Steps for investors to survive a volatile market
The stock market's plunge may require an overhaul of investment strategies.
Turmoil in global credit markets, gloomy economic forecasts, and record daily drops in the Dow and S&P 500 stock indexes continue to batter the confidence and portfolios of American investors. The economic global tsunami seems to spare none.
Despite a global bank rescue effort, even veteran financial gurus have been unnerved by the volatility. Retirement plans have lost $2 trillion over the past 15 months, according to the Congressional Budget Office; a 2009 federal budget deficit is projected to top $1 trillion, higher than any deficit since World War II; state and local governments face falling tax revenues, leading to service cutbacks; and housing foreclosures continue to undermine home prices in many markets.
But not all American households have felt the ravages of this economic downturn equally. Families with fixed-rate mortgages; significant home equity; minimal credit-card balances; comfortable savings; and a diversified, conservative portfolio may weather the storm. Households with negative home values, excessive investment in equities, underfunded retirement savings, and massive consumer debt will face serious long-term financial damage.
Significant generational differences also distinguish the affects of this economic downturn. Those in their 50s and 60s lack the advantage of time to regain lost investment values, while those in their 40s and younger will have opportunities to rebuild their wealth.
Even within generations, the willingness to take risks has exposed investors differently to market volatility. The Profit Sharing Council of America reports that the typical 401(k) plan has 65 percent in equities. Yet nearly half of 401(k) participants age 56 to 65 devoted 70 percent or more of their investments to equities, with 27 percent allocating 90 percent or more in 2006, according to the Employee Benefit Research Institute.
Those heavily invested in equities have suffered greatly. A portfolio with 70 percent stocks, 20 percent bonds, and 10 percent money-market funds would have fallen 25.5 percent year-to-date as of Oct. 15. A conservative portfolio with 30 percent stocks, 20 percent bonds, 40 percent money-markets, and 10 percent cash would have dropped by just 10 percent over that period.
A new economic paradigm
In today's harsh new economic order, investors need to recognize that market volatility will be pronounced and any recovery will be extended despite coordinated global credit infusions and new regulatory structures. With greater restrictions on creditAmerican households will shift to a "pay as you go" mentality, transforming them from borrowers to savers. Borrowers will need to allocate their limited credit more strategically.
Under the new economic paradigm, market returns will not achieve the same levels reached since 1982. As a result, investors should consider embracing three general investment principles.
•Preservation of capital is more important than growth of capital.
•Portfolio management needs to be integrated to include insurance, retirement plans, investment plans, and property investments. This step will optimize financial security in turbulent times.
•An intermediate to long-term view toward investment losses is suggested – even for those near or in retirement – as today's market woes won't be cured immediately. Patience is needed.
With market activity remaining uncertain, investors should adopt the following five strategies:
1. Review your risk-tolerance profile. Consider investing in life-cycle and target maturity funds which automatically decrease investment risks with age. To learn more about your risk tolerance, complete Vanguard's questionnaire: at https://personal.vanguard.com/us/FundsInvQuestionnaire
2. Rebalance assets. Adjust asset allocation to reflect your portfolio's appreciation/depreciation changes. Set an automatic rebalancing timetable for your portfolio. Use market rallies to reduce overexposure to equities and market dips to purchase new stock. Use the "Instant X-Ray" tool at morningstar.com.
3. Increase cash reserves to cover 12 to 18 months of household expenses to protect against potential unemployment and limited access to credit. Get savings tips at choosetosave.org.
4. Review insurance protection. Health, life, long-term care, and property insurance are important. Exposure to uninsured incidents can quickly deplete savings. Check out Ambest.com for insurance company ratings.
5. Reevaluate broker relationships. Many brokerage firms have been acquired or, perhaps, you are dissatisfied with your present service. Check new brokers' credentials at finra.org. Insist on meeting with a potential broker and carefully review fees for services.
• Dr. Kathleen Connell is a professor at Haas Graduate Business School, University of California, Berkeley.