How to thrive in a barren market
Stocks have been stranded for a decade. But times like these require the resolve to forge ahead - despite the pain.
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(Money Magazine) -- Some pundits insist that we're not in a bear market, since stocks have yet to lose at least 20% of their value. But they're missing the point. Investing in equities in the past decade has been akin to being marooned on a desert island.
Yes, you've survived. But the fact remains that your stocks have pretty much gone nowhere for 10 years. In fact, since the end of March 1998, Standard & Poor's 500 index of blue-chip stocks has returned only 3.5% a year. Even cash has outperformed U.S. equities in this arid market, growing 3.8% annually.
This isn't the first time that stocks have been stranded for such an extended period of time. After the start of the Great Depression in 1929, it took nearly a quarter-century for equity prices to fully recover. Stock prices were also essentially flat between 1966 and 1982. Today's barren market hasn't lasted nearly as long, but it still raises a hard question: What should you be doing to rescue your portfolio?
The short answer is that you need to diversify - but in more ways than you think. You already know the importance of owning different types of assets. Diversification was certainly invaluable over the past 10 years.
While U.S. stocks languished, bonds and foreign equities each grew at better than a 7% annual clip. Real estate investment trusts performed even better, returning 10.5% a year. As a result, a portfolio of some U.S. stocks and foreign equities, bonds and REITs ended up performing well during one of the worst decades for stocks.
True, since the market's October peak, traditional diversification hasn't helped much, as several asset classes have fallen at the same time. But as the table above and to the right shows, diversification works its magic over longer stretches of time.
Time is precisely the point. In fact, time itself is another great diversifier. In addition to mixing up the types of investments you own, you also need to diversify when you buy them.
The thought of investing continuously, in routine intervals, in a go-nowhere market is probably about as appealing as sticking your finger in a light socket. But history says you have to be willing to forge ahead.
Why? For starters, no one can predict in advance which assets will perform best in the future. Stocks? Bonds? Domestic? Foreign? Moreover, bull markets typically begin just when you would least expect them to: in the midst of recessions, says Steve Leuthold of the Leuthold Group.
Therefore, the most sensible approach is to dollar-cost average - in other words, put a fixed amount of money into the market every month or quarter so you're constantly investing at different prices. Check out how this strategy would have performed, hypothetically, during and after the Depression.
Say you had invested in a balanced portfolio consisting of 60% U.S. stocks and 40% intermediate Treasury bonds between the start of September 1929 and August 1953. You would have gained just 6.4% a year, which is substantially lower than the historical average of 8.8% for this mix. But had you dollar-cost averaged monthly into such a portfolio in that difficult market, you'd have earned a much balmier 8.4% a year.
Dollar-cost averaging was also more fruitful than hiding in cash. Had you begun investing $100 a month (again, hypothetically) in a balanced portfolio in 1929 - and kept investing $100 a month for the next 24 years - you would have amassed nearly three times as much as an investor who had chickened out and stashed $100 a month in cash (see the chart above and to the right).
Of course, there are no guarantees that investing more money when stocks are down will always deliver better performance in an extended downturn. But at the very least, it will ensure that you benefit from the eventual recovery.
So if you don't yet have an automatic investment plan that painlessly transfers a small amount every month from your bank account to a mutual fund, set one up now. Just call your bank or fund company to get the ball rolling.
Doing this probably won't make you feel any more sanguine about being stuck on this desert island of a market. So here are a few other things to think about that might make you feel better while you're waiting for your portfolio to be saved:
Look before you leap. It's natural to fear that if you do nothing, you will keep losing money. But remember that doing something carries risks of its own. So force yourself to think hard before you act.
Here's a quick exercise to help you do just that. Fill in the blanks in the following two sentences: "On [month, day] I will move my assets out of the stock market because ________, an indicator that ________ has proven to be reliable, makes me __% certain that stocks will fall __% by [month, day]. When ________, an indicator that ________ has proven to be reliable, makes me __% certain that stocks will rise __% by [month, day], I will move my assets back into stocks."
The point is, you won't be able to fill in all the blanks confidently. And if you think you can, you're probably fooling yourself.
Let others share your pain. Every difficult market has an upside: It enables you to make Uncle Sam share some of your losses. Let's say you invested $5,000 in Citigroup (C, Fortune 500) stock in October 2006; you now have only $2,100 left. So sell.
On your next 1040, offset the $2,900 loss against capital gains elsewhere, reducing your taxes. In the meantime, put the $2,100 proceeds into a broad-market index fund or (if you still like financial stocks) into an ETF such as iShares Dow Jones U.S. Financial Sector Index (IYF). You can do the same with a slumping mutual fund. The net result: You have the same amount invested, and you've taken a big bite out of your current tax bill.
Have courage. Finally, look on the bright side - stocks are cheaper now than they've been in years. William Bernstein of Efficient Frontier Advisors puts it this way: "If your friends are running around like recently decapitated poultry, go back in history and look how well stocks did right after things looked the bleakest: 1933, 1974, 1982, 1987."
Those were certainly desolate times. Yet investors who kept putting money to work incrementally in those markets bought their way out. 
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