A repeat of 2008, when almost everything tanked, is unlikely. It's still a good idea to spread your risk.
By Jeffrey R. Kosnett, Senior Editor
From Kiplinger's Personal Finance magazine, January 2009
The wisdom of investing in a smorgasbord of categories rests on the premise that something always works. U.S. stocks in a funk? Buy bonds and foreign stocks. The dollar is plunging? Offset it with income funds from countries with strengthening currencies. Worried about inflation? Add oil, gold and other commodities.
This strategy, which is known as diversification, rescued many an investor during the 2000-02 bear market. Even during the free fall of major U.S. stock indexes -- which tilt toward large companies -- bonds, small-company "value" stocks and real estate investment trusts made money, enabling investors with well-blended portfolios to avoid catastrophic damage.
This time, though, it really has been different. Aside from Treasury bonds, other cash-like investments and bank accounts, there have been no shelters from the storm. From dividend-paying blue chips to speculative small-company stocks, from long-term municipal debt to high-yield junk bonds, from real estate to commodities, virtually everything tanked. Even gold, the prototypical safe haven, saw its value decline. The average precious-metals mutual fund crumpled 51% in 2008 through November 7.
Some new ideas, such as foreign REITs, also failed miserably. Ditto for newly issued shares of private-equity companies, which promised growth plus high dividends from debt-fueled takeovers. And it turned out that real estate and banking failures in the U.S. did undermine rapid growth in developing nations such as Brazil, China and India. The idea -- or the desperate hope -- that these countries had grown so self-sufficient that they could prosper despite U.S. economic problems is as half-baked as it ever was.
Volatility here to stay
There is no immediate relief in sight from treacherous markets. Although Kiplinger's believes that U.S. stocks will end 2009 in the black, the market could fall another 10% to 20% before investors begin to anticipate an improving economy later in the year or in 2010. Terrifying daily swings will likely remain a constant.
Still, there are no certainties when it comes to forecasting markets. As unlikely as it may seem, stocks could surprise everyone and soar by 30% over the next year. But if you don't want to take a risk on the market, what then? You could forswear stocks and bonds and become a lifelong saver, although we don't recommend putting all your money in bank accounts and money-market funds. After inflation and taxes, and given today's low interest rates, this approach is a guaranteed loser over the long haul.
Your real decision, the way we see it, is between two different approaches to diversifying and managing your investments. The first, the traditional approach, is the one that worked so well during the 2000-02 implosion. In this scheme, you spread your money among as many as a dozen categories: stocks of big growth companies, small growth companies, bargain-priced large companies and undervalued small companies; shares of companies in developed foreign nations and emerging-markets stocks; and REITs and commodities. Add to that a variety of bonds with a wide range of maturities and issuer quality. Every so often -- say, every six months -- the traditionalist rebalances, buying more of the laggards and trimming those categories that have performed relatively well.
The nontraditional strategy is more daring. It requires more kinds of asset classes and a willingness to shift among them more frequently. ItUs a strategy that Jeff Seymour, managing director at Triangle Wealth Management, in Cary, N.C., calls "active, opportunistic and defensive." A leading advocate of the strategy is Mohamed El-Erian, co-chief executive and co-chief investment officer of Pimco, the well-known manager of bond funds. El-Erian believes that an investor who seeks to earn 8% to 10% annualized in coming years without taking undue risk will need to assemble a portfolio that has no more than one-third of its assets in U.S. stocks and the rest in real estate, precious metals and other commodities, foreign bonds, and European, Japanese and emerging-markets stocks. A return that good would be a fabulous outcome. But El-Erian's approach would also fall outside the comfort zone of millions of U.S. investors.
If the recession and bear market play out as previous downturns have, stocks are probably nearing a bottom. The economy should begin to grow again, albeit tepidly, in the second half of 2009 (see Outlook 2009). If that is the case, the bear market should end in the first half of '09 because stocks usually lead the economy by three to six months. Other economies and markets closely linked to the U.S., such as Canada, Japan and Western Europe, should revive as well.
Another reason to think we're closer to the end rather than the beginning of the bear market is the sheer ferocity of what has already struck us. Since World War II, the average bear market has lasted 15 months and slashed 29% off U.S. share prices. The current descent, which started in October 2007, has already lasted about that long and (through November 7) chopped 41% off Standard & Poor's 500-stock index. The rout is within shouting distance of the nearly 50% declines of the two worst post-World War II bear markets, 1973-74 and 2000-02.
If the past is indeed prologue, says Bruce Primeau, of Wade Financial Group, in Minneapolis, it makes sense to stick with the familiar. Long-term investors should keep 60% to 80% of their assets in U.S. stocks covering a variety of categories, including large companies, small companies, growth stocks and value stocks. Surround this "core" with funds that invest in developed foreign markets and in emerging markets, and reserve 10% to 20% for REITs, short-term or intermediate-term bonds, and cash reserves. Don't invest in anything that seems odd or unfamiliar, such as bond funds that invest heavily in derivatives. "At times like this, there's usually more risk in new ideas," says Primeau.