Posted on: Sunday, November 2, 2003

Joining bull market requires caution

By Sandra Block and John Waggoner
USA Today

The Dow Jones industrial average is up 17 percent since the beginning of the year. The Nasdaq, where many technology stocks dwell, is up 46 percent. The stock market is rocking. You're tempted to join the party, but you don't want to wake up with a dry mouth and a portfolio full of ugly stocks.

Moderation is key. Investing in stocks and funds always involves risk, but you can reduce your chance of serious injury by avoiding these bull market temptations:

• Going on a borrowing bender. Some investors are so eager to dive back into the market that they're borrowing money to buy stocks. That makes regulators uneasy.

Investors who buy stocks on margin use their other securities as collateral. In a rising market, buying on margin may accelerate your gains. But in a declining market, it will compound your losses.

Margin buying has soared this year. In August, margin borrowing hit $167.2 billion, down from July but still up nearly 20 percent from the end of 2002, according to the National Association of Securities Dealers, the watchdog for the brokerage industry.

Alarmed at the increase in margin trading, the NASD issued an advisory last month warning investors of the risks.

If you're determined to buy stocks on margin, don't invest money you can't afford to lose. Read your brokerage firm's margin agreement carefully. Keep some money in a savings or checking account in case you get a margin call. And monitor your account.

• Falling in love with stock options. Employee stock options are looking healthier this year, but don't get too attached.

Options give you the right to buy shares of your company stock at a predetermined price. If the stock price rises above that price, you can exercise the option and sell at a profit. But if the stock price falls, the options go "underwater" — meaning they're worthless.

A better strategy: Set up a plan to exercise a portion of your options at regular intervals, such as monthly or quarterly, says David Yeske, a financial planner in San Francisco. If the stock price continues to rise, you'll benefit each time you exercise options. If it heads south, you'll be glad you cut some options loose and locked in those gains.

Yeske advises picking a specific date each month to exercise your options, to remove the emotion and guesswork from the process.

• Paying high fees for hot funds. The more you give to your mutual fund manager, the less you get to keep for yourself. Over time, high fees cut returns significantly.

Expenses hit especially hard with bond funds, which rarely earn more than 10 percent a year. And expenses clobber money market fund returns — particularly now, when interest rates are low. Many money funds now pay themselves more than they pay you.

Expenses erode returns from stock funds, too. Consider large-company core funds, which invest in big companies with growing earnings and reasonably attractive prices relative to earnings. The last five years, the most expensive large-cap core funds lost 4 percent, according to Lipper. The 25 percent of large-company core funds with the lowest expenses gained 4 percent.

Most small funds have higher expense ratios than large funds, because they are more expensive to run. So are international funds. But a good fund company will reduce expenses as it grows larger. In general, avoid stock funds with expense ratios higher than 1.5 percent, for funds with expense ratios below 1 percent. And don't invest in bond funds that charge more than 1 percent a year in expenses.

• Going on a binge with company stock. There's a good chance the best-performing investment in your 401(k) plan is your company stock, particularly if you work in technology. But as many workers have learned in recent years, stuffing your savings with company stock is reckless. If your company falls on hard times, your retirement savings could disappear.

The collapse of energy giant Enron devastated workers who had invested most of their retirement savings in company stock. In the wake of that debacle, many employers have made it easier for workers to sell company stock in their 401(k) plans. But many workers haven't used the opportunity to diversify their portfolios.

Most financial advisers recommend investing no more than 5 to 10 percent of your portfolio in company stock.