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Manic Markets and You
by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc. April 8, 2008
Reprinted from the March 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.
According to an old Wall Street saw, "As goes January, so goes the year." So, it's no wonder that even seasoned investors are feeling queasy after a 6.1% stock market plunge in the S&P 500® Index this January—the sixth worst since 1926—and another 3.5% drop in February. As the "Early Warnings" table below illustrates, even when the market rebounds from a big loss in January (as it did in five of seven instances), it's extremely difficult to end the year up. Indeed, it's only happened twice since 1926, and then with meager gains.
Early Warnings: Januaries That Fell at Least 5%
Year
S&P 500 Index Change
January
Next 11 Months
Full Year
1970
–7.6%
8.4%
0.2%
1960
–7.1%
4.5%
–3.0%
1939
–6.9%
1.5%
–5.5%
1990
–6.9%
0.3%
–6.6%
1978
–6.2%
7.7%
1.1%
2008
–6.1%
?
?
2000
–5.1%
–5.3%
–10.1%
1977
–5.1%
–6.8%
–11.5%
Data from Morningstar, Inc. Returns exclude dividends.
We're not predicting a bad year. But if we get one, we shouldn't be surprised. After all, markets move in cycles. As you can see in "Stocks Had a Great Five-Year Run," annual returns averaged 13% for U.S. equities and 22% for developed international stocks. A downturn will come at some point; we can't avoid that. What we can control is the way we react to a downturn—or the fear of one.
At Schwab, we believe in selecting the asset allocation that's right for you and sticking with it through all cycles. In volatile markets, that's much easier said than done. But failing to do so can be extremely costly to your long-term financial goals. To succeed, you need to understand your risk tolerance from two key perspectives:
Emotional risk tolerance measures how you feel personally about risk, and is truly tested in down markets. Ask yourself: Could I withstand a 25% drop in my portfolio and still stick to my plan? In the bear market that followed the dot-com bust, a portfolio with 80% in stocks and 20% in bonds lost 31% of its value from September 2000 to September 2002. And when did that portfolio recover to its original wealth level? Forty months later.1 If you haven't given yourself a gut check, now's the time.
Financial risk tolerance measures how your portfolio goals, time horizon and income needs can withstand losses. For example, a Gen-Xer saving for retirement can be more opportunistic during a downturn than a 55-year-old saving for his daughter's wedding next year. That money needs to be in low-risk investments.
So, how are you reacting to the market's stomach-churning dives? My team of portfolio consultants has found three common reactions, outlined below, each with particular risks and opportunities. If any of these sounds like you, understand that you're not alone and that we've helped many other investors navigate these shoals without undue damage to their long-term plans.
1. Panicked: "Get me out now!"
Our clients' feelings of panic usually start when they realize that their portfolio risk level is not correctly aligned with their personal or emotional risk tolerance (e.g., a client who invested 80% in stocks during a bull market, but just discovered that he'd actually feel more comfortable taking on less risk, putting, say, only 60% in stocks). One client became physically ill worrying about the recent declines in her portfolio. This reaction is understandable: Planning for the future and money issues are often emotionally charged. But all-or-nothing decisions can derail your long-term plans.
Risks: Selling everything to get out of the market may have dire tax consequences. And what if you change your mind next week and want to get back into your original investments? You could run afoul of the wash sale rule and end up paying high ordinary income tax rates on all your gains.
There's also a potentially large opportunity cost while you're out of the market. We've seen some clients abandon the investment plan they started some time ago, because they feel more comfortable with cash now. They think they'll get back in when the market feels less risky—but the actual risk is that they'll be out of the market when it bounces back, which can often occur fast and furiously. Schwab research has found that missing the 10 best days over the last 10 years would have dropped your return by 80%.2 And with cash returns plunging, your money actually may not do much better if you abandon equities.
Getting out is only half the decision—the hardest part is knowing when to get back in. Investors who lock in losses near the bottom and then re-enter after the comeback is well under way may earn personal returns far lower than an average long-term investor who didn't panic. See the two charts below: We looked at the difference between mutual funds' posted returns and what average investors in those funds actually earned when factoring in the timing of their investments. The damage done by poor investment timing was most pronounced in small- and mid-cap funds. Investors in 78% of those funds trailed their funds' returns on average. And the lag was substantial: Bad timing dropped returns by 47%.
Recommendations: Instead of selling everything and possibly getting a big tax hit, consider trimming just part of your stock allocation to see if that lets you sleep better at night. And if you can, make your changes in tax-deferred accounts.
The best advice we have is to adjust your portfolio's risk level without completely bailing out of the market. Use your discomfort to learn about your personal risk tolerance. As mentioned earlier, we often learn about risk only when going through down markets. Once you know where you stand, take action. Consider lowering your portfolio's percentage in stocks. Or ask a Schwab consultant about risk-reduction strategies such as defensive sectors.
If you're already out of the market, consider getting at least partially back in now to capture the upswing, whenever it comes. Treat this as a long-term strategic adjustment: If you panicked and bailed out, re-enter with a slightly more conservative profile (less in stocks) so you won't be tempted to bail out again.
2. Uncertain: "I'm uneasy and unsure of what to do."
You may be questioning your long-term strategy and whether it's still right for you, while still wanting to take some sort of action. This is the most common reaction we've seen in our clients.
Risks: If you're feeling a sense of fear and are hesitant to make any changes, you can miss out on the opportunity to rebalance your portfolio and upgrade to higher-quality securities at lower prices.
Recommendations: First, remember that it's OK to ride out the storm and do nothing. But if your uneasiness persists, it's time for a general checkup. Start by revisiting your original plan. If your portfolio is now riskier due to the five-year run-up in certain asset classes, maybe all you need to do is adjust your allocation (to more in small-caps, bonds or cash). To stay on track, Schwab clients can sign up for a free quarterly portfolio profile report at Schwab.com/qpp.
Look at the quality of your individual holdings. Consider taking tax losses to offset any gains. Consider selling any stocks rated D or F by Schwab Equity Ratings® and upgrade to A's or B's. Schwab clients can go to Schwab.com/stocks for stock lists and screeners to get started.
If you're due to rebalance your portfolio—or if you're more than 5% off your target allocation to stocks or bonds—sell your overweighted areas and buy the underweighted ones (which may have better future growth opportunities). If you're a Schwab client, you can identify your portfolio's over- and underweights at Schwab.com/portfoliocheckup. In particular, it may be time to consider trimming international stocks and buying small-caps: International stocks gained 11%, while small-caps fell 2% in 2007. You may feel relief at this opportunity to buy at prices more reasonable than the last few years'.
3. Opportunistic: "I want to take advantage of this situation."
This is a good sign that the risk in your portfolio is a good match for your personal risk tolerance.
Risks: Take action, certainly, but don't take it to an extreme. Bargain hunters can run the risk of developing concentrations in a particular company, industry or sector.
Recommendations: If you're a Schwab client and you want to make limited short-term shifts, use Schwab's sector views at Schwab.com/sectors to find the sectors we think are poised to outperform. Implement sector tilts in a well-diversified manner using Schwab's sector stock lists at Schwab.com/stocks, sector exchange-traded funds (ETFs) at Schwab.com/etfs or mutual funds at Schwab.com/selectlist.
Limit your short-term moves to a small part of your total portfolio. Investors who tried to take advantage of a possible U.S. slowdown and moved the bulk of their assets into international and emerging-market stocks last year discovered the hard way that global economies are still connected. So far this year, international stocks and U.S. stocks have both been falling similarly.
If recent market events have been a reality check for you, use this time to properly assess your personal investment risk level. Schwab's professionals can help. Give us a call at 800-435-4000 or stop by a Schwab branch.
1. Stocks are represented by the S&P 500 Index and bonds are represented by the Lehman Brothers U.S. Aggregate Index. Portfolio is not rebalanced during the bear market.
2. Data from Standard and Poor's. Analysis uses S&P 500 daily total returns from January 1, 1998, through December 31, 2007, except the 10 highest-performing days, annualized based on an average of 252 trading days within a calendar year. When out of the market, cash was not invested.
Important Disclosures
Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Past performance is no guarantee of future results and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.
Exchange-traded funds are subject to risks similar to those of stocks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.
Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings are not personal recommendations for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolios.
The S&P 500 Index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.
Diversification and asset allocation strategies do not assure a profit and do not protect against losses in declining markets. Sector investing may involve a greater degree of risk than an investment with broader diversification. Investments in small-cap securities are generally subject to greater volatility than other asset categories.
International investments are subject to additional risks, such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.
This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice.
Examples included are hypothetical, provided for illustrative purposes only and not intended to be predictive of future results. Data contained here from third-party resources is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
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