The large declines in global stock and bond markets reflect a lack of confidence in the financial system that has its roots in failed U.S. home mortgages. Credit has become extremely difficult to obtain, as banks unable to sell non-performing assets shun new business loans and hoard cash.
The large declines in global stock and bond markets reflect a lack of confidence in the financial system that has its roots in failed U.S. home mortgages. Credit has become extremely difficult to obtain, as banks unable to sell non-performing assets shun new business loans and hoard cash. An unprecedented infusion of capital from the government has had little effect so far in breaking the logjam. However, much of the government’s actions are yet to be implemented. So it is still too early to tell what ultimate benefit these bailout packages will have.
Wall Street’s woes have become Main Street’s as individuals watch their home values decline and retirement accounts shrivel. Physicians, especially those nearing retirement, are naturally concerned about the impact on their portfolios.
What should you do about it? Should you change your asset allocation?
The short answer is that you should not make an emotional decision based on current events. Try to remain even-tempered and steadfast in your discipline. In rough seas — and we are certainly there now – stay the course.
The Market Drop in Perspective
America has gone through several financial crises over the last century. Granted, this crisis seems bigger than most. To put this crisis in proper perspective, it’s important to look back at the last 35 years to determine how the stock market was affected by other credit crises:
1973 — 1974 S&P 500 down 38%
U.S. goes off gold standard and dollar plunges
1980 — 1982 S&P 500 down 27%
Mortgages hit 20% as inflation reaches 15%
1987 — 1988 S&P 500 down 33%
The Dow falls 21% on Black Monday in October
1990 — 1991 S&P 500 down 19%
Oil prices skyrocket as Iraq invades Kuwait
1998 — 1999 S&P 500 down 18%
Credit markets freeze on Russian loan defaults
2000 — 2002 S&P 500 down 49%
Technology stocks crash, then 9/11 attacks
The S&P 500 is down about 50% from its high point in October 2007. The decline is large, but not that much greater than the 2000 — 2002 bear market. It just seems larger this time because the decline happened in half the time. For comfort, recall that stocks bounced back more than 30% in 2003. No one has knowledge of the future or the ability to look into a crystal ball to see when the market will turn around, but history tells us that after a steep decline the market often turns up very quickly and without a definitive reason. The lesson for investors is that they do not want to be out of the market when this occurs.
Should you change your strategy?
Investors should not become emotional about their portfolios. The stock market can take investors on a roller coaster ride in the short term. However, in the long term, markets tend to provide returns in balance with the risks. Changing your asset allocation is a major decision and can be compared to changing careers. There are several good reasons to change your asset allocation along life’s journey but doing so requires deep thinking and even-handed judgment. Changes should not be made in a time of duress.
There are three good reasons why an investor should make an asset allocation change:
1) Your target retirement goal is well within reach.
2) You realize that you will not need all your money during your lifetime.
3) You have realized that your tolerance for risk is not as high as you thought.
Consider a reduction to risk when you are within reach of your financial goal. That is the time to take your foot off the gas pedal and move into the middle lane. For example, assume you wish to retire in three years with $2 million in retirement savings. If you already have $1.8 million, the rate of return you need to achieve your goal does not require a high-risk allocation. It might be time to permanently lower your equity exposure because you no longer need to take as much risk.
Secondly, a change to your allocation may be appropriate if you realize that you will not outlive your money. In that case, you are investing part of your portfolio for yourself and another part for the needs of those who will inherit your wealth. Your overall asset allocation should reflect the needs of both parties. Assume you have $2 million in retirement savings. Your needs may be covered by $1 million of that amount, which is allocated to 30% stocks and 70% bonds. The second $1 million will be passed on to your heirs. Since heirs tend to be younger, they can be more aggressive. That portion receives a 70% stock and 30% bond allocation. Put together, an appropriate allocation for your portfolio is 50% stock and 50% bonds.
The Final Reason
The final reason to change an allocation would be because you have taken on more risk than you can handle. If you are not sleeping at night because you are worried sick about your portfolio and you are on the verge of taking the rash step of selling everything, then reduce your equity position by 10%. Give that reduction some time. If you are still having emotional reactions, reduce by another 10 %. The portfolio has an appropriate level of risk when you are able to think clearly. Once you find this level of risk, stay there, even when the market recovers. We do not know when the market will stabilize or at what point, but we do know there are many excellent companies selling at very low prices and rebalancing takes advantage of these opportunities.
Times may be uncertain, but this crisis is not the end of free enterprise or the capital markets that our great nation was built on. In fact, the U.S. dollar has strengthened through the crisis, and that means we are expected to emerge as a stronger nation because we are facing this challenge and dealing with it.
Richard A. Ferri is founder and CEO of Portfolio Solutions, an independent, SEC-registered investment advisory firm offering low-cost, professionally managed investment portfolios. Ferri holds an M.S. in finance and is a Chartered Financial Analyst (CFA). He has published five books and numerous articles on low-cost investing using index funds and exchange-traded funds.