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Investing successfully in a bear market

By Carrie Coghill, CFP

In a down stock market, such as we’ve been experiencing for several years, the first instinct of too many investors is to abandon the picnic basket to the bears. In financial terms, that means they rush out of the stock market to the seeming shelter of bonds, T-bills or cash. It’s a classic case of what financial professionals call “chasing performance,” leaping for a ship that may already have sailed. There’s a better way to prosper when the stock market is sluggish or giving ground: a well-considered policy of asset allocation pointed for the long term.

Asset allocation requires a long-term presence in a mix of asset classes and subclasses, including growth stocks, value stocks, bonds, T-bills, real estate and cash, along with frequent portfolio rebalancing. Asset allocation does not employ market timing, which might be considered a diametrically opposite approach.

Market timers try to predict market highs and lows and get on the sunny side of the swings, a nearly impossible task. We’re inundated with market timing advice from pundits and newsletters, but if these gurus truly knew how to time the market, they wouldnhave to peddle newsletters. While many people may agree with this intellectually, bear markets can quickly transform rational asset allocators to fidgety market timers. Investors who originally set their investment horizons at 10 years or longer begin to analyze their portfolios on a monthly or even weekly basis. This always gets you in trouble because in the short term, performance is exaggerated. During expansions, your expectations soar too high; in recessions, you expect too little.

Trying to time market swings is a classic investor mistake during bear markets. Another is hunkering down and refusing to make portfolio changes. Certainly, you don’t want to adjust just because a sector is out of favor, but you do want to assure that you own quality. In a time of excess gains or a “bubble” environment, not all companies will match the market’s exuberance. Some, due to such fundamental weaknesses as weak market share or exorbitant product costs, may lag the market. In recessions, on the other hand, some otherwise solid companies may be forced into unexpected bankruptcy due to lack of growth. Still others will fold because of unstable foundations. We saw this when the dot.com boom dot.went, showing just how speculative many Internet and technology companies were. In bear markets, it’s vital to shed shaky stocks and reinvest your dollars for the long term.

A third classic investor mistake during bear markets is converting all or most assets to cash as a presumably safe haven. On the surface, this seems a prudent strategy, since cash isn’t actually losing money. But if cash assets are earning you two percent, and inflation is running at 4.8 percent—its actual average rate over the past 25 years—your seemingly safe investments are losing you considerable buying power. Moreover, market recoveries happen quickly. You don’t want to be exclusively in cash when the rebound begins.

It may seem axiomatic to say it, but long-term investing works over the long term. Over the short term, anything can happen. Consider the typical business cycle which, as it relates to the stock market, usually consists of three phases. The first is expansion, when the economy is growing and taking stock prices with it. As with all market phases, the pendulum usually swings too far, resulting in overheated stock valuations.

The second phase is recession, when the economy cools and stock prices plunge. Here again, market movement is excessive, and stock prices decline to an undervalued level. In the business cycle’s third phase, recovery, investors again begin to look forward to increases in corporate earnings and a corresponding bounce in stock prices. Stick with your investments throughout the business cycle and you may well be rewarded for your patience. Try to chase the ebbs and flows of the cycle and you’re in a dangerous guessing game.

If you doubt the importance of a long-term approach, look at the performance of actual bear markets. We’ve experienced 10 such phenomena since World War II, excluding the current bear market that began in March 2000. The average market decline has been 20.8 percent, a worrisome enough figure. But one month after the market bottomed out, the average recovery was 10.6 percent. After three months, the average recovery was 14.7 percent; six months after bottom, the average recovery was 23.1 percent. Finally, investors who held on were rewarded with an average 34.8 percent recovery 12 months following the bottom.

It should be noted that these statistics represent the S&P 500 index only; the performance of any portfolio will be dictated by its specific asset mix. The S&P 500 index is unmanaged and not available for direct investment by the public. This index is based on the average performance of the 500 industrial stocks monitored by Standard & Poor’s. In addition, past performance is no guarantee of future results. Nevertheless, experience strongly suggests that in bear markets, patience pays.

How, then, should you invest, and what should you expect in a bear market? Consider these the three fundamental principles of bear market investing:

• Own quality.

• Don’t be afraid to invest in struggling sectors. If you’re investing for the long-term, you want to employ a system of buying low.

• Reallocate your portfolio regularly to reflect an emphasis on diversification and long-range thinking. Don’t get greedy. As the market recovers, take profits on a systematic basis. If the market keeps rising as you engage in rational profit-taking, so what? When you’re happy with your results, it doesn’t matter what the broader market is doing.

History shows that a diversified portfolio has yielded average annual growth of eight to ten percent. Years of spectacular growth will help even out your portfolio returns during bear markets. Don’t let your expectations be distorted by those years of uncharacteristic gains; they’re just as aberrant as years of dismal loss.

A successful asset allocation strategy requires a commitment to keep a designated percentage of assets invested in their respective classes, regardless of the current performance of those classes. Inevitably, some asset classes and subclasses perform better than others over the short term. But today’s underperformers typically are tomorrow’s stars.

You can see a dramatic illustration by looking at the annual returns of the Russell 2000 Growth Index and the Russell 2000 Value Index. For example, in 1999, the Russell 2000 Growth Index was positive by 43.09 percent. On the other hand, during the same year, the Russell 2000 Value Index was negative by -1.48 percent. The following year, 2000, the Growth Index was negative by -22.43 percent, while the Value Index was positive by 22.83 percent.

Keep in mind that all Indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results. Russell 2000 Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. Russell 2000 Value Index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.

What’s very clear is that growth and value stocks don’t necessarily move in tandem, and that declines in one subclass can be offset—and more—by gains in the other. A successful, diversified portfolio needs both categories—and many others. That’s the best way to tame the Bear.

Carrie Coghill, CFP is president of D.B. Root & Company, a Pittsburgh financial planning firm, and a registered representative with Commonwealth Financial Network.

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