Evaluating Your Stock Portfolio for 2010

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The start of a new year always entails a lot of reassessment, and certainly it makes sense to look over your investments and decide which to hold and which to fold. Annual statements arriving over the next few weeks make it easy to compare returns.

If your big-company U.S. stock fund has trailed its peers or lagged the Standard & Poor’s 500, you may want to look for alternatives.

But it can also pay to turn away from the fixation on returns. Instead of asking what holdings will earn the most, ask which ones will earn enough. Maybe it would be better to settle for less – hoping for 8% a year instead of 10%, for example.

This goes against Americans’ obsession with jumping the highest, running the fastest and passing for the most yards. But a policy of settling for less-than-topnotch investment gains can pay off for several reasons.

First, constantly shifting money among investments with great track records often adds up to “rearview-mirror investing,” or jumping into a hot stock, bond or fund too late, after its big gains are over and it is ready for a pullback. Not many investors are equipped to tell whether big winners of the past year benefited from skill or were just lucky.

Second, the most rewarding investments are often the riskiest. If you are disappointed with U.S. stocks’ returns for the past decade, you could plunge into emerging-market stocks, which did well. But emerging markets tend to provide a bumpy, nerve-wracking ride, with big plunges following big gains. (Morningstar (Stock Quote: MORN) has charting tools for comparing a fund’s volatility to its peers and benchmarks.)

Third, in any given year, the top-performing mutual funds tend to be actively managed funds, which have the freedom to use risky strategies. But many managed funds charge relatively high fees, or expense ratios, to pay analysts and stock pickers. High fees make losses bigger in the bad years, and make it difficult for fund managers to beat the broad market over time. Index-style funds that strive to merely match the market aren’t often among the biggest annual winners, but often beat those winners over the long term because their fees are so much lower.

A roller-coaster ride, or volatility, experienced by investments that win big one year and lose big the next can undermine compounding over the long term, as the big dips dramatically reduce the base on which future gains are built. It would be better, for example, to earn 10% every year than to earn 30% every even year but lose 10% every odd year, even though it looks like both investments return 10% a year on average.

Settling for a slightly lower but steadier return can leave you better off if the market takes a downturn, and a modest compromise in investment gains can be offset with a tolerable increase in savings.

Look, for example, at two ways to accumulate $1 million, using the Cool Million Calculator. With returns averaging 10% a year, a 50-year-old could accumulate $1 million by age 66 by starting with $10,000 and investing $2,000 a month.

Cut the returns to 8%, and this investor could reach $1 million just as fast by increasing monthly savings to $2,500. Or the investor could settle for a bit less than $1 million, or give herself two or three extra years to hit the target.

No doubt about it: boosting your savings by $500 a month could be a struggle. But it could be a lot easier to earn 8% a year than 10%. Peace of mind might be worth some belt-tightening.

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