Managing your investments in a bear market
Casey Stromer, financial adviser with Edward Jones in Santa Rosa, collects doomsday warnings about the economy. He shows me newspaper headlines and predictions, dating back to 1974, which point to “a severe recession ahead”; “Maybe a depression!”; and “The DOW will drop to below 1,000.” These predictions have one thing in common: They were all wrong. (In fact, the prediction that the Dow Jones Industrial Average [DJIA] would drop to below 1,000 was followed within days by the beginning of the strongest bull market in history.)
Stromer’s favorite is a 1998 San Francisco Chronicle morning headline that screams, “Panic hammers markets: DOW falls 513 points.” Turn the laminated front page over, and you’ll see the afternoon Examiner: “Stocks bounce back: up 288 points.”
He goes on to produce a chart showing that, historically, when consumer confidence was low, the DJIA rose impressively in the year following. Of course, all that’s hindsight, which is why no investment adviser will ever guarantee big returns if you invest when consumer confidence is low. There’s always a first time.
Since early October of last year, when the DJIA reached its historical peak at 14,165, it’s dropped about 29 percent, to below 10,000, in early October. That’s a far cry from the Great Depression, when the market lost 90 percent of its value and didn’t fully recover the loss until 1954—but it’s well into bear market territory (defined as a loss of 20 percent or more in market value for at least two months).
If you’re nervous about your investments or the economy, you’re not alone. Investment advisers are increasingly getting phone calls from worried clients. “Beginning in September, we’ve had more calls than we did during the downturn in 2000 and 2002,” notes David Wood of Wood Wealth Management in Santa Rosa. He attributes this to the fact that today’s downturn is more far-reaching than the tech bubble of 2000. “Now it has to do with gas prices, the housing market and the declining value of the dollar. Everything is taking its toll on the consumer pocketbook,” he says.
What should an investor do?
Consumer confidence, as measured by the Conference Board (www.conference-board.org), is hovering around 50 percent, the lowest since the early 1990s. And, says Petaluma’s Jim Alexander, a certified financial planner and registered representative with Foothill Securities, the media tends to help this process along by overplaying both the market’s upside and its downside. Clients want to know what they should do, if anything. We asked several financial advisers from the North Bay to weigh in.
“There are a couple of things that are important for investors to remember,” says Mary Witwer of Bell Investments in Santa Rosa. “One is, for most investors—actually all investors in the equity market—it’s important to maintain a long-term perspective.” (For all practical purposes, “equity market” means the stock market.)
Witwer believes that, historically, equity markets are where people get the best long-term returns. This means now’s the time to hang on to what you have, or even invest more. Both Witwer and Stromer agree: A bear market can be an excellent time to buy. “Everything is on sale,” she points out.
Stromer concurs. Recently, he remembers, a client arrived carrying an expensive, top-brand purse. Stromer asked her, “If you’d walked into Macy’s and that purse was selling for 20 percent off, would you have said, ‘Oh, I don’t want to buy that purse, because there must be something wrong with it’?”
“Of course not,” she answered.
“Well, that’s the same thing as the market,” explains Stromer. “If you find a quality investment that happens to be trading at a discount, there’s no reason not to buy and take advantage of it.”
Of course, advisers agree, if you have some long-term losers, it might still be better to trade them in for something else. Do you still own stock in that buggy-whip company?
Tax loss harvesting
Suppose you have losing stocks right now. There’s another thing you can do, says Theo Gallier, chief investment officer at Salient Wealth Management in San Rafael. If the stocks are taxable, you can sell them and take a loss on your next tax return. “This is called ‘tax loss harvesting,’ meaning to sell out and realize the tax losses,” says Gallier. (This doesn’t apply to non-taxable investments, like IRA and 401k accounts.)
But, he continues, don’t keep the money in cash—buy an equivalent amount of similar stocks right away. After 31 days, you can legally swap those substitute stocks for the same ones you sold and still keep your tax loss. Or, if you prefer, you can hang on to the substitute stocks. The point is, stay in the market.
Not all advisers agree. Paul Krsek, chief investment officer of K&A Asset Management in Napa, believes it’s too much to ask investors to stand by while their investments lose value. “There’s an old saying, ‘Sell until you can sleep,’” he says. “If you can tolerate these big swings, I would advise to keep buying.
Somewhere, you’re going to find the bottom, and eight to 10 years from now, you’re probably going to be very happy you had the courage to buy. But most people don’t have the stamina; they don’t want to experience the volatility and the losses.
“After 10 years of the market going nowhere, we get people being told, ‘Just hang in there and everything will be OK.’ The Dow was at about 11,000 in 1999, and it’s at about 11,000 today [as of September]. If you’ve bought and held through that whole time, you probably haven’t made any money.”
Allocate your assets
That’s why many financial advisers recommend not having all your assets in stocks. Asset allocation—dividing your assets between stocks, bonds, commodities and cash—can protect you from market extremes. A good investment adviser will steer you toward assets that go up or down independently of each other. Commodities such as corn, wheat, coffee, copper, gold and crude oil; fixed-income assets such as bonds; and cash are all things that don’t strongly follow the stock market’s ups and downs.
How much you allocate to each asset should be the subject of a conversation between you and your investment adviser. The answer will depend on your long-term goals and your appetite for risk. The less risky your investment, the more slowly it’s likely to grow. The conventional wisdom is that, as you approach retirement, you’ll want less risky investments, such as a higher proportion of bonds. But this philosophy is changing as people live longer after retiring.
That’s why it’s important to know your long-term goals and follow them. Are you preparing for retirement in 10 years? Thirty years? Are you saving for a child’s college education? An aging parent’s care?
Diversify
Another important element of a good portfolio is diversification. Putting all your money into one stock is risky, no matter how “safe” it seems, because your success is riding on that one investment. Putting it into two stocks decreases your risk by half, but to really diversify means to invest in a true variety—foreign and domestic, large and small, growth and value. You don’t want all telecom stocks or all energy stocks or all growth stocks, for instance. This is where mutual funds come in handy, because your investment is automatically distributed over a variety of stocks.
Once you have your portfolio, you need to make decisions about how to manage it. Investment advisers like Witwer, Gallier and Krsek are discretionary managers, meaning they’re authorized to make decisions about their clients’ accounts. Other kinds of advisers, who don’t have discretion, must call you with suggestions, and you make all the decisions.
Choosing a financial adviser
How can you be sure to choose an investment adviser you can trust? Ask to see the prospective adviser’s investment track record over a period of years, and stay away from an adviser who’s not willing to do this, says Witwer, who also counsels to seek out a registered investment adviser. They’re legally required to act as a fiduciary for their clients—that is, to put your financial benefit above any personal interest they may have. For instance, an adviser may receive a commission for selling one fund and none for another. All else being equal, a fiduciary adviser may not arbitrarily substitute the one he or she gains from for the other fund.
Says Wood, “Choose someone who’s independent and fee-based, who’s been in the business for several years. This will ensure the adviser has experienced both good and bad markets.” Commission-based investment advisers earn a commission every time you buy something, while a fee-based adviser receives a small advisory fee based on the client’s account balance.
When to change your portfolio
If your long-term goals change, talk to your financial adviser. You may want to change your portfolio to reflect that. A divorce, death in the family, job change or change in a child’s college plans might require a change in your long-term investment goals.
Because some assets grow faster than others, a portfolio may get out of balance over time. Gallier recommends rebalancing your portfolio when it gets more than 25 percent out of balance. For example, say your assets are allocated 20 percent to bonds and 80 percent to stocks. In a bear market, your stocks are likely to lose value faster than your fixed-income bonds. At some point, your allocation may shift from 20-80 to, say, 30-70.
By moving from 20 to 30 percent of total assets, the bond allocation has increased by one-third, or 33 percent. The appropriate action would be to sell some of the bonds and buy more stock to bring the allocation back into balance.
Above all, avoid making short-term decisions that conflict with long-term investment goals, says Alexander. “I can’t tell you how many people were telling me three years ago, ‘Oh, Jim, we have to sell everything and go into the real estate market. The real estate market is never going to go down!’”
But don’t smart investors know how to time the market to increase their profits? Check the Internet, and you’ll find pages and pages devoted to figuring out what the market will do next and profiting from it. The fact is, very few professionals claim to be able to time the market—and historically, those who try to time it don’t do as well as those who don’t. Savvy advisers use various analyses to make general predictions about the direction of the market, but those who try to second guess an individual stock’s performance usually have a lower profit margin.
All about bonds
Chances are, your balanced portfolio will include some bonds. When you buy a stock, you’re buying part of a company. When you buy a bond, you’re making a loan to a company. When a company issues a bond, it sets whatever interest rate it feels will attract buyers, usually based on a par value (basically, the stated or face value) of $1,000. If that interest rate is 5 percent, you’re going to earn 5 percent for each bond you buy.
But the price of that bond may fluctuate. For instance, if interest rates go down, that 5 percent yield will be more attractive, so the price of the bond may go up to $1,050. If you buy the bond at the higher price, you won’t get your full 5 percent per $1,000 interest. If interest rates go up, or if the company is in financial trouble and there might be some risk of a default, the price tends to go down (say, to $987). If you take the risk and buy these bargains, your effective interest rate per $1,000 will be higher than 5 percent.
“Junk bonds” are typically low-rated, risky bonds that pay high rates. Federal bonds, on the other hand, are backed by the taxing power of the U.S. government. Conservative investors are willing to accept lower interest rates because these bonds are considered very safe. Bonds are issued by state and city governments as well.
The human element
Neuroeconomics, which attempts to understand how emotions and thought errors influence investors’ decision-making process by conducting experiments in financial choices, is a subset of the behavioral finance field. In one experiment, people were invited to gamble with a chance to win $125 or lose $100. Even though the win was greater than the loss, most people declined to gamble, because people’s fear of loss is typically greater than their pleasurable anticipation of gain.
It’s called “loss aversion” and, in investing, this fear plays out as a reluctance to sell a stock for less than you paid for it, even if the stock is clearly a poor performer over the long term. On the other hand, selling a stock for more than you paid for it is so pleasurable that people may make an unwise decision to sell.
Perhaps one reason economics is called “the dismal science” is that it’s predicated on a completely rational, self-interested model of human behavior. This “ideal human” became known among economists as Homo economicus, and he turned out to be a fairly good predictor for normal market activity. But he didn’t explain bubbles, crashes or other market anomalies.
Then a bunch of economics, psychology and neuroscience professors from Princeton, Stanford and the University of Chicago began to take a clinical look at the less rational aspects of human decision-making. Neuroeconomists put people into MRI machines and gave them economic choices to make. They found that different types of choices caused activity in different parts of the brain. In general, they discovered a fair amount of activity in the amygdala, a part of the brain associated with emotions, and in other parts of the brain associated with fear and decision-making.
Several principles of human behavior emerged from these studies. One is that investors as a whole are overconfident, especially in a bull market (defined as a market associated with increasing investor confidence, optimism and expectations that strong results will continue). When it comes to investing, we often see ourselves as the children of Lake Wobegon—all above average. And this belief in our own shrewdness in picking stocks might cause us to make decisions based on limited information (or a “hot tip” from an acquaintance). Overconfident investors also tend to buy and sell more often than less confident or more financially educated investors.
What’s more, individual investors are apt to favor stocks they have a personal connection with. That’s why, against all logic, many employees buy only their employers’ stock instead of diversifying; residents buy the stock of local businesses; family members buy a particular stock because Uncle Ned or next door neighbor Sally has some.
Resist the impulse, say most analysts, to buy stock under these circumstances.
Lone investors lose out
Trading stocks individually is a sure way to lower your return from the stock market. A 1987 to 2006 study of individual investors found they made an average 3.7 percent return on their investment—just above the inflation rate. If they’d simply invested in Standard & Poor’s index funds, they would have made 11.8 percent.
An analysis of thousands of stock trades over a six-year period (between 1991 and 1997) also yielded some interesting results. On average, men trade stocks more than women do…and they do more poorly in profits than women. This may be related to other studies that suggest men in our society are generally more self-confident than women. Also at risk are people who’ve made a tidy profit in a recent stock sale, because they’re especially prone to turn their profits to risky investments. Stromer calls this type of investment, “Reno money.” The good news is, being aware of these emotions can help people make better investment decisions.
You can tell when a market is nearing its peak, says David Brown, a principal of DKB Wealth Management and registered principal with LPL Financial, because that’s when you start getting stock tips from cab drivers. Conversely, investors tend to become overly fearful during a bear market. “When everyone’s saying the stock market is done for—it’s never going to come back—that’s probably the best time to invest,” he says.
In a December 14, 1996, article in Financial Times titled “Get Smart…and Make a Fortune,” super investor Jim Rogers wrote, “It is learning to listen to the gloom and doom at bottoms and question it, and to the exultation at tops and question this as well, that makes a sharp investor.”
Behavioral finance studies also find that people tend to base their actions on what they know. Often that means buying whatever stocks are in the news at the moment. When you consider the thousands of stocks available, this isn’t a rational approach—unless you have the stamina and time to explore every one of them.
With all the turmoil in the economy—wildly fluctuating oil prices, the collapse of the housing market due to subprime lending, and the globalization of the market—it’s easy to believe we’re in uncharted waters, financially. But that’s an old story. The truth is, each new market has always brought with it those who say, “This time it’s different; this time the old rules don’t apply.” And each time, the same old principles of investing eventually carry investors through the turmoil and out the other side. Odds are, they’ll do so again.
