Stocks Are Still the Way to Go

12/10/2008 1:00 pm EST

Focus: MARKETS

Janet Brown

Editor, NoLoad Fund*X

Janet Brown, editor of NoLoad Fund*X, explains why a good asset-allocation strategy is crucial and why most people still needs to stick with stocks.

So far, 2008 has been the worst bear market year we’ve experienced since launching NoLoad Fund*X in 1976.

Market turmoil has left few areas of the investment world unscathed. The average diversified US mutual fund is down 41% this year and foreign funds, both established and emerging markets, lost more. Extreme risk aversion caused unusual volatility in the bond market as well, and the average long-term bond fund is down 11%.

The Standard & Poor’s 500 index is down 38% so far this year, on pace to suffer its worst calendar year since 1931 when the index fell 43%. But there are exceptional opportunities in the aftermath of this market meltdown: US stocks are at their lowest valuations in over 20 years.

Opportunity arises when investors dump both bad and good companies in fear or panic. In the five years after the 1931 loss, the S&P 500 gained 176%, or an average annual gain of 22.5%.

Since 1945, there have been 11 recessions, occurring every 5.5 years on average and lasting an average of ten months. Every recession since World War II was preceded by declines in equity prices, and the average decline in equity prices before and during recessions was 26% for the S&P 500, so we are far past that. The two longest recessions each lasted 16 months. But in all cases, stocks bottomed about three months before the recession ended.

Some investors wonder if it’s too late to lighten up, or even abandon equities temporarily to avoid further pummeling. The danger, of course, is missing out on the rebound and locking in the losses. Other investors have already sold. These individuals face the equally daunting decision of when and how to get back in.

With money market funds and Treasurys paying nearly nothing, most of us simply cannot afford to sit on the sidelines indefinitely. But it can be equally destructive for investors to take excessive risk in hopes of recapturing losses faster. An appropriate asset allocation ensures that investors take reasonable risk in order to achieve long-term goals and avoid taking excessive risks with short-term money.

How long it might take to recoup losses depends on your asset allocation. While the temptation to flee the market may me acute right about now, moving to a lower-returning alternative would likely lengthen the time needed to recoup your losses.

Over 82 years through 2007, large-capitalization stocks earned an average of 10.4% per year, while small caps gained an annualized 12.5%. Long-term Treasuries earned 5.4% and T-Bills just 3.7% annualized.

For most investors, rebalancing makes perfect sense. If, however, you are taking too much risk based on your current capital base, expected future savings, risk tolerance and time horizon, you may need to reduce your equity exposure.

Near-term volatility may continue for some time, but we know that if you wait for volatility to calm down and the economy to improve, you will probably miss a substantial part of the next bull market.

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