Fear Is Hazardous to Your Financial Health

Investors are taking steps to make themselves feel better in this uncertain economy, but that near-term relief could be jeopardizing their portfolio and even their retirements.

First, from January through July, investors pulled nearly $30 billion out of stock mutual funds, according to the Investment Company Institute. Some of that money has gone into bonds and bond funds, and some is sitting on the sidelines. Such moves ignore the fundamentals -- like the importance of diversity, the need to outpace inflation, and the benefits of thinking long term.

In addition, a rising number of people have tapped their 401(k)s for hardship reasons. Fidelity Investments recently released a survey showing that the percentage of participants either initiating a loan or a hardship withdrawal increased. Loans initiated over the past 12 months grew to 11% of total active participants from about 9% one year prior. The portion of participants with loans outstanding also increased 2 percentage points in the second quarter to 22%.

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And many people who were ill-prepared for an unexpected job loss have turned to credit cards to bridge the income gap. Consequently, debt levels are rising, and the rate of bankruptcy filings this year is higher than it was last year: Filings for August were up 6% compared to July 2009, and filings for 2010 through early September were running about 12% higher than the first eight months of last year, according to the National Bankruptcy Research Center.

The good news is that many Americans are saving again, but they are making some mistakes out of fear that could come back to bite them. "The American middle class and the components of the American dream are at serious risk," says Steve Carr, managing director of Dresner Corporate Services. "This is true for baby boomers and our kids."

There's plenty that's getting twisted.

Stay In It to Win It. Many investors have been spooked by the volatility of the stock market and are taking their money out. However, while the market has been erratic of late, both technical and fundamental factors point to a potential rally, says Brenda Wenning of Wenning Investments.

"Investors who maintain a steady asset allocation with funds in stocks, bonds and cash will benefit if stocks rally, but will not suffer much if prices drop," says Wenning. "With cash on hand, they can also buy more stocks if it appears that a rally is imminent."

Rainy day investors attempt to sit out the storms of the market, hoping to jump back in after the malaise has passed. "These market timers fail to realize that there is no alarm bell that rings at the lows or the highs," says John Sdajdak, senior portfolio manager with MainStreet Advisors.

Thomas Casey, a certified financial planner with Casey, Thomas & Associates, agrees. "They may never achieve the inflation-hedge and historically higher long term returns that equities provide," he adds.

As Joseph Montanaro, a certified financial planner with USAA simplifies it: "Sitting on the capital market sidelines is not going to get you where you need to go -- you must be present to win."

Maximize Returns. With interest rates at historic lows, it doesn't make sense to invest too heavily in bonds, especially long-term bonds, says Wenning. Yet investors have been pouring a great deal of money into them. For the two-year period ending June 30, 2010, bond funds attracted $480.2 billion -- similar to the 1999 and 2000 period for stock funds, which attracted $496.9 billion, points out Wenning. Some are predicting a "bond bubble," driven by too much investor demand, and are comparing it to the dot-com bubble at the beginning of the millennium.

"Investors are putting their money in bonds, not out of enthusiasm, but because they don't know where else to invest it," says Wenning.

Furthermore, while bonds are considered safe, who are they safe for? "Are they safe for the young investor investing for the long term, or are they more safe for the investor getting closer to retirement?" asks Ornella Grosz, a retirement planner with the Teacher's Retirement System of Georgia.

"Bonds do have risk -- inflation risk," Grosz says. "They typically don't keep up with the rate of inflation over the long term." Similarly, certificates of deposit, while "safe," may not pack much of a punch against inflation.

But if buying bonds will help you sleep better, Louis Abel, managing director of First Foundation Advisors recommends non-Treasury bonds, such as municipal, corproate, mortgage-backed, high yield, high yield munis and emerging-market bonds. Even then, Casey reminds investors that there are varying degrees of credit risk. "Have you heard of companies and municipalities defaulting on their debt recently?" Casey asks. "If not, you need to read the financial press and see why the SEC is preparing to sue the state of New Jersey."

Think Long Term. It's a big mistake to try to make long term strategy decisions based on constant short-term information from the media, says Thomas Mingone, founder of Capital Management Group. Take emotion out of the equation.

"Develop an asset allocation strategy based on long term goals and risk tolerance and then make tactical adjustments to 'tweak' the portfolio," Mingone adds.

Seek High Dividend Stocks. Certain areas of the stock market are beginning to look attractive relative to bonds, says Abel. For example, high-quality, large-cap, high-dividend-paying stocks are attractive. "With many stocks offering a 3% dividend yield or higher, that's a much better yield than U.S. Treasurys, and you have upside potential from the growth of earnings and hence stock price over time," he adds.

Furthermore, suggests Richard Leader, chief investment officer of First Houston Capital, some investors are willing to assume risk by buying bonds they don't know the risk of, yet are avoiding quality, dividend-paying stocks that have way less risk than junk bonds -- they're leery just because they are stocks.

Remember, Price Matters. In today's economy, risky assets are a bigger gamble than ever, yet some folks are trying to pump up their returns with junk bonds, distressed assets and the like. "Higher risk does not always lead to higher returns. In fact, right now, the risk of losing money is far greater than it would be under normal circumstances," says Wenning.

Forget the Crowds. Not only are some investors running to assets that are recent top performers, they are often paying top dollar for them.

"Don't follow the crowd. Many are being a sucker for what's popular at the moment, like gold, which is a hypothetical asset," says Leader.

Chasing performance is like driving a car by looking in the rearview mirror, adds Jerry Miccolis, chief investment officer at Brinton Eaton.

Avoid the Temptation to Stand Still. Uncertainty and fear leaves many with a certain sense of paralysis. Investors decide to do nothing. "Failure to plan is like having a float without a motor, you'll go nowhere," says Rose Greene, a certified financial planner with Rose Greene Financial Services. Not making a decision can be just as detrimental as making the wrong decision.

Be Nimble. You don't want to jump in and out of the market, but you do want to periodically examine your portfolio to see how it lines up with your goals and objectives, and then rebalance it accordingly. You might even need to be a bit more tactical in your approach.

"The old buy and hold style of investing no longer works," says Greene. "In this current environment, this strategy will result in returns that go up and go down, but over a 10-year period may go nowhere. It's important to take a tactical approach to investing. Buy and hold may work if you are very young with a long time horizon before retirement."

Most important: Fight fear and emotion with perspective, and remember that what you do today impacts what you'll have tomorrow.