The stock market has tumbled. Now what do I do?

During the 1990's, a record proportion of Americans invested in the stock market. Now that an exceptionally strong bull market has yielded to the worst market decline in a generation, many new recruits to the stock market, as well as many veteran investors, face important decisions about their financial future.

by Marvin Appel, PhD, and Brian Hufford, CPA, CFP

During the 1990's, a record proportion of Americans invested in the stock market. Now that an exceptionally strong bull market has yielded to the worst market decline in a generation, many new recruits to the stock market, as well as many veteran investors, face important decisions about their financial future. Below we answer some questions we frequently encounter from our clients.

Is there any point in selling now?

If you are holding individual stocks, you must of course evaluate them on a company-by-company basis before making final investment decisions. However, we can use the historical behavior of technology mutual funds compared to the S&P 500 as an example of what might be at stake if you part with your particular holdings in favor of a mainstream investment such as an S&P 500 index fund.

Surprisingly, during the past 40 years the S&P 500 (including dividends) and the average technology fund have had the same returns: 10 percent per year (compounded). If we instead measure from the market low of 1974 through the market peak in March 2000, we find that the S&P 500 returned 17 percent per year and that the average technology fund returned 23 percent per year.†

The profit history of technology funds and the S&P 500 illustrates a more general principle of aggressive investing: During bull markets, aggressive investments might earn more than the broader market, but those investments will likely give up some (or all) of that relative performance advantage during bear markets.

There are two implications: First, if you move from an aggressive set of investments into a more mainstream, diversified mix of stocks, you are still likely to participate in any coming market advance. Naturally, the fear exists that as soon as you move out of any downtrodden stocks, the holdings you sold will promptly rebound to higher levels. This is theoretically possible, but market history suggests that this risk is small. (There have been infrequent exceptions where only a small part of the market rises. An example would be the bubble in technology stocks from October 1998 to March 2000, which was quickly reversed.)

Second, once you decide how much of your assets to allocate to stocks, and take realistic expectations of return and risk into account, you should stick to that plan by rebalancing your holdings periodically — at least once a year. This will require selling off some stock market holdings after they have enjoyed some outsized gains, and adding to your holdings after they have under-performed. If you are uncomfortable about keeping your current holdings, but want to continue to have market exposure for the long term, S&P 500 index funds, such as the one offered by Vanguard, have a solid history of performing as well as or better than a majority of other mutual funds over the long term (ticker VFINX, telephone (800) 662-2739).

Do bonds make sense for me?

We are living through a demonstration of one reason why low interest rates are good for stocks: Low returns available from bonds make stocks potentially more attractive, at least on a relative basis.

Past results, which of course do not predict future performance for any investment strategy, suggest that placing up to 25 percent of assets in bond investments makes sense for all but the most aggressive investors. As with any other portfolio strategy, if you start with a certain percentage in bond funds, it is important to rebalance your holdings at least once a year to restore your original portfolio strategy.

Current low interest rates, both on an absolute basis and relative to inflation, do pose high risks for investors adding to their bond holdings. There are three ways to reduce (but not eliminate) this risk.

• Emphasize money market or short-term bond funds while awaiting more favorable interest rates or while slowly building positions in long-term bonds.
• Invest in a bond ladder, which we described in our September 2001 "Practical Investor" column.
• Place at least part of your bond holdings into inflation-protected bonds issued by the Federal Government.

If you want to invest in bond mutual funds, some low-cost, no-load selections with favorable performance over the past decade include the Eclipse Bond Index Fund (ticker symbol NIIBX, telephone (800) 695-2126) or the Manager's Bond Fund (ticker MGFIX, (800) 835-3879). Individual, high-quality bonds held to maturity are potentially safer than bond mutual funds provided you have a good bond dealer and enough assets to diversify well (usually at least $100,000).

Are there any other investment alternatives besides stocks and bonds?

It is possible to invest in real estate through the stock market by trading in real estate investment trusts (REIT's). Although REIT's have been among the top performers of this bear market, they have historically carried about the same balance between risk and reward as the S&P 500.

As of this writing (Sept. 10, 2002), REIT stocks have already enjoyed a large advance, so there does not appear to be any urgency to add to REIT positions. Nonetheless, over the long term, investors have benefited by including some REIT's (up to 20 percent) with their other stock holdings.

For certain individuals, direct investment in rental property can be a good source of income and potential tax benefits. However, a significant time commitment and a high degree of expertise about local economic conditions may be required. Also, compared to buying local property directly, REIT's offer greater diversification (less potential risk) and the ability to retrieve your investment capital on short notice with more modest transaction costs than you would incur selling a piece of property.

Bottom line: Recent and long-term history shows that long-term, buy- and-hold investors should expect occasional losses of 30 percent or more as a necessary cost of participating in the potential long-term growth of stocks.

Since 1926, stocks have returned an average of 7 percent per year over inflation, although many analysts expect lower returns during the coming decade. You should make an investment plan in view of the current (not past) value of your savings and income, your anticipated future needs, and the potential risks and rewards of different investment options. Then stick with your plan, and rebalance as necessary.

† Data are from the July 31, 2002, issue of the Mutual Fund Expert Database.

The 6 percent per year advantage of technology funds over the S&P 500 from the market low to the market top is larger than you could likely have realized. First, many technology mutual funds could have gone out of business before July 2002, and these laggards would not be reflected in the current database (survivorship bias). Second, in order to realize this large of an advantage, you would have to have invested exactly at the market bottom and sold exactly at the market top.

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