There's a frenzy of stock buying going on now, because no one wants to be left out of the stock market recovery.
To some extent, this enthusiasm is warranted. The long-term data fully support investing in stocks. From 1926 through 2010, the average annualized return of the U.S. stock market has been almost 10%.
However, it's short-term data that's fueling the current rush into stocks. The rapid recovery of the stock market has put most "buy and hold" investors back in the black, granting them a full recovery from the market crash that began in 2008. So much for those who claimed that buy and hold was dead.
No Risk, No Reward
All that euphoria, however, is proof that investors have short memories for the risks associated with overexposure to stocks.
Investing in stocks is a double-edged sword. The profits can be worthwhile, but buying equities always involves uncertainty about returns and a risk of losses. Most investors view the risks as negatives, but they are actually positive forces: It's only by accepting the uncertainty and the risk that investors get compensated with higher returns.
The problem with most investors is they want the returns of stocks with the risk of the bonds. When stocks tank, as they did in 2008, those investors dumped their stocks and fled to safety. Now that the markets are in recovery mode, we're seeing the opposite trend. But investors who move in and out of stocks, trying to predict short-term trends, receive only a fraction of the returns reflected in long-term market data.
There have been four periods since 1926 when the stock market had two or more consecutive years of negative returns. If you aren't prepared to hold on during those periods, you should have no exposure to the stock market. I tell my clients not to have any stock market exposure if they will need 20% or more of their invested assets within five years.
Keep Your Eye on the Right Ball
Investors who are betting on a recovery are engaged in what I call "wrong ball investing." No one can predict the short-term direction of the markets. Market prices are determined by tomorrow's news, and none of the pundits confidently predicting the continuation of the stock market recovery have read that news yet.
Your investing decisions should not be based on a belief that the stock market will continue its upward trajectory in the near term. It might, or it might not. Instead, you should be determining your asset allocation -- the division of your portfolio between stocks and bonds -- and investing in a globally diversified portfolio of low-management-fee stock and bond index funds. I have a good asset allocation questionnaire on my website: smartestinvestmentbook.com.
By following this advice, you'll be able to withstand the inevitable short-term volatility in the stock market and enjoy the long-term historical returns stocks have delivered. That kind of investing is keeping your eye on the right ball.