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Lessons From the Bear Market

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By John Vineyard

What should you do, now that the bear has spent the past year mauling your life's savings?

Consider the losses reported by the higher-education pension giant, the Teachers Insurance and Annuity Association and College Retirement Equities Fund, better known as TIAA-CREF. For the fiscal year ending March 31, the CREF Stock Account had a return of minus 22.9 percent, and the CREF Growth Fund lost 43.9 percent. The declines in other equity funds were comparable, while bonds had one of their better years.

Most people who are saving for retirement invest in equities, and so they have "enjoyed" significant losses. An academic with 60 percent of his retirement assets in CREF stock and 40 percent in CREF bonds would have seen his investments lose about 9 percent of their value during that period. It was the worst year for stocks since 1974, when the S&P 500 lost 26 percent. Before that, you have to look all the way back to the Depression years of 1930, 1931, and 1937 to find worse years for the S&P. So you're absolutely right to feel that you've been through a major market event.

Since March, however, there's reasonable evidence to suggest that the worst of the declines are over, that the hemorrhaging has stopped, and the patient can begin to recover. But even if the March drop does prove to be the true bottom, and the economy now marches steadily away from recession, it would be smart to review the lessons we can draw from the past year's experience:

The markets are more volatile than you think.

Not only are the overall market swings often hair-raising, but in some industry sectors, general business risk can be extraordinary, even when we're not officially in a recession. Lucent Technologies was the most widely held stock in January 2000, trading at around $75 a share. Beginning in January, Lucent handed investors a series of major earnings disappointments, and by March 2001 it was trading below $6 a share, more than a 90 percent decline. It's hard to think of any other example of a blue-chip stock that fell so hard so fast. Old stalwart AT&T lost over 60 percent in the same period. This means that some of the comforts of the standard "buy and hold" philosophy have to be reviewed. It's just not good enough to hold a clutch of top names through thick and thin, no matter what. And stock prices could drop again unless a number of positive indicators stay in place, such as low inflation, no war, and continued good prospects for strong economic growth.

Furthermore, bonds are not always the logical counterweight to stocks, since a rise in inflationary expectations, or a fall in the dollar, could punish both bonds and stocks at the same time.

Even after the overall market recovers, things are never quite the same.

It's a Darwinian world, and there will be major winners as well as losers after the recovery. That's because different companies will adopt different strategies in response to their current challenges, and this will position some of them much better than others. One company may decide that the slowdown provides a great chance to expand aggressively, and try to take market share from faltering competitors; another many concentrate on slashing costs to regain profitability. If the downturn is brief, the first strategy will probably prove to be the best. If things stay down longer, the second. In any case, we won't soon see a return of the Internet bubble.

More choice = more risk

For years, academics yearned for more investment choices. Today they can choose from among dozens of retirement funds, but they suddenly find themselves in a contradictory position. In the bad old days when there were only a couple of choices, people naturally resented the limited options. Beginning in the 1980's, the choices proliferated. And that was O.K., because all you had to do was pick a few large equity funds, leave your money there, and the markets -- on the greatest growth tear in our history over the past 18 years -- would take care of the rest. Not only did we see more choices, but it also became easier and easier to move money around among the funds.

Now that we've had a lesson in the volatility of markets, it's clear that things are more complicated. You have more choices, and you know that you've got to exercise those choices, but it's possible to go very wrong indeed in this new world.

Suppose that one of your choices was to put $100,000 of your accumulated retirement savings in the Janus 20 mutual fund, and you did this on March 31, 2000, when it traded at about $80 a share. Top fund-rating agencies would have given this fund five stars and shown a very impressive track record of growth. With 20 large growth companies, how bad could it get? Well, by March 31, 2001, your $100,000 investment would have shrunk to about $50,000, worse than any one-year loss in the past 75 years for the S&P 500. Naturally you would have felt justified somewhere along the way in getting out. Or, you might have tried to "buy the dips," trading in and out to take advantage of some of the big swings during the past 12 months. With just a little bad luck and lots of active trading, you could easily have bought high and sold low all year long, and ended up with a loss much greater than 50 percent. Perhaps by the end of March 2001, you would have sworn off the world of growth funds altogether, and put whatever was left in bonds.

Just after April Fool's Day, you would have watched from the sidelines as the equity markets began to recover. Bonds, having done so well for the past 12 months, began to slide, and some growth funds regained a nifty 20 or 30 percent in just two weeks! So, "buy and hold" is hazardous, and active trading is even more so.

The wide range of choices and the ease of moving your retirement funds around combine to provide some scary pitfalls indeed. That forces us into a kind of hybrid investment stance -- what I like to call "informed buy and hold." It means you need to have a basic strategy for allocating your money that makes sense for you and your goals. But you also need to recognize that plans based on textbook allocation models are subject to change. Or, if you really want to file your retirement account away and forget about it, you'd better be a bit more conservative than the models suggest.

A diversified portfolio matters more than ever, but ...

It's easy to take advantage of the many investment options, but to wind up with a less diversified portfolio in the process. How? Because the top mutual funds in any investment category all tend to invest in the same or similar stocks. Investing in several "top-performing" funds can thus increase your risk because they all concentrate on the same segment of the market. For example, if you bought three different Internet funds, you didn't get diversification away from the risks of any one stock because you probably had a lot of the most popular names in each fund. Owning just one market index fund already diversifies you completely in that market. Any attempt to concentrate your investing on one sector decreases your overall diversification.

That's especially true if you like to pursue the "hot" funds, presuming that whatever has done the best has done so because of management's superior skill. The chances are that the top-performing funds at any given time have done so mainly because they just happened to be positioned in precisely the best way at that particular time. At any other time, that positioning would have performed worse. With millions of people thinking just alike, billions of dollars pour into the hottest funds, so that any special stock-picking skills the managers actually have tend to get swamped by the flow of new money. In order to keep bringing in their fat fees, the hot-sector managers try to replicate the same strategies on a larger and larger scale. Their initial success draws in still more money from people who confuse the impact of the flood of incoming capital with management skill. This works for a time, but eventually the world changes enough so that the same strategy just doesn't work any longer. The promised growth begins to lag, and people rush out -- first because they notice that the growth isn't there any more, and second because they mistake the outflow of capital for an indication that the economic sky is falling.

For people armed with brochures showing the great performance of certain communications- or technology-sector funds, it would have been easy to load up with several such funds last year, thinking that having more different funds meant they were spreading their risk. Such people have had a long, distressing 12 months indeed. They would actually have gotten much better diversification by putting everything into just one market index fund. In fact, deliberately owning some classes of funds that are not "hot" may help protect you from these errors.

The market recovers earlier than you might expect.

In most recessions, the market begins to recover about halfway through, well before an improvement in the profits picture has been confirmed. People who stay out of the market until they can see convincing improvements in profits are apt to miss as much as 50 percent of the recovery in stock prices. This puts investors in a bind: Sometimes we have to avoid the market, but if we stay out too long we will miss some of the best returns. A lot of active traders know they may have to jump in and out several times before they get it right. No wonder things are so volatile, as active investors continually try to position themselves.

In the long run, the market tracks the economy.

That's very good news. No matter what errors you make, or what bumps come along, there is simply no substitute for being mostly invested most of the time. This guarantees that you participate in the broad pattern of growth. There's no reason to expect the basic attractions of the capitalist system to fade, and no reason to think that the torrid pace of technological innovation driving gains in productivity is likely to lose any steam, either.

The basics of compound interest still matter, and they still work.

By making regular contributions month after month, you automatically minimize the errors that come from trying to guess when to invest. Salting away equal amounts on a regular basis means that you get more shares when the market is cheap and less when it's expensive. It also means that you actually end up better off if the market lags while you're working and contributing and then takes off in your later years than if it rises steadily the whole time.

Keep it simple.

There's little reason to believe that any strategy of avidly buying and selling mutual funds is likely to pay off in the long run. With your retirement funds you need to get things basically right and save speculation for some other pot of money. Avoid the performance game, the ego, the regrets, and the locker-room comparisons. If you are well-positioned and take risks that are appropriate for your situation, you'll almost certainly do fine.