Wall Street brokerage firms, various pundits, newspaper columnists, and the talking heads on TV networks such as CNBC always have a lot to say about what you should do. The best thing you can do is ignore them because they are much more interested in their own welfare than yours. A couple of old saws put it well: "If they are so smart, how come you are not rich?" and "Where are the customers' yachts?" which was the title of a perceptive book written around 1970.
Instead, you are better off doing your own thinking and analysis. If you follow another's advice, do it with someone whose does better when you do better and who is independent of brokerage firms, mutual fund companies, and other sellers of financial products.
Let's take a look at the most popular conventional advice:
Buying and holding. If the previous pages haven't told you why this a very bad idea, then you probably should go to another web site and not "waste" any more of your time here. To be fair, if you are younger than 35 or 40 and not expecting to retire for another 25 or 30 years, then buying and holding is a reasonable approach. Your investment horizon is long enough that you will be able to reap the gains from the next secular bull market, and you will have the benefit of not needing to pay a whole lot of attention to your investments. Even so, you will do better and have more financial assets and possibly be able to retire sooner if you adopt the solutions to bear market investing presented later.
Dollar cost averaging. This popular approach is promoted to those who are making regular investments. This is usually the case in a 401(k) or similar plan when some percentage of the employee's salary is contributed to the plan each month or quarter. The attraction is buying more more shares of the stock or mutual fund when the price has dropped and fewer when it has gained. Assuming the stocks are higher when it is time to sell, those additional shares will have gained more. Another advantage is the discipline of regular investing.
There is merit in this concept, particularly if it is going to be a long time until you will need to sell. In that sense, it is similar to buying and holding. However, if you need to sell before stocks recover and start making new highs, dollar cost averaging is not going to remove the substantial risks, and it could end up costing you quite a bit.
Each individual's particular investments, holdings, and contribution amounts are different, so your situation may not be at all like the illustration that follows. However, it will illustrate the devastation that a severe drop in stock prices can bring to carefully devised plans.
The S&P total return index is assumed to be investment vehicle. At the end of 1999, suppose that one has $10,000 in this investment and that $100 will be added at the end of each month. These might be amounts typical for someone who had been participating in a 401(k) or similar retirement account program for several years. The table shows the value of the account at the end of each quarter and how the account value compares to the amount invested. That assumes $10,000 invested at the end of 1999, and in effect by holding on and not selling at that time, one is in the same position as another who buys in at that date.
Dollar Cost Averaging Example End of Amount Account Percent Month Invested Value Change Dec-1999 10,000 10,000 0.0% Mar-2000 10,300 10,546 2.4% Jun-2000 10,600 10,568 - 0.3% Sep-2000 10,900 10,760 - 1.3% Dec-2000 11,200 10,211 - 8.8% Mar-2001 11,500 9,278 -19.3% Jun-2001 11,800 10,117 -14.3% Sep-2001 12,100 8,908 -26.4% Dec-2001 12,400 10,169 -18.0% Mar-2002 12,700 10,501 -17.3% Jun-2002 13,000 9,379 -27.9% Sep-2002 13,300 8,038 -39.6% Dec-2002 13,600 9,010 -33.7% Mar-2003 13,900 9,025 -35.1% Jun-2003 14,200 10,722 -24.5% Sep-2003 14,500 11,303 -22.0% Dec-2003 14,800 12,981 -12.3% Mar-2004 15,100 13,514 -10.5% Jun-2004 15,400 14,055 - 8.7% Sep-2004 15,700 14,082 -10.3% Dec-2004 16,000 15,686 -2.0% Mar-2005 16,300 15,647 -4.0% Jun-2005 16,600 16,166 -2.6% Sep-2005 16,900 17,049 0.9% Dec-2005 17,200 17,699 2.9% Mar-2006 17,500 18,757 7.2% Jun-2006 17,800 18,784 5.5% Sep-2006 18,100 20,156 11.4% Dec-2006 18,400 21,810 18.5% Mar-2007 18,700 22,247 19.0% Jun-2007 19,000 23,943 26.0% Sep-2007 19,300 24,271 24.5% Dec-2007 19,600 24,197 23.5%The percentages on the right depend strongly on the ratio of the monthly contributions ($100) to the value of the account at the beginning ($10,000), which is 1%. An older employee who had been building value for a long time might have a smaller ratio, and the percentages in that case would be worse. A younger participant with a low (or zero) beginning value would fare better.
The total return index fell 42.5% below the end of 1999 value at the end of its lowest month and was 21.6% higher at the end of 2007, eight years later, which is an anemic 2.5% compound annual rate of return. Taking the monthly contributions in the example into account, the "internal rate of return" is 4.3%. Even with the S&P 500 making new highs during 2007, just owning T-Bills or a money market fund would have done almost as well with virtually no risk.
The worst month end for the dollar cost averaging was down 39.6% in September 2002, which is not much better than the largest drop in the index, and ignores the possiblity of saving the additional investments. If you needed to sell some or all of your stock holdings then, the fact that you lost a little less than a buy and hold investor would be of little comfort. Since the market has recovered quite a bit since Fall 2002, the ending value comparison looks decent, but the internal rate of return, which accounts for the monthly deposits is a skimpy 4.3% over the eight year period. If the market rises a lot more, which is a big if, dollar cost averaging will look even better. Even with a period of very low returns on money market funds, they have been proved to be a better investment than what is shown in the table. For example, the Vanguard Federal Money Market has had a annualized return of 3.7% over the eight year period. That is slightly less than the return of dollar cost averaging, but never a down day, much less the gut wrenching drops in 2002.
We see that dollar cost averaging can help, particularly after the stocks bounce back after a sharp decline. However, wouldn't be even better to be out of the market when the risks of losses are relatively high? Of course it would. The key is identifying the most dangerous periods, and the models discussed later do just that.
Diversification is an effective risk reduction tactic to the extent that it reduces the investments in the worst performing assets during that time period. In other words, you shouldn't put your eggs all in one basket. To the extent the performances of the various assets are not correlated, the equity curve over time will show less fluctuation, so called "smoothing" of the curve. That is usually considered to be a good thing since reduced downward movement means less risk.
Your overall and retirement investments should be diversified to some extent. The particulars depend on each individual's financial situation. In fact, your allocation among asset classes is likely to be the most important determinant of your long-term investment returns. In practical terms, that means those who are nearing or in retirement most likely should reduce the percentage of holdings in volatile assets such as most stocks and increase the portion in low volatility holdings such as money market funds and short-term bonds. The trade-off is that the expected long-term returns will be lower, but there is a point where protecting one's equity is much more important than trying to grow it by a large amount.
That being said, the effectiveness of diversification depends quite a bit on the asset classes not being highly correlated. One problem is that the correlations can vary quite a bit over time. For example, overseas stocks used to be considered effectively diversified from domestic equities. The most common measure for foreign stocks is the Morgan Stanley Europe, Australia, Far East (EAFE) index. For the past few years, that index has shown the same general pattern as the S&P although it has gained more after making lows in Fall 2002. Moving some of one's investment in stocks to it would not have provided much in the way of divesification and risk reduction.
On the other hand, bonds historically have moved in the same direction as stocks but with less volatility. The reason is that rising interest rates, which result in falling bond prices, usually occur as the economy is nearing the end of an expansionary period, and stocks tend to fall in anticipation of the coming recession. That relationship is far from perfect, but it is more reliable than most intermarket correlations. However, stocks peaked in 2000 just as the Federal Reserve Board began cutting short-term interest rates. As things turned out, the economy weakened despite the rate cuts and stocks fell accordingly in conjunction with the bursting of the bubble in technology issues. However, bonds gained as interest rates dropped. That meant bonds provided more diversification recently than they have historically. Nonetheless, buying and holding bonds or bond mutual funds, while not as risky as following that policy with stocks, still entails important risks. Later, we will see how that risk can be greatly reduced by employing a model that identifies when the risks of owning bonds are at higher levels.
The better writers and analysts make the point that rebalancing your portfolio periodically is important to maintain diversification. This is sage advice. It prevents becoming too concentrated in the asset classes that have gained the most recently, which are usually the most volatile and risky ones. It also sets up a discipline of selling things that have gone up to buy things that have not performed as well. Since asset class values, as opposed to individual securities, tend to ebb and flow, that is beneficial although many find it hard to do. There is no magic time interval for rebalancing, but it should be done at least once a year, and more often if the relative asset class holdings vary considerably from their targeted percentages. Rebalancing helps a little, but it is far from being an answer to avoiding the lurking danger during a secular bear market.
By now you should understand why traditional investment methods pose a great
risk to your retirmenet plans. On the next page, we
will begin to discuss the solution to this important problem.