CONVENTIONAL ADVICE IS UNLIKELY TO HELP MUCH

Wall Street brokerage firms, various pundits, newspaper columnists, and the talking heads on TV networks such as CNBC always have a lot to say about what you should do. The best thing you can do is ignore them because they are much more interested in their own welfare than yours. A couple of old saws put it well: "If they are so smart, how come you are not rich?" and "Where are the customers' yachts?" which was the title of a perceptive book written around 1970.

Instead, you are better off doing your own thinking and analysis. If you follow another's advice, do it with someone whose does better when you do better and who is independent of brokerage firms, mutual fund companies, and other sellers of financial products.

Let's take a look at the most popular conventional advice:

There is some wisdom in the last of these, but overall the above advice is not going to solve the problem of reducing risk to an acceptable level during a secular bear market for stocks. Here's why.

Buying and holding. If the previous pages haven't told you why this a very bad idea, then you probably should go to another web site and not "waste" any more of your time here. To be fair, if you are younger than 35 or 40 and not expecting to retire for another 25 or 30 years, then buying and holding is a reasonable approach. Your investment horizon is long enough that you will be able to reap the gains from the next secular bull market, and you will have the benefit of not needing to pay a whole lot of attention to your investments. Even so, you will do better and have more financial assets and possibly be able to retire sooner if you adopt the solutions to bear market investing presented later.

Dollar cost averaging. This popular approach is promoted to those who are making regular investments. This is usually the case in a 401(k) or similar plan when some percentage of the employee's salary is contributed to the plan each month or quarter. The attraction is buying more more shares of the stock or mutual fund when the price has dropped and fewer when it has gained. Assuming the stocks are higher when it is time to sell, those additional shares will have gained more. Another advantage is the discipline of regular investing.

There is merit in this concept, particularly if it is going to be a long time until you will need to sell. In that sense, it is similar to buying and holding. However, if you need to sell before stocks recover and start making new highs, dollar cost averaging is not going to remove the substantial risks, and it could end up costing you quite a bit.

Each individual's particular investments, holdings, and contribution amounts are different, so your situation may not be at all like the illustration that follows. However, it will illustrate the devastation that a severe drop in stock prices can bring to carefully devised plans.

The S&P total return index is assumed to be investment vehicle. At the end of 1999, suppose that one has $10,000 in this investment and that $100 will be added at the end of each month. These might be amounts typical for someone who had been participating in a 401(k) or similar retirement account program for several years. The table shows the value of the account at the end of each quarter and how the account value compares to the amount invested. That assumes $10,000 invested at the end of 1999, and in effect by holding on and not selling at that time, one is in the same position as another who buys in at that date.

Dollar Cost Averaging Example

End of     Amount      Account   Percent
Month      Invested    Value     Change

Dec-1999   10,000      10,000      0.0%
Mar-2000   10,300      10,546      2.4%
Jun-2000   10,600      10,568    - 0.3%
Sep-2000   10,900      10,760    - 1.3%
Dec-2000   11,200      10,211    - 8.8%
Mar-2001   11,500       9,278    -19.3%
Jun-2001   11,800      10,117    -14.3%
Sep-2001   12,100       8,908    -26.4%
Dec-2001   12,400      10,169    -18.0%
Mar-2002   12,700      10,501    -17.3%
Jun-2002   13,000       9,379    -27.9%
Sep-2002   13,300       8,038    -39.6%
Dec-2002   13,600       9,010    -33.7%
Mar-2003   13,900       9,025    -35.1%
Jun-2003   14,200      10,722    -24.5%
Sep-2003   14,500      11,305    -22.0%
Dec-2003   14,800      12,994    -12.2%
Mar-2004   15,100      13,511    -10.5%
Jun-2004   15,400      14,048    - 8.8%
Sep-2004   15,700      14,089    -10.3%
Dec-2004   16,000      15,701     -1.9%
Mar-2005   16,300      15,660     -3.9%
Jun-2005   16,600      16,179     -2.5%
Sep-2005   16,900      17,065      1.0%
Dec-2005   17,200      17,725      3.0%
Mar-2006   17,500      18,771      7.3%
Jun-2006   17,800      18,798      5.6%
Sep-2006   18,100      20,171     11.4%
Dec-2006   18,400      21,826     18.6%
Mar-2007   18,700      22,263     19.1%
Jun-2007   19,000      23,960     26.1%
Sep-2007   19,300      24,755     28.3%
Dec-2007   19,600      24,214     23.5%
Mar-2008   19,900      22,216     11.6%
Jun-2008   20,200      21,893      8.4%
Sep-2008   20,500      20,316    - 0.9%
Dec-2008   20,800      16,172    -22.3%
Mar-2009   21,100      14,703    -30.3%
Jun-2009   21,400      17,350    -18.9%
Sep-2009   21,700      20,370    - 6.1%
Dec-2009   22,000      21,912    - 0.4%
Mar-2010   22,300      23,403      4.9%
Jun-2010   22,600      21,010    - 7.0%
Sep-2010   22,900      23,697      3.5%
Dec-2010   23,200      26,522     14.3%
Mar-2011   23,500      28,393     20.8%
Jun-2011   23,800      28,717     20.7%
Sep-2011   24,100      25,016      3.8%
Dec-2011   24,400      28,255     15.8%

The percentages on the right depend strongly on the ratio of the monthly contributions ($100) to the value of the account at the beginning ($10,000), which is 1%. An older employee who had been building value for a long time might have a smaller ratio, and the percentages in that case would be worse. A younger participant with a low (or zero) beginning value would fare better.

The total return index has fallen more than 40% below the end of 1999 value during the two severe drops. Even at the market's highs in 2007, the compound annual rate of return for the total return index was less than 3%. Taking the monthly contributions in the example into account, the "internal rate of return" did not get much above 4% at the market's peak. Even at that point owning T-Bills or a money market fund would have done almost as well with virtually no risk.

The plunge in 2008 shows how dollar cost averaging provides very little help in down markets. Even after more than nine years of contributions, in the example there was less than 70% of the total invested at the end of the first quarter of 2009. The strong rally since then, with a few bumps in the road, has helped, but not all that much. The compounded annual rate of return of the 15.8% in the table for twelve years is a whopping 1.2%. To keep up with the growth in the Consumer Price Index, an investor needed to earn 34% over 2000-2011, a modest 2.5% compound annual rate, but dollar cost averaging has not even met that standard. It is not going to provide enough help during a secular bear market.

The table shows that dollar cost averaging can help, particularly after the stocks bounce back after a sharp decline as was the case in late 2007. That's great if you need the money when stock prices are high, but as the severe plunges in 2001-03 and 2007-09 show, it is a far worse and quite different story if you want or need the money after stocks have fallen. In any case, wouldn't it be even better to be out of the market when the risks of losses are relatively high? Of course it would. The key is identifying the most dangerous periods, and the models discussed later do just that.

Diversification is an effective risk reduction tactic to the extent that it reduces the investments in the worst performing assets during various time periods. In other words, you shouldn't put your eggs all in one basket. To the extent the performances of the various assets are not correlated, the equity curve over time will show less fluctuation, so called "smoothing" of the curve. That is usually considered to be a good thing since reduced downward movement means less risk.

Your overall and retirement investments should be diversified to some extent. The particulars depend on each individual's financial situation. In fact, your allocation among asset classes is likely to be the most important determinant of your long-term investment returns. In practical terms, that means those who are nearing or in retirement most likely should reduce the percentage of holdings in volatile assets such as most stocks and increase the portion in low volatility holdings such as money market funds and short-term bonds. The trade-off is that the expected long-term returns will be lower, but there is a point where protecting one's equity is much more important than trying to grow it by a large amount.

That being said, the effectiveness of diversification depends quite a bit on the asset classes not being highly correlated. One problem is that the correlations can vary quite a bit over time. For example, overseas stocks used to be considered effectively diversified from domestic equities. The most common measure for foreign stocks is the Morgan Stanley Europe, Australia, Far East (EAFE) index. For the past few years, that index has shown the same general pattern as the S&P although it has gained more after making lows in Fall 2002. Moving some of one's investment in stocks to it would not have provided much in the way of divesification and risk reduction. In 2008, overseas markets generally fell as much or more than the U.S. ones. One old saw containing a lot of wisdom is that in a bear market the only things that go up are correlations. In other words, diversification is likely to fail just when it is most needed.

On the other hand, bonds historically have moved in the same direction as stocks but with less volatility. The reason is that rising interest rates, which result in falling bond prices, usually occur as the economy is nearing the end of an expansionary period, and stocks tend to fall in anticipation of the coming recession. That relationship is far from perfect, but it is more reliable than most intermarket correlations. However, stocks peaked in 2000 just as the Federal Reserve Board began cutting short-term interest rates. As things turned out, the economy weakened despite the rate cuts and stocks fell accordingly in conjunction with the bursting of the bubble in technology issues. However, bonds gained as interest rates dropped. That meant bonds provided more diversification recently than they have historically. Nonetheless, buying and holding bonds or bond mutual funds, while not as risky as following that policy with stocks, still entails important risks. The financial crisis in 2008 led to a two-headed bond market as Treasury issues gained rapidly as the Fed cut interest rates and there was a general "flight to safety." In contrast, corporate bonds, even quite secure ones, fell as fears that many firms would, like many banks, run into severe problems. Later, we will see how that risk can be greatly reduced by employing a model that identifies when the risks of owning bonds are at higher levels.

The better writers and analysts make the point that rebalancing your portfolio periodically is important to maintain diversification. This is sound advice. It prevents becoming too concentrated in the asset classes that have gained the most recently, which are usually the most volatile and risky ones. It also sets up a discipline of selling things that have gone up to buy things that have not performed as well. Since asset class values, as opposed to individual securities, tend to ebb and flow, that is beneficial although many find it hard to do. There is no magic time interval for rebalancing, but it should be done at least once a year, and more often if the relative asset class holdings vary considerably from their targeted percentages. Rebalancing helps a little, but it is far from being an answer to avoiding the lurking danger during a secular bear market.

By now you should understand why traditional investment methods pose a great risk to your retirmenet plans. On the next page, we will begin to discuss the solution to this important problem.

Next page: avoiding the danger

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