Steer clear of making investments based on emotions

Here’s a hot investment tip: Don’t try to time the markets, because it doesn’t work.

No one knows when a market has hit bottom or when it has topped out. Anyone who promises to show you on a consistent basis how to buy low and sell high is peddling snake oil.

In fact most people behave in just the opposite manner: They buy high and sell low, because they make their investment choices based on their emotions, the two most dangerous being greed and fear.

When markets boom, people get greedy and do very foolish things. (I wish I had a dollar for everyone who asked during the late ‘90s if I could get them in on some hot Internet IPOs.) When markets slump and gloom spreads across the land, people become fearful and sell. They don’t want anything to do with “risky” investments – although when markets are rising (and risks are even higher), these investments are fine as far as they are concerned.

Urging investors on in their foolish behavior are the pundits – money managers, stock brokers, TV personalities and newspaper columnists who pretend that they know the short-term direction of the investment markets. Of course they must pretend – if the Wall Street Journal calls and asks where the stock market is going this week and, being honest, they say, “I don’t know,” they will never get another call.

There are, however, some strategies to filter out the noise that goes on every day in the investment markets. I’ll show you two, both designed to take emotion out of investing and do a little market timing without having to think about it. The strategies can work in any market environment, although I can’t guarantee their future success. But I know that in the past they have produced superior returns while minimizing risk.

The first strategy is asset allocation. This simply means deciding based on your risk tolerance and time constraints the types of investment assets to hold – broadly stocks, bonds or cash – then shifting among the types every four to six months to bring the portfolio back into balance as market conditions change.

For example, say you determined that with your $100,000 retirement account, you were comfortable with an asset mix of 80% stocks, 20% bonds. Six months later your stocks had shrunk to 75% and your bonds had grown to 25%. You would sell the bonds and buy the stocks to restore your original balance. You would be selling high (bonds) and buying low (stocks).

You would continue to do this regardless of market conditions or what the prognosticators say. Unless your goals or the timing of those goals change, you stand by your allocations.

The second strategy is dollar-cost averaging. This is adding a fixed amount on a regular basis to an investment that fluctuates in value. The result is that you buy more when the price is low, less when it’s high, and your average cost per share is actually less than its average price.

To take averaging a step further and enhance its positive effect, instead of investing a fixed amount each period, take into consideration the growth or shrinkage of the investment during the period. This is called value averaging, and it can produce even better results. For example, say you have $100 to invest each month. You invest the $100 on Oct. 1. On Nov. 1 the $100 has grown to $105. Instead of investing $100, you invest $95. Or, if your original $100 has shrunk to $90, you invest $110.

Investing isn’t that difficult. The most important qualities for a successful investor are discipline and patience. Without these it doesn’t matter which investments you pick or when you pick them, your success will be limited.