The New Rules for Investing: Same as the Old Rules

by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc.
July 7, 2009

Reprinted from the June 2009 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

As I'm sure you're well aware, we've experienced the worst financial meltdown since the Great Depression. Both Wall Street and Main Street borrowed way too much, and when the home-price bubble finally popped, the house of cards collapsed. Markets plunged around the world. Overleveraged balance sheets—and massive frauds—were exposed as the tide rolled out.

Like so many investors, you may wonder if the U.S. financial system is somehow broken, or if the stock market is no longer worthy of your trust. Given the size of the meltdown, shouldn't more people have seen this coming? More importantly, as we sit here in the rubble, how can the old rules of investing—asset allocation, diversification, buy and hold—possibly still apply?

The world has not changed
While the market drop has been incredibly painful, especially for those in or near retirement, it didn't create a "new world" of investing. Rather, it was a natural course correction back to fundamentals after a period of excess. In short, the financial system was on an unsustainable path before—this is the fix.

We see nothing that's changed in the U.S. free-enterprise system that warrants a change in our approach to investing. And we remain confident that over the long term, most high-quality companies will continue to attract capital and likely reward shareholders with higher returns than they would find with less-risky assets.

To save or to invest? That is the question
Take a moment to really consider: Are you a saver or an investor? The rationale behind a pure savings plan is to preserve wealth, while an investment plan aims to build wealth to fund a future need—to buy a home, to save for college and, most importantly for many, to make sure you have enough income in retirement.

If you're a saver only, you'll need to out-save current inflation and save enough to cushion against future inflation, since bank accounts, money market funds and other saving vehicles barely keep up with inflation over time (see chart below).

Inflation will slowly but surely decrease your purchasing power—for example, during 20 years at an inflation rate of 3.5%, nearly half of your money's purchasing power would be lost. So while being a saver might sidestep the risks inherent to the stock market, it carries its own big risk: inflation risk.

Chart: Stocks: your best defense against inflation

Chart: Stocks: your best defense against inflation

If you're an investor, that means you're looking to create inflation-beating wealth over time. To do that, history shows you'll want stocks in your portfolio (bonds do outpace inflation, but not by nearly as much)—and owning stocks means you're exposed to risk.

The best way that you, as an individual, can mitigate that risk is through asset allocation (your portfolio's target mix of large-cap, small-cap and international stocks, along with bonds and cash investments) and diversification (spreading your investment dollars across multiple countries, sectors, industries and companies).

Perhaps you consider yourself an investor, but you're still reluctant to accept this logic. But consider the alternatives—trying to time the market, concentrating your portfolio in a few investments, or frequently trading in and out of positions. Ask yourself: After the volatility of 2008, do I feel more confident in my ability to pick a small number of winning investments, and to know when they've reached a peak and it's time to sell?

In fact, picking quality investments is no easier now than before, and having concentrated positions increases your overall risk. Also, historical return patterns tell us that an "out and back in" strategy must be done with uncanny precision to beat a long-term, buy-and-hold strategy (still monitored, of course). The truth is, we know of no one who's successfully timed the market over the long run.

Asset allocation and diversification: Still the right tools
With the downturn in most asset classes and increased volatility during the past year, it's often been said that the "old" investing rules no longer apply. But as investors, we must guard against extrapolating that what's just happened will continue.

We've already seen a big turnaround, and whether or not it represents the end of the bear market, it demonstrates a normal pattern of returns moving from negative to positive with limited short-term predictability.

Asset allocation and diversification together enable you to develop and maintain a plan that aligns with your personal tolerance for risk—and that gives you the peace of mind to maintain the strategy through incredibly tough periods like 2008.

There's been a lot of talk lately about a "lost decade," with stock investors having nothing to show for the past 10 years. Is this truly the case? Only if you invested 100% in large-cap U.S. stocks, which had an annualized return of -1.4% for the 10 years ending in 2008.

However, there was a severe bear market near the beginning of that 10-year period and one of the worst bear markets at the end. Should you alter your plan based on the worst decade for U.S. stocks?

We'd never recommend a plan concentrated in just one asset class. An investor using an asset allocation strategy for the past 10 years would have had positive returns in other asset classes, demonstrating the power of asset allocation.

For example, our moderate asset allocation plan (comprised of 60% equities) experienced a positive annualized return of 2.8%—not very high, but certainly not negative. This would represent a cumulative return of nearly 32%, meaning a $100,000 portfolio would have grown to more than $130,000.

Even with the negative returns for large-cap U.S. stocks, it's helpful to understand how often the stock market goes up.

As the chart below shows, over longer-term periods the market (as represented by the S&P 500® index) generally has positive returns.

Obviously, that's not true 100% of the time, which is precisely the reason most plans should include a mix of stocks, bonds and cash investments to smooth out returns in the short run and help you live through the short-term risk necessary to receive higher long-term returns.

Chart: How often has the stock market gone up?

Chart: How often has the stock market gone up?

Action steps for investors in three different situations:

You bailed out of the market at a low point, and now you can't decide when to get back in (if at all).

If this sounds like you, you likely had a riskier portfolio than you were really comfortable with.

Your first step should be to reexamine your tolerance for risk—now that you've really experienced a true down market!—and then review your longer-term investing goals and plans to try to achieve them.

Assessing your risk tolerance should include an examination of full market cycles, considering both ups and downs. For details on determining your risk tolerance, you can read my article Know Yourself, Know Your Risk Tolerance. You might find your risk tolerance is skewed abnormally high right after bull markets and too low just after bear markets—make sure you don't overcorrect.

Once you've determined your true risk tolerance and decided on an asset allocation plan, the next step is to dust yourself off and get back on track with your plan—which for many will mean buying stocks (either individually or through mutual funds).

Market history might suggest committing all of your investable assets immediately (see the "How often has the stock market gone up?" chart, which shows that the longer you hold stocks, the greater your chance of having a positive return).

But if the thought of jumping back in is unsettling, you can ease back in gradually by investing over a period of months, perhaps with slightly larger amounts during market pullbacks. (The silver lining for many investors is that enough losses have probably been booked in taxable accounts to offset gains for some time.)
You're half in, half out of the market, but your faith is shaken and you're not sure how to tell if things are truly getting better.

As in scenario 1, there was likely a mismatch between your actual portfolio risk and your true risk tolerance. But since you didn't totally withdraw from the market, you have less correcting to do.

Also as in scenario 1, take another look at your risk tolerance and adjust your portfolio accordingly so you can stick with your plan through future ups and downs. One strategy to consider: Target new deposits (or withdrawals) to the appropriate asset classes and adjust to your revamped plan over time.
You stuck to your investment plan throughout the maelstrom, but are still concerned about how much risk you can handle.

Sticking with even a perfect plan can be difficult during one of the worst bear markets ever, so pat yourself on the back for properly aligning the risk in your portfolio with your risk tolerance. You've benefited most from the recent rally, which illustrates the benefit of sticking with a plan through a downturn.

However, experience is one of the best teachers, so reassessing risk still isn't a bad idea at this point. Thinking about the emotional rollercoaster and considering whether or not you could stick with your plan through another market downturn should tell you if adjustments are necessary. Changes are likely to be minor, unless something else in your situation has changed. Consider some tax-loss harvesting and rebalancing to realign with your original plan.

The severity of the recent downturn, a 50% decline from October 2007 through February of 2009, ranks as one of the worst bear markets of modern times. The bear market in 1973-1974 totaled a 43% loss, while the 2000-2002 bear market resulted in a loss of 45%.

And, of course, the worst was the Great Depression, starting in 1929 and dragging on through the early 1930s, with a loss of 80%. But despite these stomach-churning drops the market has suffered through before, it has always come back.

It's natural to question tried and true rules of investing after markets like we've seen, but beware of making dramatic changes to try to avoid something that has already occurred. You can still be a successful, long-term, buy-and-hold investor—and asset allocation and diversification remain the keys.

As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

1. Chart illustrates the growth in value of $1 invested in various financial instruments on December 31, 1925. Results assume reinvestment of dividends, capital gains and coupons, but do not include taxes or transaction costs. Generally, small-cap stocks are in the bottom 50% of publicly traded companies based on market capitalization; such stocks are subject to greater volatility.

2. Indexes representing each asset class are the Center for Research in Security Prices (CRSP) 6-8 Index (small-cap stocks), S&P 500 index (large-cap stocks), Ibbotson Intermediate-Term U.S. Government Bond Index (bonds) and Ibbotson U.S. 30-day Treasury bills (cash investments). Total returns of the S&P 500 index (composed of large-cap stocks) represent the stock market return, with dividends reinvested. Holding-period returns are annualized. One-, three- and five-year returns roll forward in one-month increments.

Important Disclosures
Diversification and asset allocation strategies do not assure a profit and do not protect against losses in declining markets.

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. Past results are not indicative of future performance.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

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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