Ignore the News, Stay the Course

 

The stock market is one of the best places to invest your money; over the long haul, the S&P 500 – a grouping of 500 of the largest US-based companies — has returned between 8% and 10% annually. An 8% annual return means that your money doubles every nine years; after 40 years, an initial investment of $100 will increase to over $2,172. Nice in theory, but in practice, it doesn’t work exactly like that; you don’t get a steady 8% annual increase, some years that market goes up, some years the market goes down. And some of those down years can really test your resolve.

Recently, the stock market declined by 10% from its highs set in May. While such a decline can be frustrating and tough to swallow, it’s actually quite common to have such market “corrections” as they’re called. Until this most recent sizable decline, the stock market had gone 2,359 days since its last correction.

bull market

This 2,359 day extended bull market is notable as the 3rd longest period in the stock market’s history without a 10% drop. For those people who are new to investing in the stock market, this may have been the first time that you have ever experienced a correction. Having your investment portfolio lose 10% of its value in just short period of time can be enough to make you want to take your money out of the market and stuff it in your mattress. During the six trading days, between August 18th and August 25th, the Dow Industrials, the S&P 500, and the NASDAQ,– the three major US-based stock market indices — lost 10.7%, 11.2%, and 11.5%, respectively. Such downward movements are fodder for the media; people who don’t typically pay attention to the stock market start talking about it, saying things like: “I’ll never be able to retire,” “They’re just paper losses,” and “I’m taking my money and putting it in CDs.” It is really frustrating for most people when the markets decline; you carve off a portion of your salary and invest it in the stock market hoping to be able to retire comfortably. When you have a big decline, it’s easy and understandable to get scared. Some people get so nervous they pull their money out of the stock market. There’s an old stock market adage: “Buy low, sell high.” When you sell your holdings after a large decline, you’re likely doing the exact opposite; you are selling low. Over the long haul, the markets have returned between 8% and 10% annually. If you have a long enough time horizon, these 10% drops will look like the ripples in an ocean.

That said, a 10% correction might only be the tip of the iceberg. Those who have been investing for more than five years will certainly remember the financial and housing collapse in 2008/2009. During the 18-month period from October 9, 2007 through March 9, 2009, hundreds of banks either closed or were absorbed by other financial institutions, housing prices collapsed, people lost their homes, and the major stock market indices declined by 50% or more; talk about gut wrenching!

financial crisis

Source: Wall Street Journal

A 10% correction seems like a bump in the road when compared with the price declines which took place at the end of the previous decade. If you look at the chart above, the only investments categories which were making money were bonds and commodities; gold, specifically.

It’s easy to invest when times are good; it feels good to watch your stocks go up and the dollars in your retirement accounts getting larger. When the market is thriving everyone thinks that they’re a genius and that it is easy to make money in the stock market. If you would have invested all of your money into the S&P 500 just prior to October 2007, you would have lost 57% of the value of your investment by March 2009. Ouch! This is primarily why most people should have a portion of their portfolio in bonds. Granted, bond yields are paying next to nothing these days, but your investments in bonds tends to offset the negative impact that huge declines can inflict. As you can see from the chart above, bonds (10-year US Treasury Bonds) returned 16% during the period when the S&P 500 declined 57%. Having an investment allocation which includes bonds as well as stocks can mitigate the damage that large declines can inflict on your portfolio.

Let’s look at several examples showing the impact of varying stock to bond asset allocations. We will assume that you had $100,000 and only had two holdings in your portfolio: a stock allocation via the S&P 500 and a bond allocation comprised solely of 10-year US Treasury Bonds. We’ll look at the investment returns during that 18-month period mentioned above: a starting date of October 9, 2007 and an ending date of March 9, 2009

If you had invested 100% of your money in the S&P and 0% in bonds, you would have lost 57% of your assets as the S&P 500 suffered a 57% decline, therefore your $100,000 investment would have decreased in value to just $43,000 by March 2009. Investing a portion of your money in bonds softens that blow:

Asset Allocation
Stock / Bond

Starting Balance

Ending Balance

Gain / (Loss)

100% : 0%

$           100,000 $            43,000

(57%)

90 : 10

$           100,000 $            50,300

(50%)

80 : 20

$           100,000 $            57,600

(42%)

70 : 30

$           100,000 $            64,900

(35%)

60 : 40

$           100,000 $            72,200

(28%)

50 : 50

$           100,000 $            79,500

(21%)

40 : 60

$           100,000 $            86,800

(13%)

30 : 70

$           100,000 $             94,100

(6%)

20 : 80

$           100,000 $           101,400

1%

10 : 90

$           100,000 $          108,700

9%

0% : 100%

$           100,000 $           116,000

16%

The more money that you had allocated to bonds during that time frame, the better your returns would have been. I am certainly not going to recommend to you that you allocate all of your money to bonds. That 18-month time-frame was more of an anomaly than the norm; as mentioned earlier, historically, stocks average an 8% to 10% annual return. 10-year T-bonds have averaged about 5%, but in the recent low interest environment, it’s been hard to get excited about bonds. The 10-year T-bond is currently yielding 2.2%. Since the market bottomed in March 2009, it has rebounded dramatically and had a compounded annual growth rate of nearly 18% over the past six and one half years. If you had maintained a large bond allocation, you would have missed out of those gains.

So how much should you allocate to stocks and to bonds? That’s a personal decision; most people suggest that you increase your bond allocation as you age. Many Life Cycle mutual funds take this approach and will migrate more of your funds into bonds as you age. Some people suggest that you use your age as a guide to the allocated percentage of bonds in your portfolio. That is, if you are 30, you would have 30% in bonds and 70% in stocks, conversely if you are 61, you would have 61% in bonds and only 39% in stocks.

Our friends at NerdWallet polled a group of financial advisors and they suggested that there are two key drivers to investing success:

  1. Spending less than you earn
  2. Commit more money to equities

The more money you allocate to equities (stocks), the more money you will likely have many years from now. While some people are cautious about allocating large portions of their investments to stocks, arguably the greatest investor in history, Warren Buffet, thinks otherwise.

Mr. Buffett takes a more radical approach; he advocates that you always maintain a 90:10 stock-to-bond allocation. He suggests a 90% in an S&P 500 index fund and the remaining 10% in either cash or short-term treasuries (not 10-year treasuries).

As with any of these strategies, the decision is yours. Many financial advisors suggest doing a periodic asset allocation; simply stated that’s taking money from better performing asset classes and reallocating the excess portion to the lesser performing classes. If you establish an allocation of 60:40 stocks-to-bonds you would sell excess stocks when they exceed the 60% allocation and use the proceeds to buy more bonds. Conversely, if, as was the case in 2008, stocks were under-performing bonds, you would use some of your bond allocation to buy more stocks. In this instance, you would have been buying more stocks when the market was low and would have been selling stocks as the market climbed; buying low instead of selling low. This is as close to timing the market as you should get; most anyone who tells you that they can time the market probably has a crystal ball in their office too.

There are certain things that the market reacts to, such as rising interest rates, war, or unemployment numbers. However, none of these things occur on their own. These events occur with other market conditions, and sometimes, these events have been a long time in coming, so their effects are already baked into market prices. Since most people can’t accurately predict when the market will go up or down, you probably shouldn’t deviate from your general investing strategy. It might be appropriate to consult with a financial advisor.

This week the FOMC will meet; speculation is that interest rates will rise since rates haven’t gone up in over nine years. (The head of the Federal Reserve committee meets eight times each year and determines whether or not to raise interest rates.) If the Fed elects to raise rates, will the stock market decline? Lower interest rates allow businesses to borrow money and theoretically that grows the economy. An interest rate increase can result in stock prices declining, as investors expect a slowdown in economic growth. So, as an individual investor, should you sell today? Or should you buy? Since there has been expectation all year of a rise in interest rates, the decline may already be priced in.

Some people will tell you that it’s time to get defensive and move more of your money into safe investment vehicles, like gold and bonds. Such actions may protect you in the event of a further decline. However, a defensive position could result in losses in your portfolio since bonds are worth less when interest rates rise. It’s impossible for the individual investor to time the market. It’s not that easy for professionals either. Often, your best course of action is to stay the course. If you are investing for the long haul, just keep putting money in the market with the understanding that – at least based on history – you should see an 8% to 10% increase on average, when you look back, many years from now.

 Image: John McSporran via Flickr

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