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Train to get in financial shape

Bear markets like this demonstrate that you need to be emotionally "fit" to invest for the long run.

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By William J. Bernstein, Money Magazine

William J. Bernstein is co-founder of Efficient Frontier Advisors and author of "The Four Pillars of Investing" and "A Splendid Exchange."
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(Money Magazine) -- Welcome to the Olympics of investing. Unfortunately, you are not a spectator. The S&P 500 index of large-cap stocks has lost more than 40% since November 2007, and about $2 trillion in value has disappeared from investors' 401(k)s and IRAs, according to the Center for Retirement Research.

So you probably don't feel that you have much chance of taking a victory lap. But if history teaches us anything, it's that the sweetest victories are won in markets just like this one, even if it doesn't seem that way at the time.

Think of bull markets as a 5K fun run. Just about anyone can join in and earn boffo returns for a while. This time, though, what you thought was a fast neighborhood jog turned out to be an elite marathon - just another 23 miles to go! - with many participants having collapsed wheezing and exhausted on the sidelines. That means that they are handing over their stocks, at cheaper prices, to the disciplined investors who began the race in good financial condition.

By financial condition, I don't mean the state of the buyers' bank account or even their market expertise but rather their emotional fitness to handle market volatility. And most of us aren't born with that. You have to train.

Why emotional fitness matters

Well-trained investors know the collapse of 2008 was not some aberration. In fact, there have been four other times since 1926 that stocks have fallen at least 40% from a recent peak. The first three - in 1929-30, 1937-38 and 1972-74 - allow us to examine long-term returns after a crash. (The fourth, from 2000 to 2002, is too recent.) The lesson? As John Maynard Keynes observed, "selling at very low prices [is not] a remedy for having failed to sell at high ones." Quite the opposite.

Imagine that you had the psychological fortitude to invest in stocks on Nov. 1, 1930, after the market fell 41%. This was by no means the bottom: The bear still had another 20 months to run, bringing eventual losses to 83%, according to Ibbotson. Even so, equities delivered a real (after inflation) return of 2.9% annually over the subsequent 10 years and 4.5% over the next 20 years.

But that's the worst-case scenario. Buying stocks after the 1937-38 and 1972-74 debacles provided far better results. If you invested in equities on Oct. 1, 1974, for example, your real annualized return was 7.5% over the next 10 years and 9% over 20. This suggests that high future returns are a good possibility now.

Your training regimen

Now that you know just how long and rigorous this event really is, how do you train for it? The basic workout is consistent asset allocation. It's okay to keep your plan simple - say, 45% domestic stocks, 15% foreign stocks and 40% bonds. The point isn't to come up with the perfect strategy as much as it is to have one that you'll stick with in up-and-down markets. Then, once a year, rebalance back to those levels. In the good years, this means selling some stocks to get things back into balance, and in the bad years it means selling some bonds to buy more stocks. The latter is harder to do than the former.

There's no better way of keeping yourself fit than regular rebalancing, particularly during bear markets. By making it a routine math exercise instead of an annual review of the market or your strategy, you'll find it easier to tune out your emotions.

The good news is that unlike an elite athlete, an emotionally fit investor doesn't have to wake up at 6 a.m. every morning to work out (or tune in to CNBC). In fact, it's better not to think about investing most of the time. I know no greater investment pro than Vanguard founder John Bogle; he tells me that he peeks at his holdings only once a year. In this race, the edge goes to the disciplined couch potato.

William J. Bernstein is co-founder of Efficient Frontier Advisors and author of "The Four Pillars of Investing" and "A Splendid Exchange."

Need help with a financial dilemma? In an upcoming issue, Money magazine will be answering reader questions. Email money_letters@moneymail.com.
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