It won’t surprise you to read that many of our clients have had a pretty tough time with the market this year. Over and over again, we hear from people who want to take action instead of sitting still. The three most common things people seem to want to do are:

•    Get out of the market immediately and go to cash.
•    Buy commodities and commodity funds.
•    Dump the “dogs” in their portfolios, the funds that have underperformed.

I believe that each of these is a mistake. Recent articles have dealt with going to cash (see “Is it time to get out of the market? ” by Paresh Kamdar) and commodities (see “Why we still don’t favor commodities ” by Dennis Tilley). In this article, I want to talk about getting rid of underperforming parts of a well diversified portfolio. Dumping the dogs, in other words.

For starters, let’s talk about the optimum way to diversify a portfolio. The equity side (as opposed to fixed-income) is most challenging to most investors, so I’m going to focus on that. We can’t predict which asset classes will do best over the short run, and we don’t even try. For more than a decade we have believed in wide diversification into low-cost funds that invest in large stocks, small stocks, value stocks and international stocks.

Specifically we believe the equity side of a well diversified portfolio should be made up of funds that invest in U.S. large-cap, U.S. value, U.S. small-cap, U.S. small-cap value, U.S. real estate, international large-cap, international value, international small-cap, international small-cap value, international real estate and emerging markets stocks.

In any given week, month, year or decade, some of those asset classes will shine and some will lag. The problem is that we cannot know which ones will lead and which will fall behind. History tells us that over long periods of time each of these asset classes has a very attractive reward-to-risk ratio, making it a worthwhile holding. Because we can’t know which are the best in any given time period, we simply own them all.

This sort of diversification has produced very favorable long-term results. (See “Ten years of superior performance is no accident ” by Paul Merriman.) But it hasn’t been easy.

IN THE TRENCHES

All this is wonderful on paper and in theory. But when you’re living through a bear market, the view from the trenches doesn’t look so rosy.

This year, I have worked with a number of clients worried about what the market has done to their accounts. Often I hear complaints that certain funds (certain asset classes, in other words) have declined in double-digit percentages; clients sometimes think we should ditch those dogs and concentrate their money on what’s been working.

In some areas of life, that’s a great approach. But for investors, it’s usually the opposite of the right thing to do.

Some clients become so upset that they regard ALL the equities in their portfolios as dogs that should be dumped. Yikes!

I do my best to remind clients of what we all know: Market declines are a normal part of long-term investing. Fortunately, they don’t last forever. It’s tempting to think that a falling market will keep going down indefinitely (or that a rising market will keep going up indefinitely) and as a result of that to make emotionally based transactions (usually at precisely the wrong time). History has one piece of advice about that: Don’t do it.

Actually, our clients’ portfolios are behaving the way we would expect them to during a decline of this magnitude.

We also have to remind our clients that looking at the performance of individual funds is not a productive avenue. Successful investors learn to focus on the total portfolio. And when clients want to just go to cash, we warn them about that, too. As one of my colleagues wrote to a client this summer, “If you get out of the market now, at some point you will want to get back in. That is tougher than you might think. If you wait until it is comfortable to re-commit, you will almost certainly have missed a big rally – possibly even the majority of the market’s next upswing.”

TODAY’S DOGS, TOMORROW’S HEROES

The dogs of today will someday be the stars; today’s stars will someday turn into dogs. This is a pendulum that swings back and forth in ways that cannot reliably be predicted.

Investors who focus on specific asset classes tend to want to engage in whipsaw trades that force them to constantly buy what’s dear and sell what’s cheap. As you know, that’s the opposite of the way to make money.

To make this point as persuasively as I could, in July this year I asked one of my clients to look at a colored table showing annual returns of the major asset classes we recommend. The table makes it clear that no asset class has consistently been a top performer and none has consistently been at the bottom. In fact, it shows that each one tends to migrate from the bottom ranks to the top ranks, and vice versa. Sometimes the migration is stunningly quick, sometimes much more gradual. There is no discernable pattern that would let anybody make accurate predictions.

I could have used any pair of asset classes to illustrate this. In writing to this client, I focused on two: international large-cap value stocks and emerging markets. The returns I cited are those of the Dimensional Fund Advisors fund in each asset class, before any management fees or transaction costs.

INTERNATIONAL LARGE VALUE

If you look at those numbers, you can see that by the end of 2000, few investors would have been concerned about owning this fund. But by the end of 2001 many would have become nervous. At the end of 2002, investors who bought this fund at the start of 2000 had sustained losses of 22.7 percent, enough to make many people more than ready to “dump that dog” after three disappointing years.

Investors who did so probably felt good for awhile. But they might have felt less happy if they watched the fund appreciate nearly 50 percent in 2003 and nearly triple in value from 2003 through 2006. Though they could not have known it at the time, investors who dumped that “dog” effectively locked in their losses and locked themselves out of very robust gains.

“Can you imagine the impact of that on the overall performance of the rest of their portfolio for those four years?” I wrote to my client. And what of investors who intended to get back into the fund once things settled down? Unless they did so early in 2003 (which seems highly unlikely), they would not have been able to recoup their losses.

EMERGING MARKETS

Next I turned to emerging markets, an asset class with dramatic (some would say nasty) volatility.

Investors who bought at the start of 1997 could be forgiven for feeling quite discouraged two years later, having lost more than 26 percent of their money while the U.S. stock market was surging. But those who bailed out missed what seemed like (and may have been) a once-in-a-lifetime gain in 1999 of 71.7 percent. Those who got back in at the end of that year could not have known they would face three more losing years.

This asset class lost money in five of the six calendar years 1997 through 2002. That’s not a recipe for enthusiasm. But in the following five calendar years, 2003 through 2007, the fund scored cumulative gains of 387 percent. By far the biggest of those yearly gains occurred in 2003, the time investors were least likely to jump on the emerging markets bandwagon. In other words, those who took their time to get into the action missed out on the biggest gains.

Referring to the multiple losing years in emerging markets, I told the client: “Every asset class performs like this from time to time. … The worst scenario, of course, is when all the funds do poorly at the same time. However, that has happened only six times in the past 37 years. The worst such period (1973-1974) lasted two years; the others ranged from three weeks to three months.

“Last fall, all the international funds were positive while the U.S. funds were down. In February through May, the U.S. funds were all up. I hope this helps clarify the risk of moving in and out of funds during tough markets.”

CONCLUSION

The volatile stock market has not made things any cheerier over the past two months. Most of our clients are hanging in there. To them and millions of other investors, these are scary times. But that is the way the market works.

When the current bad period clears up and equity returns are positive month after month and quarter after quarter, many people will forget the bad times. They will decide that we have returned to “normal” conditions, and some will let down their guard.

We will certainly encounter another bear market someday. When that happens, investors whose actions are driven by their emotions may have to re-learn these lessons again and again. The most successful investors will be those who are able to make good long-term allocations, then stick with them through thick and thin.

Jim Whipps was formerly a financial advisor for Merriman.