Let’s not mince words. The stock market lately has been pretty ugly. In more than 40 years helping people with their money, I don’t think I’ve been through a tougher period than this one. As I write this, the major U.S. stock indexes have dropped about 40 percent in the past year.
In early October I received an email from an investor who told me he was starting to doubt the wisdom of buying and holding even a well diversified portfolio. He said he had lost almost every gain he’d made since 2005. “This is disgusting, and to add insult to injury, the market is dropping off a cliff at about 5 percent to 6 percent every day with no end in sight.”
He continued: “I am afraid that by buying into your philosophy I have destroyed my retirement nest egg. The damage done to us may be irreparable. I have no other choice now but to ride this out, but never again will I blindly support buy and hold. I am not sure that you have done investors any favors by pushing the buy and hold philosophy that may bankrupt us in the end.”
In a brief follow-up email exchange, we learned that this investor had carefully considered his risk tolerance and had chosen a 60 percent equity allocation, with 40 percent in fixed income. We believe this balanced approach is a good one for many long-term investors.
But the past few months have certainly put investors to the test. It’s easy to be a successful investor when prices are going up. It can be very hard when they are going down.
Here’s something I have learned in more than 40 years of helping investors: Your real job as an investor is the same during the euphoria of a raging bull market as it is in the gut-wrenching losses of a raging bear market. That job is to manage your risks and manage your emotions. If you don’t do those two things, you can get in big trouble no matter what the market is doing.
Will our buy-and-hold advice bankrupt investors in the end, as our email correspondent suggested? The truth is that we can never know the future. And if anybody actually DID know the future and reveal that future to us, few of us would believe it.
Imagine for a moment that a year ago I had written a book predicting that the stock market would fall this fast and this far and that large parts of the financial industry would be nearly immobilized in a global credit crisis. In one year, many big financial institutions would be flirting with insolvency; Lehman Bros. and Merrill Lynch would disappear; and Fannie Mae, Freddie Mac and Washington Mutual would all fail.
Would you have believed my predictions? Would you have sold all your equity investments? I doubt it very much. One year ago there were undoubtedly a few people predicting global financial collapse, as there always are. But such prognosticators are almost never taken seriously. Their analysis and predictions just don’t fit with what we think we know and understand.
Now let’s look at what we actually have told investors. There’s almost nothing in this business that anybody can guarantee. But when I’m leading workshops, I tell the participants that if they invest in the stock market, they are guaranteed to lose money. Not everybody believes it, of course, and relatively few people think that they personally will sustain serious losses. Somehow, we think we’ll be able to duck and dodge when reality throws the killer punches our way. This time, there has been nowhere to hide.
If you believe my promise of losses, then it is your responsibility – either on your own or with a good adviser – to build a portfolio that addresses the probable losses you are willing to accept.
Since the 1990s, we’ve been helping people do this with the help of a table called Fine Tuning Your Asset Allocation . It’s on our educational web site and in our workshop workbook. This large table shows year-by-year returns since 1970 for 11 combinations of globally diversified equity and fixed-income funds, along with the Standard & Poor's 500 Index for reference.
Last month, investors’ one-year losses in many cases began to exceed the worst 12-month periods shown in that table from 1970 through 2007. Now that the awful month of October is behind us, we can update the worst-12-months data since 1970, which we have done in Figure 1. Notice that in nine of the 12 portfolios shown, the 12 months ending October 31, 2008 was the worst such period since 1970.
Figure 1
Worst 12-month periods since 1970 (in percentages)
Portfolio | Through 12-07 | Through 10-08 | Fixed income | -4.8 | -4.8 | 10 percent equity | -4.0 | -4.0 | 20 percent equity | -5.9 | -8.3 | 30 percent equity | -10.0 | -13.7 | 40 percent equity | -14.0 | -18.8 | 50 percent equity | -17.8 | -23.8 | 60 percent equity | -21.5 | -28.4 | 70 percent equity | -25.1 | -32.9 | 80 percent equity | -28.5 | -37.2 | 90 percent equity | -31.9 | -41.3 | All equity | -35.1 | -45.1 | S&P 500 Index | -38.9 | -38.9 |
What about buy and hold?
There is no question that in the past, buy and hold has worked for patient, long-term investors who can stay the course during the bad times and hang on until the good times return. However, some investors who regard themselves as buyers-and-holders still bail out when the chips are down. In doing so, they usually gain some emotional relief. But here’s the problem: Investors who go to cash in bear markets may be converting temporary losses into permanent ones.
The price of that comfort is the loss of the profits which have always been there for the taking when the stock market has rallied. While there’s no guarantee that a rally will ever take place, history tells us it is highly probable. What’s also highly probable is this: If you bail out when losses get too scary to tolerate, you at some point will want to get back in when things are moving upward. The problem is that when that day comes, you won’t have any objective way to know whether or not it’s the right time.
If you wait until you feel comfortable getting back into stocks, you will probably have missed most if not all of the recovery. You will undoubtedly have “sold low” after a decline spooked you and “bought high” after a rally restored your confidence. This is an example of how our emotions and our herd instincts prompt us to do the exact opposite of Wall Street’s classic advice: Buy low and sell high.
Buying and holding, while it can be very challenging, at least is a system to protect you from your emotions.
Something else we have been preaching for many years is wide diversification. While no sector of the stock market is immune to a global financial crisis, diversification helps. Remember a few months ago when oil peaked at more than $145 a barrel and people were eagerly buying energy stocks and commodities? I wonder how happy they are now, with the price less than half of the summer peak.
Bill Miller became a legendary mutual fund manager, loading up his Legg Mason Value Trust with stocks from sectors he regarded as good values. A year ago, he loaded the fund up with financial stocks, and the media praised him for being far-sighted. In the 12 months ended October 31, his fund was down 55 percent.
Overconfidence isn’t limited to Wall Street. It exists on Main Street, too. I know a 65-year-old man who has an all-equity portfolio, with more than half of it in financial stocks. Most of that was in stock of Washington Mutual, which just last month became essentially worthless. (The shares are reportedly trading on the over-the-counter pink sheets for 16 cents apiece.)
My friend loaded up on Washington Mutual stock because the bank was in an industry he knew and trusted. Now he probably will have to keep working for as long as he is able to. When he finally retires, he and his family are likely to have a much more modest lifestyle than they had been counting on. (For more on the risk that this man took, see “A ticking time bomb: Owning company stock” by Tom Cock.)
Personally, I feel terrible about the losses that almost everybody is experiencing. I believe that recovery will take place, but it may be long and painful, and it certainly won’t treat everybody equally. Like you, I have lost money. Our clients have lost money.
Despite these awful losses, I am proud that our company has always focused on preparing investors for the bad times. It’s always much tougher to face these times in reality than when you’re looking at numbers in a table, and inevitably some of our clients have discovered that they invested too aggressively.
There’s an old saying on Wall Street: The market is a very tough teacher; it gives you the test first and the lesson later. For more than a quarter of a century, we have tried to give “the lesson” to every investor who will listen. We’ll keep doing that for the next quarter of a century, and I hope some people have learned from the present situation that it makes sense to be cautious with money that’s important. I hope they will be ready the next time the market gives its test.
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