Lummer's Logic
March Madness
By Scott Lummer
Chief Investment Officer, mPower

March 20, 2001

The recent market volatility has caused many investors to become concerned and the pressure is starting to show. It is essential to stick with a well thought-out, long-term investment strategy and not to panic. For this week's column, I wanted to share with you a series of four short commentaries I wrote for mPower's clients last week when the market turned bearish, answering some common queries.

Why Should I Stay In the Market When Others Are Bailing Out?

Believe me, I understand the temptation. While I've been an investor in other bear markets, frankly, I didn't have as much invested then as I do now. Over the past year and a quarter, I have personally lost more portfolio value than ever before. However, I also know this isn't the first bear market we have experienced (and, unfortunately, it won't be the last).

A bear market can be defined as the S&P 500 declining by 20 percent or more over some period of time. The downturn we have had this week has caused the last 12 months to be defined as the sixth bear market since World War II. I think by analyzing what happened during those past markets we can gain some insight about what we should do as investors today. The duration of a bear market, its overall decline, and the length of time until it recovers are instructive.

 

 

What lessons can we learn from these figures? The most obvious one is that the market has always recovered, but you probably already knew that. What you may not have known is that it took only an average of 1ý years for the market to recover from an average loss of 29 percent. And, in all five cases, investors earned their money back within three years after the end of the decline.

Thus far, the current decline has been 23 percent. Of course, we can never be certain that the end is in sight (more on that issue in the next section) but, generally speaking, recoveries have been relatively swift. Of course, there is one notable exception — the market decline surrounding the Depression of the early 1930s. That decline was 84 percent, lasted nearly three years, and took 13 years from which to recover. However, I doubt whether many of you believe we are heading for the financial and agricultural calamity of that period.

Of course, all I have done is present statistics. After all the analysis, you have to ask yourself a fundamental question: Do you think that the stock market will stay down until you retire? Remember, we have a solid, well-functioning economy. Unemployment and inflation are relatively low compared to the past 30 years. My belief is that while the market will continue to be turbulent over the next year, there is no reason to suggest it won't continue to grow going forward.

When I consider that I have no intention of retiring for another 20 years, I feel very comfortable remaining an all-equity investor. In each of the other five bear markets, there were also groups of investors who bailed out of the market after a loss of 20 percent or more. However, after all was said and done, the investors who got out of stocks merely locked in their losses, while investors who rode out the storm recovered in a surprisingly short amount of time.

Why Shouldn't I at Least Temporarily Get Out of the Market?

Even if you still believe that you should be in the market for the long term, I can understand the temptation to move some money to safer investments right now, with the intent of moving them back to stocks later. The problem is, this requires you to make a specific timing decision about when to move your money back into stocks. On the surface, the answer seems obvious — you should put your money back into stocks when the market hits bottom. However, in practice, that bottom is impossible to determine, at least until long after it has been reached.

Let's look at a hypothetical situation. Suppose you pull some of your money out of stocks and watch the market move up and down over the next few months. Ask yourself what would convince you to come back into the market. You'll probably answer that you would want to see good returns for a reasonable amount of time. But, how long a period of good returns would it take to convince you that the bear market was over? One month? I doubt it. A quarter? Perhaps. Six months? Probably.

Suppose you put your money back into stocks three months after the bottom of the market. Let's see what you might have missed. As I mentioned in the previous section, there have been five bear markets (besides the current one) since World War II. In the first three months of recovery after the market hit bottom in 1946, stocks earned a 6 percent return. The returns during the first three months of recovery for the other four bear markets were, respectively, 4 percent, 17 percent, 9 percent, and 17 percent. That means an investor participating solely in the first three months of the recovery of each of the last five bear markets would have earned a combined return of 65 percent over those 15 months! That seems like a lot to give up.

My point is this: Because no one knows precisely when the bottom of the market is occurring, investors who pull out of the market will be late in returning to stocks and, by being late, they will miss much of the comeback. That is the true danger inherent in timing the market — missing those big upward movements.

That is why I am keeping my money in stocks, and why I am advising our clients to do the same. If I were smarter or had psychic powers, I would tell you to get out now and come back when the market was about to rise. But, once you get off a train, it's difficult to climb back aboard after it's left the station.

If I Believe the Market Is Coming Back, Shouldn't I Invest In the Most Aggressive Stocks?

The logic of this idea is appealing — particularly for those of you who had large losses stemming from being overexposed to technology stocks. The thought process goes something like this: "I lost three times as much money in technology funds (or small company growth funds) as I did in my other equity investments. If I have faith that the market will recover, won't I get three times as much recovery?" Unfortunately, it isn't that simple.

What may lead us to this belief are two different facts that can easily get twisted. First, in order to get greater returns over the long run, you need to take additional risk. Second, the broad market volatility over the past year has at least partly been triggered by the decline in technology stocks. While those two statements are true, many people jump to two related conclusions that are incorrect: "If I take more risk, I will be rewarded with higher return," and "the broad market won't recover until tech stocks recover."

If you always got greater return by taking additional risk, then Las Vegas would have more "investors" than Wall Street. Some risks may pay off in terms of higher return but others won't. If I move money from money market funds to stock funds, I take greater risk and expect greater return over the long term. If I and other investors did not expect higher returns from stocks than from money market funds, we would stay in those safer investments.

However, I do not expect much greater returns from investing in a particular sector of the market even though that sector is riskier than the market as a whole. Nearly all investors have a portion of their money in technology stocks, but the majority of investors diversify their risk by spreading most of their money in other investments. As a result, the extreme risk of having a large amount invested in technology is diversified away.

Consequently, there is no reason to suggest I should get a higher return from tech stocks because the specific risk of those stocks does not greatly affect most investors' diversified portfolios. That means if you are holding an unbalanced position in a technology fund or small-cap growth fund, you are taking risk without a long-term expectation of higher returns. This is like putting that part of your retirement savings on No. 17 on a roulette wheel.

Moreover, a market recovery is not entirely dependent on technology. Many analysts have said that the technology sector is still overvalued. Suppose there were these three news items on the same day:

 

 

In this hypothetical situation, the broad market would likely have a healthy increase in value, while technology stocks would continue to tumble.

Risk is a two-edged sword. It is possible that tech stocks could outperform the market for the rest of the year. My point is that it is just as likely that tech stocks and the NASDAQ in general could underperform the market for the remainder of the year and, more importantly, the remainder of your investing life. There is no certainty that loading up on any particular sector will help your portfolio's recovery — in fact, the only certain outcome of such a strategy is that you will take on more risk. Regardless of the magnitude of your losses or the tactics you used while achieving them, the safest way to recover is to broadly diversify your holdings.

When Is It Appropriate for Me to Change My Strategy?

There are a few reasons why you should adjust your investment strategy. But, before mentioning those, I want to re-iterate the main reason why you shouldn't. You should not reduce the amount of equities in your portfolio simply because the market has declined in value. Selling after market declines causes a buy-high, sell-low timing strategy that will diminish your wealth over time. The important corollary is that any modification you make to your policy should be a long-term adjustment. If you change your investment strategy, again, you shouldn't alter your policy simply because stocks increase in value or one sector outperforms another.

That said, there are three reasons why you might consider making a change to your investment strategy:

 

  1. The first is a very general reason — a significant event in your life changes your investment outlook. Realize that such a change is as likely to make you think about increasing the amount of equities as decreasing them. For example, suppose a significant part of your financial plan was paying for your daughter's education but, as a result of her outstanding play on the basketball court, she got a full college scholarship. In that case, your short-term needs have diminished and you would probably want to put more of your money in equities.
  2. The second reason would be that you realize your original investment is significantly out of balance. For example, it might have too much in a single industry or risky asset class, like small company growth stocks or emerging markets. As I mentioned in the previous section, it's better to balance your plan now, even after a decline, than to continue with an ill-advised strategy.
  3. Finally, for those of you who never understood how volatile stocks might be until the past 12 months, you may now realize that you have less tolerance for risk than you thought you had. If you are so uncomfortable with an all-equity portfolio that you can't sleep at night, then you might want to consider a slight and permanent allocation to fixed income. While I don't think that this is really the time to make such a move, and you would be better off postponing a re-allocation until the market settles down, I recognize that you may need some immediate stability for your psyche. If that's the case, then take no more than 10 percent or 20 percent of your money out of stocks and put it in a money market, short-term bond, or stable value fund. It may be a slight losing proposition but it's better than damaging your emotional health and doing greater damage to your financial wealth by bailing out of the market completely.

 

I am truly concerned about those of you who are retired or within five years of retirement. I don't think it's advisable for anyone in or approaching retirement to have all of their money in stocks. You don't have the same financial flexibility that investors with longer investment horizons have (it's harder to work longer, save more, or reduce your goals). When you are within five years of retirement, you should have no more than 80 percent of your portfolio in equities. And, after retirement, that figure should be less than 60 percent. (This refers to the funds you expect to use during retirement — this does not apply for those of you lucky enough to have money dedicated to estate planning). That's an upper bound — you may want to invest considerably less in equities. To demonstrate why, read this e-mail I received this morning:

I just turned age 63 in January and at that time had $300,000 in mutual funds, of which about $60,000 is parked in money markets. I have started Social Security but need to start a withdrawal plan of approximately $17,000 a year to supplement the payments. My mutual fund values decreased substantially over the past two months. So, now what do I do to provide the income stream I mentioned for the rest of my life? Do I need to return to work?

I think that this investor had too much at risk in the market. When a market decline like we have just seen can cause you to make a significant adjustment to your lifestyle, like having to return to work, that's too much risk.

In conclusion, I just want to emphasize that I am very sincere when I say I understand how you feel — I have lost more than double as much financial wealth during the past year than at any other time of my life. And, I have the same type of retirement goals that many of you have.

So, I'll share something with you. How did I spend this weekend? I went to a movie with my wife. I worked on some special school projects with my daughter. I played a lot of baseball with my son. And, in doing so, I re-confirmed the noninvesting things in my life that are truly important to me.

It didn't do a darn thing to help my portfolio, but I definitely feel wealthier than I did on Friday.


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