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Sunday, 26 August 2007

Has Market Turmoil Shattered the Investing Rules?

By Gregg Wolper

The past month's stock-market gyrations seem to have everyone on edge. If you've managed to remain calm, congratulations--that's the way to succeed as a long-term investor. If you've been shaken, that's understandable, too. It's tough not to be, given the drumbeat of dramatic news reports about collapsing mortgage firms and 200-point drops in the Dow.

Even more unnerving than the stock market's slide itself is the notion that the recent turmoil has taken an unprecedented and completely unexpected turn. From several fronts we've heard that the markets are behaving in strange, wild ways. The implication: All the assumptions previously underpinning standard investment theory have gone up in smoke.

For example, the manager of a long-short fund, which is designed to handle all sorts of market conditions, explained in The Wall Street Journal his fund's unimpressive showing by saying recent events were "an anomaly." In a Financial Times article, Lehman Brothers explained that its computer models were "behaving in the opposite way we would predict and have seen and tested for over long periods." Later, that same article noted that the computer models running an institutional Goldman Sachs fund had called the confluence of market events so unusual it could happen only once every 100,000 years.

Similarly, according to The Wall Street Journal, some managers "said they were surprised the sell-off was spread so widely across various sectors of the market--from stocks to bonds, to commodities such as gold--which usually tend not to move in tandem. The correlation meant that no matter where they had invested, they would take a hit."

Scary stuff, no? Panic might indeed be called for if every sector was, in fact, behaving in new and irrational ways, and if there truly was no place to hide. Fortunately, neither of those claims is true.

I don't doubt that shocking, unprecedented things have happened to mortgage-bond traders or others at the immediate center of the storm. But it's important to note that the investments favored by the masses generally have performed just as one would expect--and that most time-tested investing tenets remain intact.

Moreover, hiding places weren't hard to find.

Safe Haven?
Bonds don't always provide shelter when stocks are falling. Bonds (even Treasury securities) and stocks can decline in value simultaneously, most commonly during periods of sharply rising interest rates. In such periods, the rising rates make the coupon payments on existing high-quality bonds less valuable, sending the bonds' prices down. Meanwhile, those same rising rates increase the cost for businesses that must borrow in order to invest, and they make it less likely consumers will borrow in order to spend. As a result, stocks can fall as well.

Even at such times, though, bonds typically suffer milder losses than stocks. More important, in many other situations higher-quality bonds actually rise when stocks fall, as frightened investors overloaded in equities turn toward alternatives they consider less risky.

The managers' statements above would seem to indicate that this standard relationship had disappeared. But bond-fund investors know better. Over the one-month period through August 16, while every one of Morningstar's diversified stock-fund categories, domestic or international, suffered painful losses of at least 7.7%, the long-government bond category gained more than 2%. The intermediate bond group (the biggest bond-fund category, which includes core corporate-bond funds) and intermediate government category also landed in positive territory, posting gains of more than 1% each.

In other words, investors who had bought straightforward bond funds for protection against a stock-market swoon got exactly what they hoped for.

Keeping Their Balance
How about old-fashioned balanced funds--those that split their investments between stocks and bonds? And target-date funds, the newest of balanced-type offerings, which have taken the fund world by storm? These, too, behaved as one would have expected over the past month. The conservative-allocation category (funds that own a mix of stocks and bonds but tilt more toward bonds) lost just 3.5% on average over the month-long period. The funds we classify as moderate-allocation, which have higher stock allocations, also provided the expected results under the circumstances. They lost more than their conservative cousins--down 6.4%--but less than any of the diversified stock categories.

The reassuring patterns go further. The target-date funds designed for the youngest investors are the most aggressive, and those geared for older investors are the most conservative. So you'd expect the former to have suffered the worst losses and the latter to have held up best--and for all of these funds to have fared better than all-stock funds. (That's because these portfolios tend to include bonds and cash in addition to stocks.) Sure enough, the groups' results over the past month fit that pattern almost exactly. Those funds targeting 2000 through 2014 lost a little more than 4% on average, the middle range of target funds lost a bit more, and those aiming for 2030 and beyond lost the most but still outperformed nearly all the pure-stock categories.

High-yield bonds also behaved as theory would have it. Conventional investment wisdom holds that the prices of such "junk" bonds, which have below-investment-grade ratings, should behave partly like high-quality bonds, which respond primarily to interest-rate movements, and partly like stocks, in that the changing outlook for the particular company or sector has a substantial effect on the price. And over the past month, the high-yield category lost 3.6%, one of the weakest showings among the bond categories but far better than any stock category.

The Other Extreme
So much for those funds that were supposed to hold up fairly well. How about the other end of the spectrum? Conventional wisdom states that in exchange for their higher potential gains, emerging-markets funds also pose a greater risk of loss than do foreign funds that focus on developed markets. That goes double when such funds have been on a heated rally for years, as they've been since 2003.

So what happened this time? Over the past month, emerging-markets funds suffered the worst losses of any Morningstar categories, with diversified emerging-markets funds losing more than 16% and the Latin America category plummeting roughly 21%.

Don't Rip 'Em Up
Not every type of fund reacted in expected ways. As Russel Kinnel explained in a Fund Spy column last week, some ultrashort-bond funds performed much more poorly than most would have predicted. Precious-metals funds sank sharply. Surprises could be found in certain other corners of the investment world as well, especially in the more esoteric realms explored by quantitative hedge funds and the like. By and large, though, true surprises in more standard areas were much less common than the startling media reports would lead one to believe.

Of course, such reassurance only goes so far. Even if your bond funds held up well, it's no fun watching your stock funds fall. But we can at least take comfort in the fact that we need not rip up those investing guidebooks just yet.


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