By Christopher Farrell
On Mar. 2, I gave a talk on the economic and market outlook as part of the grand opening of the first new public library to be built in Grand Rapids, Minn., in more than a century. The library, constructed in a stunning North Woods style, is nestled alongside the Mississippi River. A large crowd gathered for the evening, and everyone was quite interested in what has been happening in the markets. Inevitably, with the Nasdaq losing more than half its value from its peak a year ago and the Standard & Poor's down about 20% from its high, someone asked, "How should I change my portfolio to weather this bear market?"
My instincts were to go for the standard response: Construct a vastly more conservative portfolio. Dramatically reduce your exposure to equities. Cut back on high-tech and other growth stocks while loading up on defensive industries and value stocks. You also could hike your investment in cash and other fixed-income securities, including Treasury bills and bonds.
All good strategies to limit a financial mauling during a bear market. For instance, during the 1973-74 bear market an investor with $10,000 in stocks lost $4,800. In sharp contrast, a portfolio composed of 60% stocks and 40% bonds showed a paper loss of only $2,900, according to calculations by the Vanguard Group.
But here's another strategy: Why bother making any adjustment at all? There's a case to be made that, for most long-term investors, sticking with your original asset allocation is a good plan, too, assuming you took the time to construct a portfolio that reflected both your willingness to take risk and your time horizon.
How come? For one thing, it's striking that the average bear market in the post-World War II period has lasted about 12 months. That seems like a long time when you're living with a bear. Stock market values crumble week after week. But it's a fairly brief period of time for someone investing with, say, a 10-year time horizon, if not longer.
"BACK IN THE BLACK."
The far bigger risk is selling stocks at a loss when the market is down and then getting back into the market long after the rally has commenced. Many are called to time the market -- but only a handful do it well. Stocks still returned an average of 17.2% a year from 1975 to 1999, despite being interrupted by four brutal bear markets (see ). "Even if you go back to the 1800s and look at bear-market cycles, outside of the Great Depression of the 1930s, investors were back in the black after five years or so," says James Paulson, chief investment strategist at Wells Capital Management.
The real issue is whether your ability to absorb market volatility has changed. In a 1994 speech at the Cambridge Center for Behavioral Studies, the Nobel laureate Paul A. Samuelson criticized investors who make large portfolio adjustments in reaction to market swings. Indeed, the octogenarian economist pointed out that his risk aversion or asset allocation hadn't changed over time. "When I do my sums right, I find myself picking exactly the same equity fraction at every year of my life cycle," Samuelson said. "In my case, it doesn't matter whether I review my portfolio weekly, monthly, yearly, or not at all."
Still, Samuelson, as rational an economist as they come, did offer "Samuelson's Law" as a sop to frightened investors. Paraphrasing St. Augustine, Samuelson's Law proclaims if you must sin by changing your asset allocation, sin only a little. After all, says Jim Paulson, minor tweaks "won't do much damage and may make you feel a little better."
When should you consider making big changes? Some people probably never should, since their risk aversion is stable and their investment time horizon lengthened by many children and grandchildren. Others may need to radically overhaul their portfolio simply because they greatly underestimated how badly they would react to a sinking stock market.
But for most people, the time to think about major shifts in asset allocation involves major life changes and not swings in the market. For instance, retirement may loom on the horizon, or you may have only a few years remaining until the college-tuition bills come due. Yes, I'm assuming we're not about to stumble into another Great Depression. But I don't believe we are. And absent a calamity of that magnitude, the average baby boomer and Generation Xer should just ride out the bear.
|STOCKS IN BEAR MARKETS|
|Aug. 1956-Oct. 1957||14.7||-21.6%|
|Dec. 1961-June 1962||6.4||-28.0%|
|Feb. 1966-Oct. 1966||7.9||-22.2%|
|Nov. 1968-May 1970||17.9||-36.1%|
|Jan. 1973-Oct. 1974||20.7||-48.2%|
|Sept. 1976-Mar. 1978||17.5||-19.4%|
|Jan. 1981-Aug. 1982||19.2||-25.8%|
|Aug. 1987-Dec. 1987||3.3||-33.5%|
|July 1990-Oct. 1990||2.9||-19.9%|
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online
Edited by Douglas Harbrecht