull or bear markets begin and end regularly, money flows tend to reflect confusion and the timing of the flows becomes mismatched with actual market movement. (Discover how some strange human tendencies can play out in the market. Are we really rational? Check out Understanding Investor Behavior.)

Strategies to Take the Emotion Out of Investing
A 2009 study of investment behavior by DALBAR showed that over the 20-year period from January 1989 to December 2008, the S&P 500 returned an average annual 8.4% but the average stock investor returned only 1.9% annually. The evidence suggests that emotional investing gets the best of the typical investor during periods of uncertainty. There are strategies, however, that can alleviate the guess-work and reduce the effect of poorly timing fund flows.

The most effective tends to be the dollar-cost averaging of investment dollars. Dollar cost averaging is a strategy where equal amounts of dollars are invested at a regular, predetermined interval. This strategy is good during all market conditions. During a downward trend, investors are purchasing shares at cheaper and cheaper prices. During an upward trend, the shares previously held in the portfolio are producing capital gains and fewer shares are being added at the higher price. The key to this strategy is to stay the course- set the strategy and don’t tamper with it unless a major change warrants revisiting and rebalancing the established course. (There is more than one way to work this strategy. Find out more in Choosing Between Dollar-Cost And Value Averaging.)

Another technique to diminish the emotional response to market investing is to diversify a portfolio. There have been only a handful of times in history when all markets have moved in unison and diversification provided little protection. In most normal market cycles, the use of a diversification strategy provides downward protection. Diversifying a portfolio can take many forms – investing in different industries, different geographies, different types of investments and even hedging with alternative investments like real estate and private equity. There are distinctive market conditions that favor each of these subsectors of the market, so a portfolio made up of all these various types of investments should provide protection in a range of market conditions.

Conclusion
Investing without emotion is easier said than done, especially because uncertainty rules the market and the media. Evidence suggests that most investors are emotional and maximize money flows at the wrong times - a surefire way to reduce potential returns. Strategies that eliminate the emotional response to investing should produce returns that are significantly greater than those indicated by the typical investor responding to the market rather than proactively investing in the market. Dollar-cost averaging and diversification are two proven strategies within a multitude of other alternatives to reduce an investors emotional reaction to the market. (Curious about how emotions and biases affect the market? Find some useful insight in Taking A Chance On Behavioral Finance.)

by Kristina Zucchi (Contact Author | Biography)

May this year’s celebration brings greater meaning and joy.