NEW YORK (Money Magazine) - The third year of this bear market finally took the fight out of some of us. As of Nov. 30, investors had dumped $20 billion more in U.S. equity fund shares than they bought.
That may not sound like much, but it means that 2002 could end up being the first year to see net redemptions out of stock funds since 1988. With the S&P 500 index now down more than 40 percent since its March 2000 peak, that urge to put up your guard is understandable.
But at MONEY, we still believe that stocks get better when they get cheaper and that having the discipline and courage to buy when others are bailing is crucial to accumulating real wealth.
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Not that you should ignore what's happened to your portfolio since the crash. As you'll see, the bear market has taught us all some crucial lessons about risk, as well as about how mutual funds work. And with the threats of terrorism, war in Iraq and perhaps a double-dip recession looming, you still need to be prepared to lose money on some of your funds.
But as long as you keep in mind these eight timely rules, we believe that you'll be a winner in the end.
Round 1: You need funds, now more than ever
You may be feeling pretty burned right now. Over the past three years, the typical diversified domestic-stock fund has lost a cumulative 28 percent. And for the privilege of losing your money, the average fund manager was charging you 1.3 percent a year in expenses.
Scores of well-known fund managers fell for the dot.com and telecom hype or were duped into believing the numbers on Enron's and WorldCom's earnings statements. It's enough to make you think you might as well just do it yourself.
|Fund ||Ticker ||3-year return ||Expense ratio |
|Fidelity Dividend Growth ||FDGFX ||-3.9% ||0.95% |
|Growth Fund of America ||AGTHX ||-9.4 ||0.75 |
|Thompson Plumb Growth ||THPGX ||6.6 ||1.2 |
|American Century Equity Income ||TWEAX ||9.1 ||1.25 |
|Calamos Growth ||CVGRX ||-1.5 ||1.5 |
|FPA Perennial ||FPPFX ||6.9 ||1.24 |
|Royce Total Return ||RYTRX ||10.8 ||1.24 |
|Van Kampen Equity & Income ||ACEIX ||2.5 ||0.82 |
|Dodge & Cox Income ||DODIX ||10.8 ||0.45 |
|Fidelity Spartan Investment Grade Bond ||FSIBX ||9.9 ||0.5 |
Well, for those investors who take the time to do the research, stock picking can be richly rewarding -- but we submit that even the most committed do-it-yourselfers should make funds a part of their portfolio. If the people who buy stocks for a living weren't able to spot Ken Lay's shenanigans, there's even less chance that a part-time investor would.
And if you think it's hard to stay on top of just one stock, consider that many financial planning experts believe you'll need at least 50 stocks to have a truly diversified portfolio. For the vast majority of us, mutual funds are the best way to get a stake in the stock market while limiting the impact of one or two bum picks.
If you're incurably skeptical of the pros, there are always passively managed index funds like Vanguard 500 Index. They'll let you invest in a big, diversified slice of the market (such as the S&P 500) without relying on a manager's judgment.
Understand that index funds have their limits though. Vanguard 500's popularity soared during the 1990s, in no small part because it beat the average diversified U.S. stock fund every year from 1994 through 1998. Over the past three years, however, the Vanguard portfolio has trailed the average fund by an annualized 2.7 percentage points.
What's changed? We doubt that the bear market has made professional stock pickers better at their jobs -- what we're really seeing is that the managers weren't as bad as they seemed. Companies too small to be included in the S&P 500 languished when everyone was loading up on Microsoft and Cisco Systems, but they've withstood the correction far better than blue chips, giving the edge to hundreds of active funds with the freedom to invest in small-caps.
There were even some smart large-cap managers who held fewer tech stocks than the index and thus missed the worst of the Nasdaq debacle. Over the long term, index funds still have important built-in advantages and we strongly recommend them, but the best active managers are clearly doing many investors a lot of good.
Round 2: Don't hold out for the bottom
Because how will you know it when you see it? You can always find convincing arguments that the market will go up or down. Money manager Jeremy Grantham worries that equities are still expensive: Stocks in the S&P 500 trade for around 20 times trailing 12-month earnings, yet the S&P's average P/E over the past century is 14.
Grantham suspects the "right" price is somewhere in between, perhaps 16 times earnings. He's more pessimistic than most, however. Since market corrections have almost never lasted more than three years, sharp minds like Peter Lynch and Legg Mason's Bill Miller are saying we're already overdue for an upturn.
Our verdict: Be prepared for surprises, both positive and negative. Commit to a program of dollar-cost averaging, putting money into the market every month or quarter. You'll own shares at a variety of prices, including some that should prove to be near that elusive and lucrative bottom.
The other major benefit of dollar-cost averaging is that it takes the emotion out of buying stocks. The excitement of a rally can be contagious -- and disastrous. Investors pumped a record $33 billion into technology and large-cap growth funds in March 2000, the Nasdaq's peak, and many of those funds have since lost more than 90 percent of their value.
We can't say how long it will take to recoup those losses, but according to the Leuthold Group, it was decades before investors who put a lump sum into the market at the highs of 1929 or 1968 finally broke even. Now think about this: The legendary value investor Benjamin Graham once observed that anyone who began dollar-cost averaging just before the '29 crash would have realized an 8 percent compounded annual return by 1948.
So if you can muster the nerve to keep investing on a regular basis now, history says you'll make money. And your good habit may also keep you from overdoing it when the market rebounds.
Round 3: Be realistic about stocks
Over the past century, equities returned an average of 10 percent a year (before inflation), while bonds delivered just 5 percent and supersafe Treasury bills only 4 percent. But this "equity risk premium" (that is, the extra reward for taking a chance on stocks) may not be quite so wide in the future.
In their landmark 2002 study of global stock market returns, The Triumph of the Optimists, London Business School economists Elroy Dimson, Paul Marsh and Mike Staunton argue that stock investors are likely to get significantly less bang for their buck. Why?
The simple answer is that both the stock market and the economy changed profoundly in the second half of the 20th century. New financial tools, including funds, made it much easier and safer for investors to buy stocks. Also, the U.S. achieved new levels of productivity and a global economic dominance that would have been unimaginable for an investor in, say, 1945. Stock valuations had to rise sharply as investors adjusted to the new reality.
But this was probably a one-time adjustment: Even if all these positive trends were to continue, they can't surprise the market the way they did the first time around. So assuming that the U.S. economy keeps growing in our lifetime -- and the good news is that few economists doubt that it will -- we figure that investors can expect a long-term return of 7 percent or 8 percent, not 10 percent, on equities.
Round 4: Buy stocks anyway
Even if this is an age of lower expectations, the London economists still expect stocks to significantly outpace bonds in the long run. The lesson here isn't that you should be more conservative but that you can't let the stock market do your saving for you.
What's more, equities should continue to be one of the most effective bulwarks against inflation, which is still a long-term hazard even if we haven't seen much of it lately. So the classic 60-40 split between stocks and bonds or cash remains a sensible starting point for most investors.
But it really is only a start. You also need to know how much you can stand to lose -- and if nothing else, the past three years have given you a chance to see how you perform under fire. If you've been ditching stocks lately, it's fair to say that during the bull market you overestimated your ability to ride out volatility.
That doesn't mean you shouldn't buy equities again; the real problem is that losing so much money at once may have shocked you into selling low just when you could be snapping up bargains. So by all means, invest now if you don't need the money in the immediate future.
But while the memory of these losses is still fresh in your mind, make a solemn promise to yourself to never, ever bet as much of your savings on stocks as you did in 1999 and 2000, no matter how strongly the market rebounds.
One clear lesson of this bear market is that diversification can keep you in the game. According to T. Rowe Price, a diversified fund portfolio with 60 percent in stocks, 30 percent in bonds, and 10 percent in cash would be up 14 percent over the past five years (versus just 2 percent for the S&P 500), leaving a nice chunk of capital to buy cheaper shares with now.
Round 5: Think inside the box
As you do your soul-searching about risk, remember that you may be both a conservative and an aggressive investor at the same time. Most of us keep our investments in several separate mental boxes -- 401(k)s, taxable accounts, 529 college savings plans and so on.
If you are worried that you have too much (or too little) exposure to the stock market, sit down at your kitchen table and start sketching out what's in each box. Then ask yourself this: Over the next decade or so, will you be putting more money into each box or taking money out? If you're still putting money in, you can afford to regard this market as a buying opportunity.
But if you'll be taking cash out, you should be shifting money into more stable investments. (And if dropping stocks now makes it hard to meet your goals, you may simply have to save more money to put into the box.) So a 40-year-old investor with a 529 plan may need to move much of that account into bonds once the kids hit junior high.
Likewise, some fearless 60-year-olds could decide to keep a taxable account 80 percent in stocks, if they've already scaled back the risk in their retirement plans. After all, some of that money may still have 20 years or more to grow.
Round 6: Diversify for real
Some investors went into the peak of the market in 2000 with a false sense of security, believing that their collection of eight, 10 or 20 funds gave them the diversification to ride out the rough patches. But the number of funds you own has almost nothing to do with diversification; it does you little good when the bubble bursts to own five different flavors of blue-chip or growth funds.
As long as you own all of the major parts of the market, you may need as few as four funds -- for example, the Vanguard Total Stock Market Index fund, an actively managed international fund, a small-cap fund and the low-cost Vanguard Total Bond Market Index.
But for most of us, with all our different boxes, it's not quite that simple. Go back to that kitchen table sketch, and this time look at all of your funds together. You may find that you have two or more funds that invest in the same kinds of stocks; think about replacing one of them.
You might also see that you have too many funds that react to the same broad market trends -- for example, a junk bond fund in one account may be as vulnerable to telecom bankruptcies as a growth-stock fund in another. For a more detailed look at what all your funds really own and how they all fit together, try the Portfolio X-Ray tool at Morningstar.com.
Round 7: Don't give away your gains
So what should you look for when you finally get down to picking funds? Start with funds with a long history of performance in both up and down markets and managers who have been around long enough to prove their mettle. But most of all, think twice about funds with above-average expenses.
A fund that charges 1.5 percent in annual expenses, for example, may easily lose another 1.5 percent to hidden trading and administrative costs. That 3 percent drag, Dimson and company note, could easily reduce a stock portfolio to bondlike returns, but with the risk of equities. That gives cheap index funds -- which can charge less than 0.2 percent a year -- a lead only the best and most innovative active managers can hope to surmount.
Round 8: Get help if you need it
This last rule is as important as it is simple. The experience of the past three years has shown us that it isn't easy to plan for and cope with risk. While keeping expenses low is important, brokers and fee-based advisers are worth the money if their advice gives you the confidence to stay in the fight. Now get back out there.