Plug Your Ears: The Bull Market Sirens Are Singing

Sandra Block and John Waggoner. USA TODAY

Managing your money; Every Friday

The Dow Jones industrial average is up 17% since the beginning of the year. The Nasdaq, where many technology stocks dwell, is up 46%. 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 mutual 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. And that makes regulators uneasy.

Investors who buy stocks on margin use borrowed money, using other securities in their portfolios 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, total margin borrowing hit $167.2 billion, down from July but still up nearly 20% from the end of 2002, according to the National Association of Securities Dealers, the watchdog for the brokerage industry.

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

If you buy stock on margin and your account declines below a certain value, your brokerage firm may issue a margin call — a demand that you deposit more money or securities in your account. If you don’t have cash to spare, your broker has the right to sell some of your shares, locking in your losses.

You don’t get to choose which securities are sold to meet a margin call. And while most brokerage firms will attempt to call you before selling securities, they’re not required to do so, the NASD says.

If you’re still 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 the stock at a profit. But if the stock price falls, the options go “underwater” — which means they’re worthless.

With the Nasdaq up 46% this year, some stock options that were underwater are bobbing to the surface. It’s tempting to hold on to them as long as the market is rising in hopes of making a big profit. But if the market sinks, you could end up with another batch of soggy options.

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 a batch of options. If it heads in the other direction, you’ll be glad you cut some options loose and locked in those gains. “You won’t get the high, but you won’t get the low,” he says.

Yeske recommends picking a specific day — such as the 15th of the month — to exercise your options. That removes the emotion and guesswork from the process, he says.

Paying high fees for hot funds

It’s this simple: The more you give to your mutual fund manager, the less you get to keep for yourself. Over time, high fees cut returns significantly.

How much? Let’s look at U.S. government securities funds, a popular type of bond fund. Funds whose annual fees are in the highest 25% of the group had an average expense ratio of 1.8%. (A fund’s expense ratio is its annual expenses, divided by its assets. The higher the expense ratio, the more it costs you to own it.) These expensive funds earned an average 26% the past five years.

Now let’s look at the funds whose expense ratios were in the lowest 25% of the group. They had an average 0.71% expense ratio. Average gain? 32%.

Expenses hit bond fund returns hard, because those funds rarely earn more than 10% in a year. And expenses clobber money market funds’ returns — particularly now, when interest rates are so 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 stocks of big companies with growing earnings and reasonably attractive prices, relative to earnings. The past five years, the most expensive large-cap core funds lost 4%, according to Lipper, the fund trackers. The 25% of large-company core funds with the lowest expenses gained 4%.

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%, and prefer funds with expense ratios below 1%. And don’t invest in bond funds that charge more than 1% a year in expenses.

Binging on company stock

There’s a good chance that the best-performing investment in your 401(k) plan is your company stock, particularly if you work in the technology sector. 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 taken advantage of the opportunity to diversify their portfolios. At the end of 2002, the average worker with company stock in a 401(k) plan had 42% of the portfolio invested in that stock, according to according to Hewitt Associates.

Owning a large amount of any single stock is always risky, but it’s particularly dangerous when it’s your employer’s stock, says Lori Lucas, a research manager at Hewitt. If your employer goes under, you’ll lose your job and your retirement savings. Most financial advisers recommend investing no more than 5% to 10% of your portfolio in company stock.

Flirting with sector funds

You’ll be tempted. Your eyes will pop at its hot figures. You’ll fall for its seductive come-ons. You’ll run after it in a field in slow motion. But sooner or later, the magic of sector funds disappears, and you’ll be left with one more expensive, poorly performing fund.

Sector funds, as their name implies, specialize in just one industry or sector of the marketplace. You can buy funds that invest only in gold-mining companies, or electronics companies, or electric utilities.

If you use sector funds responsibly, you have some chance of augmenting your returns. That means investing only small amounts in sector funds, and having a strict selling discipline for them. Sector funds are essentially trading vehicles, not long-term, buy- and-hold investments.

Why? Because Wall Street is fickle, and few sectors stay in favor for more than a year or two. If you don’t take your profits, they will often go away.

Most people buy them when they’re at their peak, however, and for that you can thank the mutual fund industry. Fund companies often roll out sector funds precisely at the top of their performance. Part of this is because it takes a while to get permission from the Securities and Exchange Commission to sell a new fund to the public. But the main reason is greed. A hot sector means hot performance, and hot performance lures new investors.

So, you should be wary of sector funds in general, but you should run screaming from new sector funds — especially highly specialized ones. For example, the fund industry trotted out 20 new technology funds in 1999, and 28 in the first six months of 2000. Tech funds fell an average 32% in 2000, 36% in 2001 and 43% in 2002. Not all sector funds have such spectacularly catastrophic years as tech funds did. But their history is littered with booms and busts. In most cases, you’re better off looking for a long-term relationship with a fully diversified fund.

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Securities funds

How U.S. government securities funds have fared the past five years, by expenses.

Total return (1)

Expense ratio

5 years

More than 1.75%

-4.0%

1.74% to 1.86%

-0.4%

1.85% to 0.87%

3.6%

Less than 0.86%

4.3%

1 — Dividends, gains reinvested through Sept. 30.

Source: Lipper