Question:
For more than 35 years, we investors have enjoyed the benefits of a rising stock market. Most advisors are committed to the buy-and-hold approach, discouraging people from selling their holdings during a slump because the market has always come back in the past. For many people, that is all they have ever known. However, the major indexes are down 20 percent or more from the October 2007 peak. Some analysts think the market will go down a lot further. My question is what if - just what if - that "rising tide" of the past 35 years becomes a "falling tide" lasting who knows how long? If that happens, all portfolios - lazy or not - will be severely stressed. In my case, all my holdings are in cash, where no losses are allowed. As a retiree, I don't have time to recover. In these times, the best gain is not having a loss. Your suggestions, please, on money management to produce a return that will beat cash with no losses. Is this possible?
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JEREMY BURGER:
That’s a great question. Let me get to the heart of it immediately: Your request for a cash-beating return with no losses. Of course it’s possible to get this in the short run if you are lucky. But if your prohibition on losses is absolute, then it is essentially impossible.

Virtually anything you buy can go down in price as easily as it can go up. If you buy a stock or a fund and it loses 0.01 percent of its value in the first hour you own it, you have a loss. You have failed. In the real world, once you leave the realm of cash and cash equivalents, there’s nothing that won’t be subject to an occasional loss.

It is worse than that. Consider what happens to your money when it’s in cash. In the short run, you start with some amount of money, and it never loses any of that principal. No loss, right? It even gains interest, most likely. But if you aren’t willing to risk any of that principal, then you’ll probably get a return that’s less than the rate of inflation. In very real terms, you are almost certain to lose purchasing power in the long run.

Make no mistake about it: That is a loss. For a retiree, this erosion is very serious, because as you say in your question, you don’t have time to recover.

As Paul Merriman has said repeatedly, investors get paid for taking risks. That means accepting the possibility that you could encounter a loss.

You are correct that from October 9, 2007 through July 15, 2008, the Standard & Poor's 500 Index lost 22.4 percent, putting it in bear market territory. Since 1928, that index has entered into this territory 24 times, with a mean loss of 34.8 percent, and it has taken an average of 304 days to turn around. On the other hand, during this same time period, the average bull market gain was 105.7 percent.

Of course we don’t know where this current market will lead. It is possible, as you suggest, that we are at the start of a very long bear market that could last for decades. It is also theoretically possible that two days after you read this article, the market will start going up at the rate of 1 percent every business day without a single loss for years.

Based on the 80 years of detailed market history that is available to us, I don’t think either of those scenarios is likely. I would not be comfortable recommending that you invest based on either of those scenarios.

There have been long periods when the stocks in a specific asset class or the stocks of a single country have experienced negative returns. For example, the MSCI Japan Index, in the 10 years ending in April 2003, lost 50 percent of its value, equivalent to 10 straight years of 6.7 percent annual losses. I find it hard to believe any investor would feel like staying the course through such a period if his or her whole portfolio were in that index. During the same 10 years, the S&P 500 Index achieved an annualized return of 9.6 percent.

The problem is that it could have been the other way around. At the start of that period, there was no way to know whether Japan or the U.S. would be the more productive stock market. A good case could have been made for either scenario. This is precisely why we believe in having equity assets diversified globally as much as possible.

As you can see in an article recently published on our site (“Ten years of superior performance was no accident,”) during the 10 years ending June 30, 2008, the S&P 500 Index achieved an annualized return 2.9 percent. According to Morningstar Inc., this 10 year annualized return for the S&P 500 happened to be the worst 120-month period since 1978.  

By contrast, our managed accounts for clients, after all costs and management fees, compounded at 7.5 percent annualized, even with the risk-reducing inclusion of 40 percent in fixed-income. (All-equity accounts rose at a rate of 9.5 percent.) The equity part of these accounts is broadly diversified to include U.S. large-cap stocks, U.S. small-cap stocks, U.S. value stocks, international stocks, real-estate investment trusts and emerging market stocks. In total, the funds we use own more than 10,000 individual stocks.

Like most investors, you have a risk tolerance that means a 100 percent stock allocation is not likely to be ideal for you. While you need some equities to keep ahead of inflation in the long run, you also need a significant part of your portfolio in fixed-income funds to mitigate the risk of those equities. Just how much of your investments should be in equities? There is no one answer that fits everybody. But you’ll get a pretty good idea if you study one of our most popular articles, “Fine tuning your asset allocation.” It reviews a full spectrum of equity/bond allocations with results going back to 1970.

I think you may need to revise your definition of “No losses allowed.” There are already at least two types of losses that you are subjecting yourself to. As I mentioned earlier, you are now losing purchasing power due to inflation. The July 2008 Consumer Price Index data showed an annual inflation rate of 5.6 percent. Meanwhile, the current yield for the Vanguard Prime Money Market fund was only 2.2 percent.

Second, and most important, unless you have so much money that you’ll never be able to spend it all, you face the risk of running out of money prematurely. I suggest you work with a professional advisor to determine the rate of return you must get on your portfolio to meet your needs. When you know that, you’ll be able to accurately pinpoint how much equity exposure you may need for your future, using the “Fine tuning” article I mentioned.

In the end, based on all the facts we have, I am pretty confident that the future will be kinder to investors who choose their asset allocation carefully than it will be to those who hunker down in fear and stick to cash. However, the future is unknown, and only you can make the final call for yourself.

Jeremy Burger is a financial advisor at Merriman