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Sunday, 26 August 2007

How You Can Survive The Correction

Paul Katzeff

The sell-off hurts. The S&P 500 was off about 7% from its July 19 intraday high through Monday's close.

That leaves the big-cap index up a scant 1.92% for the entire year.

So we're in a wrenching correction. The sparks for this conflagration are the credit crunch and fallout from the subprime meltdown.

Many investors have been wondering if they should bail out of the market -- before their accounts dwindle further. Should they go to cash?

The question is especially urgent for people near retirement.

The trouble with exiting is that the medicine is often worse than the ailment.

People don't get back into the market in time. As a result, they miss the start of the next rally. That means they lose a big chunk of gains.

"If you're getting hurt by this downturn, it means you weren't able to foresee the sell-off," said Stuart Ritter, a financial planner at T. Rowe Price. "What makes you think you'd be any better at foreseeing the start of the next rally?"

In fact, growth you miss out on is a bigger loss than whatever setback you suffer in a downturn, says Ritter.

Still, investors obsess over how much they lose from a market peak. They overlook their long-term gains, he says.

Market timing makes more sense with individual stocks. Three out of four stocks move in the same direction as the market. And a stock can dart way above or way below the market average. Failing to trade in step with the market can be ruinous to those not committed to keeping losses small. A stock can take many months to come back from a plunge, or never recover at all.

But risks shift with a broad portfolio of stocks. Just as the stock market has recovered from every bear market, so do stock funds diversified across several industries.

The average bear market has taken the Dow industrials down 31% and has lasted 13 months, according to the Stock Trader's Almanac. From bottoms, it has always marched on to new highs.

Buy And Hold

So with funds you should focus less on protecting your capital from sell-offs and more on not missing gains that the next uptrend brings.

Look what happened to investors who were out of the market on days it scored its biggest gains from 1969 through 2001, a period of 8,100 trading days.

If they missed out on just the 10 best days in that time, $10,000 they invested at the outset grew to $74,000, according to T. Rowe Price. If they missed the 40 best days, their end balance was $24,900.

But if they had stayed in the market through its ups and downs, their end balance would have been $124,700.

Some studies show that missing the worst days can provide an even better return than making sure you're in on the best days. But the kind of risk is the same. If you're wrong or get whipsawed in and out of the market during volatile times, you miss big chunks of uptrends. You may end up buying high and selling low.

"Unfortunately, people get shook up by short-term volatility," Ritter said. "Too many of them think they're better off if they try to dodge short-term ups and downs."

A buy-and-hold strategy works better. Take the 50 years that ended Dec. 31, 2006. If you stayed invested in stocks in the S&P 500 during any 10-year period in that half-century, the worst you would have done was gain an average annual 1.2%.

In the most lucrative 10 years, your annual gain would have averaged 19.2%. That was the decade through 2006. The average annual gain was 11.3% for an all-stock portfolio.

Time is on the side of long-term investors. The average bull market has taken the Dow up 84.6% and lasted nearly 25 months.

But what's the best course of action for someone near retirement?

Don't put money you'll need to spend soon into stocks, Ritter says. "Money you need within two years should be put into a money market fund, not stocks," he said. "Return is lower, but so is volatility."

Money you don't need right away should be allowed to grow.

"We tell people to plan to live 30 years in retirement," Ritter said.

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