The market's long-term trajectory is up, of course. But, as we've seen over the last year, there can be plenty of fits and starts -- not to mention precipitous declines along the way.
Slightly more distant history makes the point dramatically. Remember early 2000? During that year, the Nasdaq 100-tracking Cubes (QQQQ) -- an exchange-traded fund (ETF) that recently included Costco (Nasdaq: COST ) , Starbucks (Nasdaq: SBUX ) , Symantec (Nasdaq: SYMC ) , and eBay (Nasdaq: EBAY ) among its holdings -- swooned to the tune of nearly 37%. Investors who plunked down their hard-earned moola on that passive pick in January 2000 are still sitting on a sizable loss. Investors in more mild-mannered index trackers fared better, but still, between January 2000 and the close of 2006, SPDRs (SPY) -- an S&P 500 tracker that provides dirt cheap exposure to the likes of PepsiCo (NYSE: PEP ) , Wal-Mart (NYSE: WMT ) , and Verizon (NYSE: VZ ) -- managed an annualized gain of just over 1%.
That's hardly adequate compensation for the risk you assume when investing in the stock market, but there's a common-sense way to navigate a sell-off without stuffing your money under a mattress: a carefully calibrated portfolio that features world-class mutual funds alongside cherry-picked individual equities.
There's no guarantee, of course, but with a stock-picker-in-chief at the helm, an active fund -- unlike an index tracker -- can dodge bullets, preserving your nest egg so that when the market's upswing begins anew, you'll have a bigger pile of loot for the miracle of compound interest to work its magic on.
Funds also make light work of intelligent asset allocation -- another vital technique for playing defense. When you own large caps and small -- as well as value stocks and growth plays -- you've effectively insulated your portfolio. Make no mistake: During downturns such as the one we're experiencing, an all-equity portfolio is going to get dinged, perhaps hard. Sell-offs create buying opportunities, however, and smart money managers know how to prepare during the market storm for the calm that will almost inevitably follow.
The thing is ...
The vast majority of funds, alas, aren't worth the exorbitant expense ratios they charge, leading many savvy investors to settle for index investing. My advice? Don't do it. Going the indexing route means forgoing the safety net of an active manager. It also means your chances of beating the market are exactly zero: Passive funds are destined to lag their benchmarks by roughly the amount of their annual fees.
To my way of thinking, the better bet is to build your portfolio upon active funds with managers who have long and successful track records. They should invest their own money alongside that of their shareholders. When managers have their loot on the line, after all, they're just as interested in growing wealth as their shareholders are -- perhaps even more so: In addition to their nest eggs, their jobs depend on it.
Speaking of which ...
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This article was originally published Feb. 6, 2007. It has been updated.
Shannon Zimmerman runs the Ready-Made Millionaire portfolio. He does not own shares of any security mentioned in this article. The Motley Fool owns shares of SPDRs and Starbucks. Costco, Starbucks, and eBay are Motley Fool Stock Advisor recommendations. Starbucks and Wal-Mart are Inside Value selections. You can check out the Fool's strict disclosure policy by clicking right here.