from Sun NYTimes Business Section - How to Survive Bear Market

July 6, 2008
Fundamentally
A Bear Market, Mauling Not Included
By PAUL J. LIM
WITH the Dow Jones industrial average and the Nasdaq composite index down about 20 percent from their recent highs, this sure looks like a bear market.

But does it feel like one yet? Before you answer, check how your overall portfolio has performed lately. You’re probably not happy with the returns — but if you have been a conservative, diversified investor, you may well be doing better than the overall stock market. “In most cases, the experience of your own portfolio is not what you’re reading in the headlines,” said Stuart L. Ritter, a financial planner at T. Rowe Price in Baltimore.

To be sure, this has been a particularly painful nine-month span, marked by a historic credit crisis, record-high oil prices, heightened inflation fears and perhaps even a recession. And considering that many foreign markets — like China, India and much of Europe — have declined sharply, there is a growing sense among investors that there is no place to hide.

But most individual investors don’t invest all their money in stocks. They put a portion of it into bonds, in part to stabilize their portfolios in a market storm.

This old-fashioned diversification has demonstrated its value. From the start of October 2007 — around the peak of the domestic stock market — to the end of June, a portfolio of 70 percent stocks and 30 percent bonds fell just 9 percent, according to the research firm Morningstar. The stock portion mirrored the Standard & Poor’s 500-stock index, while the domestic bond allocation was based on the Lehman Brothers Aggregate Bond index.

You would have fared even better if you had been gradually putting money into the stock market, a strategy known as dollar-cost averaging. In a falling market, this offers another form of ballast: it means that investors are buying new shares at ever-lower prices, thereby averaging out the returns they earn on each pot of new money.

“Times like these should remind people of the importance of the basics — like having a long-term asset-allocation strategy,” said Liz Ann Sonders, chief investment strategist at Charles Schwab.

Investors might also want to remind themselves of the following three basic rules:

DON’T PANIC Downturns like this one may be painful, but “they’re a normal part of the market,” Mr. Ritter said.

Generally, the market has experienced a 20-percent-plus pullback every five years or so since 1900, according to James B. Stack, editor of the InvesTech Market Analyst newsletter. Some market strategists, including Ms. Sonders, say they think this downturn won’t be as severe as the bear market of March 2000 to October 2002, which cut the Standard & Poor’s 500 in half and erased nearly 80 percent of the value of the Nasdaq index. That bear was marked by sky-high stock valuations amid weak corporate fundamentals. This time around, corporate balance sheets — with the exception of financial companies — are in decent shape and price-to-earnings ratios are generally in line with historical standards, Ms. Sonders said.

“So I don’t think we’re necessarily going to suffer the same type of market pain as the last time,” she said.

STAY PROPERLY DIVERSIFIED This means not only owning different types of stocks, but also committing a permanent portion of your portfolio to fixed-income investments.

Why? Bonds can be a remarkably valuable part of a portfolio when stock prices decline.

Peng Chen, president and chief investment officer of the investment advisory firm Ibbotson Associates, recently studied the diversification benefits of various assets under different market conditions. He found that when domestic stocks went south, there was a tendency for many other investments to follow suit.

In a recent article in the journal of the CFA Society of the United Kingdom, “Re-evaluating Asset Allocation in a One-Basket World,” he found that correlations between the S.& P. 500 and foreign stocks increased in periods when the American index declined. By contrast, the correlation between American bonds and stocks fell to virtually zero in months when the stock market declined, according to Ibbotson. That makes bonds, as an asset class, an extremely effective buffer when the stock market is shaky.

STAY THE COURSE “Sticking to the original plan is the best course of action,” said Alison Borland, the defined-contribution consulting practice leader for Hewitt Associates.

History certainly bears this out. Say you were dollar-cost averaging $1,000 a month — with 70 percent going into S.& P. 500 stocks and 30 percent into a diversified basket of bonds — during the bear market from 2000 to 2002. While the market slide reduced the value of the stocks around 50 percent, the value of the new investments you made during that period would have fallen about 14 percent during this stretch, according to Morningstar.

Moreover, by continuing to invest through the bad times, investors set themselves up to bask in the long bull market that started in October 2002.

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.