Ready for the Rebound?

by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc.
December 9, 2008

Reprinted from the November 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

The media relentlessly bombards us with reports of the dire downturn we're experiencing, often noting that it's unprecedented. But we've gone through stressful periods before: the energy crisis of the 1970s, the bank crises of the 1980s, the tech wreck of the early 2000s, and 9/11, to name a few. And disciplined investors have emerged from those nerve-wracking times—often stronger—by using periods of weakness to strengthen their portfolios.

Between 1926 and 2008, the U.S. experienced 16 corrections or bear markets—periods of at least six months during which the S&P 500® Index fell 10% or more (see "Bear Markets: We've ..."). During the 15 historical bears (excluding the one still unfolding), the market declined an average of 28% and the bears averaged 13.6 months.¹

Yet, when those 15 bear markets ended, the stock market bounced back, typically in short, powerful bursts. As the "Bear Market Recoveries ..." table shows, an investor who was fully invested in the stock market when the bear markets ended could have enjoyed an average return of 45% in the year after the bear market—but much less if he or she'd been holding cash for even short periods.²

Missing those periods of explosive growth would have seriously damaged a portfolio's long-term return. During the 12 months starting in July 1932, the S&P 500 had three months when it was up more than 38%. And it rose nearly 17% in October 1974, 41% from January through June 1975, and 21% from March through August 2003.

We believe the current crisis isn't so different that it requires abandoning time-tested investment principles. Making investment decisions based on emotions created by short-term market volatility isn't likely to help you reach your goals. Instead, focus on the future, and consider taking the following actions to help position your portfolio for an eventual turnaround in the markets.

Reassess your risk tolerance
Does the recent market decline have you rethinking your tolerance for risk? If so, that's normal. Many investors overestimate their risk tolerance in a rising market. So, now's a good time to do a goal-by-goal gut check. Ask yourself if you can stomach, say, a 15% or 35% drop in your retirement portfolio or your children's education fund.

Also, consider your investment time frame. The more time you have before you'll need to use certain money, the more risk you can take with it, as there's more time to recover from market downturns. You can't risk losing money that you'll need to pay for expenses during the next few years. But if retirement is 10 years away, you can accept short-term swings in your portfolio value so it has the potential for long-term growth. Likewise, the smaller your withdrawals are relative to the size of your portfolio, the more risk you can generally take.

Risk and return generally go hand in hand: The higher the risk, the higher the potential return, as long as you stick with your investment plan. If you reduce the risk level of your portfolio, its potential declines may be smaller, but so will its potential growth. So, make sure your portfolio offers the level of potential risk and return that's likely to help you reach your goal and that you can handle in both up and down markets. That way, you're more likely to avoid the common pitfall of moving to a less risky portfolio after the market has gone down, only to move to a riskier portfolio when things feel better due to market gains—the worst case of selling low and buying high.

Once you have a good sense of your risk tolerance, then make sure your investment mix offers the level of potential risk and return that is appropriate for each of your goals. Here's how:

Match your target asset allocation to your goals
Your target asset allocation is the mix of stocks, bonds and cash investments that fits the risk tolerance, required return, investment time frame and liquidity needs of your particular goal. We believe that once you've set your target, the key to success is sticking with it. As the "Target Asset Allocation Has Worked" graph illustrates, $100,000 invested in 1926 in a variety of hypothetical portfolios (which were rebalanced monthly) generated respectable average annual returns for the 1926–1950 period.³ This occurred despite the hit most equity investors took in the Depression years. Of course, the aggressive portfolio had higher returns and higher risk. But all the returns of all the portfolios required sticking with the target asset allocation.

To find your target asset allocation, log in to Schwab.com. Click on the Planning & Advice⁴ tab, then on Portfolio Checkup. Complete Sections A, B and C for one of your goals. Schwab.com will then show you the target asset allocation that's suitable for that goal. Click on Analyze Portfolio. If your actual allocation to stocks, bonds or cash investments is more than 5% different from your target asset allocation, we'd advise you to consider adjusting your actual allocation accordingly. Click on Choose Investment Alternatives at the bottom of the page for help selecting specific investments. Your Schwab Financial Consultant can also help you with this process.

Rebalance your portfolio
Stocks, bonds and cash investments tend to generate different returns from each other. Some return more than others; some go up when others go down. This phenomenon can throw your portfolio out of balance by moving your actual investment mix away from your target asset allocation. For example, if your portfolio held 60% stocks (your target allocation) a year ago, it probably has shifted closer to 50% stocks due to the equity market decline. If you don't rebalance your portfolio back to 60% stocks now, you'll probably miss out when the stock market rebounds.

For successful long-term investing, we believe you need to gradually buy asset classes as they go down in value—just as you'd take profits if an asset class were going up. Disciplined rebalancing in all market conditions can potentially help reduce the risk and boost the return of your portfolio. To see how you need to rebalance your portfolios, log in to Schwab.com and click on the Planning & Advice⁴ tab, then on Portfolio Checkup.

Review your longer-term financial plan
Reviewing your goals and liabilities and the money needed to fund them can shift the focus from daily market moves to what the money will be used for. For help planning, go to Schwab.com and click on the Planning & Advice⁴ tab.

Avoid pulling out of the stock market altogether
Timing the market is nearly impossible—large wholesale moves in or out rarely work, in our experience. And if you plan to return at some point, precise timing is required on that call as well (see "Bear Market Recoveries ..."). If you have taken on too much risk and must pull some money out of the market, consider gradually withdrawing it during a few months. That way you won't regret having taken it out too early or too late—as you might if you take it out all at once.

Beware the siren song of cash
Some investors have fled stocks for the seeming safety of cash, like savings and checking accounts, and what investors consider cash investments, such as certificates of deposit (CDs), money market funds and Treasury bills. Cash investments offer safety of principal, liquidity and low correlation with other asset classes. So it's prudent to include some in your portfolio. However, although cash-heavy portfolios tend to be stable, they've tended to have poor long-term return prospects. For example, as of October 30, 2008, a one-year CD yields 3.58%. Subtract 4.9% for inflation and you end up with a negative real return: –1.32%; subtract taxes and it's even worse. Inflation destroys the purchasing power of your money. Historically, long-term stock returns have been higher than inflation. So, to help maintain your portfolio's purchasing power, consider investing in the stock market at least 20% of the money designated for goals with time frames that are at least three years away.

Need your money in less than three years? Avoid stocks
That money you'll want to keep safe. So consider putting 60% of it in cash investments and 40% in shorter-term fixed income.

Need your money in three to five years? Limit stocks to 40%
Keep at least 60% of that money in fixed income and cash investments. Consider putting the rest in a well-diversified stock portfolio or mutual fund. This mix may give you the potential to modestly increase the value of your investments and will likely be less volatile than the market.

Watch out for concentrated positions
Severe drops in the price of stocks and bonds illustrate the outsized risk of concentrated positions. Scan your portfolio and evaluate the risk of any position representing 5%–10% of the portfolio. Consider plans to reduce positions in the 10%–20% range, and take immediate action to reduce any positions greater than 20%.

Harvest losses and upgrade the quality of your portfolio
Consider selling stocks, mutual funds and other investments that have a loss and can be replaced with an investment of equal or greater quality from the same sector or industry (see "Get a Tax Break by Harvesting Losses"). We believe many great stocks are now attractively priced. At Schwab.com, click on the Quotes & Research tab to research possibilities.

Play defense
Make small shifts to generally more defensive sectors, such as health care. Also consider dividend-paying stocks, inflation-protected securities, and funds that hedge some equity exposure.

These are trying times for everyone, so you're not alone. While your plans may need to be adjusted, your goals are likely still achievable if you manage your portfolio in a disciplined and measured manner and follow the key investment principles outlined in this article.

1. Source: Schwab Center for Financial Research, with data from Morningstar, Inc. The market is represented by total monthly returns of the S&P 500 Index, January 1926–October 2008. The historical bear markets analyzed are defined as periods with cumulative declines greater than 10% and durations of at least six months.

2. Source: Schwab Center for Financial Research, with data from Morningstar, Inc. The market is represented by total monthly returns of the S&P 500 Index, January 1926–September 2008. Cash is represented by total returns of the 30-day T-bill. The 15 historical bear markets analyzed are defined as periods with cumulative declines greater than 10% and durations of at least six months, and do not include the current market.

3. Source: Schwab Center for Financial Research, with data provided by Morningstar, Inc. The asset allocation plans are weighted averages of the performance of the indices used to represent each asset class in the plans and are rebalanced monthly. Returns include reinvestment of dividends and interest. The indices representing each asset class are the S&P 500 Index (large-cap stocks), CRSP 6–8 Index (small-cap stocks), Ibbotson Intermediate-Term Government Bond Index (bonds) and Ibbotson U.S. 30-day Treasury Bill Index (cash). The Conservative allocation is composed of 15% large-cap stocks, 5% international stocks, 50% bonds and 30% cash. The Moderately Conservative allocation is 25% large-cap stocks, 5% small-cap stocks, 10% international stocks, 50% bonds and 10% cash. The Moderate allocation is 35% large-cap stocks, 10% small-cap stocks, 15% international stocks, 35% bonds and 5% cash. The Moderately Aggressive allocation is 45% large-cap stocks, 15% small-cap stocks, 20% international stocks, 15% bonds and 5% cash. The Aggressive allocation is 50% large-cap stocks, 20% small-cap stocks, 25% international stocks and 5% cash. International stock allocation is treated as allocation to large-cap stocks due to the unavailability of a high-quality international stock index for this period. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly.

4. For clients using the new Schwab.com site, please go to the Guidance tab.

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.

An investment in a money market fund is neither insured nor guaranteed by the FDIC or any other government agency. Although the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in the fund. Please note that bank deposits are FDIC insured up to $250,000 per person per institution through December 31, 2009, while non-bank independent products have no such guarantees.

Diversification strategies do not assure a profit and do not protect against losses in declining markets.

Schwab does not provide tax advice. Clients should consult a professional tax advisor for their tax advice needs.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Each investor needs to review an investment strategy or security transaction for his or her own particular situation before making any investment decision. The types of securities and investment strategies mentioned may not be suitable for everyone. Examples provided are for informational purposes only and not intended to be reflective of results you can expect to see.

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