The wisdom of investing in a smorgasbord of categories rests on the premise that something always works. U.S. stocks in a funk? Buy bonds and foreign stocks. The dollar is plunging? Offset it with income funds from countries with strengthening currencies. Worried about inflation? Add oil, gold and other commodities.
This strategy, which is known as diversification, rescued many an investor during the 2000-02 bear market. Even during the free fall of major U.S. stock indexes -- which tilt toward large companies -- bonds, small-company "value" stocks and real estate investment trusts made money, enabling investors with well-blended portfolios to avoid catastrophic damage.
This time, though, it really has been different. Aside from Treasury bonds, other cash-like investments and bank accounts, there have been no shelters from the storm. From dividend-paying blue chips to speculative small-company stocks, from long-term municipal debt to high-yield junk bonds, from real estate to commodities, virtually everything tanked. Even gold, the prototypical safe haven, saw its value decline. The average precious-metals mutual fund crumpled 51% in 2008 through November 7.
Some new ideas, such as foreign REITs, also failed miserably. Ditto for newly issued shares of private-equity companies, which promised growth plus high dividends from debt-fueled takeovers. And it turned out that real estate and banking failures in the U.S. did undermine rapid growth in developing nations such as Brazil, China and India. The idea -- or the desperate hope -- that these countries had grown so self-sufficient that they could prosper despite U.S. economic problems is as half-baked as it ever was.
Volatility here to stay
There is no immediate relief in sight from treacherous markets. Although Kiplinger's believes that U.S. stocks will end 2009 in the black, the market could fall another 10% to 20% before investors begin to anticipate an improving economy later in the year or in 2010. Terrifying daily swings will likely remain a constant.
Still, there are no certainties when it comes to forecasting markets. As unlikely as it may seem, stocks could surprise everyone and soar by 30% over the next year. But if you don't want to take a risk on the market, what then? You could forswear stocks and bonds and become a lifelong saver, although we don't recommend putting all your money in bank accounts and money-market funds. After inflation and taxes, and given today's low interest rates, this approach is a guaranteed loser over the long haul.
Your real decision, the way we see it, is between two different approaches to diversifying and managing your investments. The first, the traditional approach, is the one that worked so well during the 2000-02 implosion. In this scheme, you spread your money among as many as a dozen categories: stocks of big growth companies, small growth companies, bargain-priced large companies and undervalued small companies; shares of companies in developed foreign nations and emerging-markets stocks; and REITs and commodities. Add to that a variety of bonds with a wide range of maturities and issuer quality. Every so often -- say, every six months -- the traditionalist rebalances, buying more of the laggards and trimming those categories that have performed relatively well.
The nontraditional strategy is more daring. It requires more kinds of asset classes and a willingness to shift among them more frequently. ItUs a strategy that Jeff Seymour, managing director at Triangle Wealth Management, in Cary, N.C., calls "active, opportunistic and defensive." A leading advocate of the strategy is Mohamed El-Erian, co-chief executive and co-chief investment officer of Pimco, the well-known manager of bond funds. El-Erian believes that an investor who seeks to earn 8% to 10% annualized in coming years without taking undue risk will need to assemble a portfolio that has no more than one-third of its assets in U.S. stocks and the rest in real estate, precious metals and other commodities, foreign bonds, and European, Japanese and emerging-markets stocks. A return that good would be a fabulous outcome. But El-Erian's approach would also fall outside the comfort zone of millions of U.S. investors.
If the recession and bear market play out as previous downturns have, stocks are probably nearing a bottom. The economy should begin to grow again, albeit tepidly, in the second half of 2009 (see Outlook 2009). If that is the case, the bear market should end in the first half of '09 because stocks usually lead the economy by three to six months. Other economies and markets closely linked to the U.S., such as Canada, Japan and Western Europe, should revive as well.
Another reason to think we're closer to the end rather than the beginning of the bear market is the sheer ferocity of what has already struck us. Since World War II, the average bear market has lasted 15 months and slashed 29% off U.S. share prices. The current descent, which started in October 2007, has already lasted about that long and (through November 7) chopped 41% off Standard & Poor's 500-stock index. The rout is within shouting distance of the nearly 50% declines of the two worst post-World War II bear markets, 1973-74 and 2000-02.
If the past is indeed prologue, says Bruce Primeau, of Wade Financial Group, in Minneapolis, it makes sense to stick with the familiar. Long-term investors should keep 60% to 80% of their assets in U.S. stocks covering a variety of categories, including large companies, small companies, growth stocks and value stocks. Surround this "core" with funds that invest in developed foreign markets and in emerging markets, and reserve 10% to 20% for REITs, short-term or intermediate-term bonds, and cash reserves. Don't invest in anything that seems odd or unfamiliar, such as bond funds that invest heavily in derivatives. "At times like this, there's usually more risk in new ideas," says Primeau.
But what if a long, severe recession results in the worst down market since the 1930s? A cataclysmic 89% decline like the one at the start of the Depression is inconceivable. But suppose the U.S. market fell 65% from peak to trough, sending the Dow Jones industrials to about 5000. Unable to endure more pain, many if not most investors would surely bail out of stocks and safeguard whatUs left in low-yielding cash instruments.
And even if stocks stop falling soon, they may not earn their historical 10% rate of return in coming years because of worldwide deleveraging -- the process, by governments, businesses and individuals, of paying down debt. That trend implies lower corporate profit margins and slower earnings growth, and it "is damaging to future returns," says Ron Roge, a money manager in Bohemia, N.Y. So why go overboard on stocks if they're destined to deliver substandard gains?
The alternative is to ease up on stocks, bulk up on low-risk investments and get ready to shift gears when the economic picture brightens. Under the nontraditional approach, put no more than 50% of your portfolio in stocks, with an emphasis on utilities and other high-dividend payers.
Consider, for example, shares of pipelines, which in early November generally yielded 8% to 10%. The cash flow they distribute comes from fuel-transportation charges and is independent of oil-and-gas prices (although cheaper gasoline prices generally mean more volume). One good choice: Magellan Midstream Partners (symbol MMP (opens in new tab)). You could also add a fund, such as Hussman Strategic Growth (HSGFX (opens in new tab)), that gives its manager the flexibility to sell stocks short as well as to own them.
Add some high-quality corporate bonds and short-term or intermediate-term Treasury IOUs (both standard and Treasury inflation-protected securities). If you're in a high tax bracket, take advantage of today's extraordinarily high yields on tax-free municipal bonds. Build up a cash position, too. Then, if the economic cycle turns out to be like those of the past, you can turn traditionalist later and put more money to work in stocks, real estate or whatever else appears to be a bargain.
Round out your portfolio by putting 10% in commodities. Stuff took a beating in 2008 because a decline in global growth dampened demand for steel, coal, corn and other commodities. But commodity prices wonUt always be so closely correlated with stocks.
If you'd rather let someone else pick among all these asset classes, consider one of two Pimco funds. Pimco All Asset All Authority (PAUDX (opens in new tab)), run by Rob Arnott, invests in a passel of other Pimco funds, including those that own foreign bonds, junk bonds, convertible bonds, commodities and stocks. The Class D shares, which are available at some discount brokers without sales loads or transaction fees, lost 11% year-to-date through November 7 but eked out a 1% annualized gain over the past three years.
A more adventurous idea is Pimco Global Multi-Asset (PGMDX (opens in new tab)), the vehicle for El-ErianUs personal strategy. The fund, run by El-Erian and two others, "allows for the full expression" of Pimco's short-term and long-term outlooks and can own a wide range of instruments. Launched in October, the fund is not a complete investment plan, but it should exhibit little correlation to the stock market and hold up well when stocks are taking a licking.
Some things never change
After an especially trying year, it's important to remember some of the basic rules of investing.
First, there's a strong connection between risk and return. If you buy a one-year Treasury bill that yields 1%, you will earn 1% -- it's guaranteed. If you invest in an index fund that tracks the U.S. stock market, you have a strong chance, based on history, of earning 10% a year over the long term. But history has also shown that you could lose as much as 43% in a single year or make as much as 54%.
Second, in a freewheeling capitalist system, booms and busts are inevitable. That means you'll always have an opportunity to make a killing. The 1990s were marked by a rise in emerging-markets stocks, followed by their collapse. Then came the technology-and-Internet bubble, followed by the vicious 2000-02 bear market. Next came the housing and commodities booms and the current hangover. Will an Obama-inspired boom in alternative energy be next? Stay tuned.
Finally, patience pays. Investing remains (or should be) a long-term process. Don't try to regain your losses too quickly. You'll just be asking for more trouble. With the economy sagging badly, this isn't the right time to be a swashbuckler.
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