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Stock Investment Strategies In the Deep Freeze

No matter whether you are a small or big-time investor, nor what your stock fund strategy, nothing seems to be working. And this has been true for at least the last year. Here's further proof of that:

Regardless of what type of mainstream stock fund you invested in starting in Jan. of '08, as the bear market got off the ground, it almost didn't make any difference. The average stock fund was down nearly 39% over the year. If you invested all of you money in the average Small-Cap Value fund, you were down 33.5%; if instead, you were in a Mid-Cap Growth fund, you were down by 44.5%. All the other major fund categories were in this tight 11 point range. (Some specialized international funds did even poorer though.) In other words, investors did not see value in any traditional stock category as measured by the fact that they indiscriminantly sold all types of funds to about the same degree.

A stock fund picking strategy is based on the idea that some funds should perform better than others. And usually that is the case. If we go back to Jan. '07, which type of fund you were invested in that year truly made a big difference. The average US stock fund returned +6.6%. But if you were in the average Small-Cap Value fund, your return over the next year was -5.5%. If you were in Mid-Cap Growth, your return would have averaged +16.5%. That's a 22% range, exactly double the 2008 range.

It is normally the case that a good stock fund picking investment strategy can make a big difference, even the difference between achieving good results vs. mediocre (or worse) ones. But when a bear market hits, it seems investors are no longer paying attention to picking the wheat from the chaff; they are throwing out everything. And when they do, it becomes almost impossible for any stock fund picking strategy to work.

In this case, overall asset allocation strategy, that is, which broad types of assets you have your investments in, would appear to be far more important. If no mainstream categories of stock funds are doing well, then the only way to do significantly better than what stocks are delivering is by trying to be in bonds or cash, assuming, of course, that these categories will do better than stocks.

Obviously, though, changing your overall allocation strategy is not an easy decision to arrive at. Many of us have come to believe that stocks are the best investment for the long term, regardless of relatively short-term fluctuations. Perhaps changes in allocations should only occur as a function of your age, or if you anticipate the need to withdraw a proportion of your assets in order to cover a large upcoming expense within the next several years.

Aside from hesitation to change one's previously well-thought out strategy and thereby undo prior decisions, one obstacle, especially now, is that you might have to accept a loss when moving out of your current fund into another asset. This involves not only the actual loss of money but the psychological loss that comes with acknowledging that you "erred" by choosing a given asset, or at least, stayed too long before things got considerably bad. Or, if held in a taxable account, you might have to pay taxes on any fund that might still have a gain. All this pain might be avoided one could be reasonably sure that the fund in question will eventually come back and still provide ample rewards. So when faced with these choices, it is not surprising that the majority of people will wind up deciding to keep on holding even in the face of adversity. And many will continue to do so as long their patience, nerves, and necessary financial resources hold out.

Of course, if you are investing new money, changing you asset allocation strategy can occur without the potential drawbacks of selling anything. You just gradually direct your new investments, such as ongoing 401(k) contributions, into types of funds that now seem more prudent. Or, if allowed as an investment option, re-direct your fund distributions from being re-invested within the original fund, to a different one.

For readers who might remain skeptical as to the advantages that can accrue from changing one's asset allocation strategy in the face of harsh economic realities, let's, as an example, see what the difference is between remaining invested in a typical allocation, 60% stocks, 25% bonds%, and 15% cash vs. following the allocation I recommended in my 3rd Qtr '08 Newsletter for moderate risk investors which was 45% stocks, 35% bonds, 20% cash.

For ease of comparison, assume the funds were invested in the Vanguard S&P 500 Index fund (VFINX), the Vanguard Total Bond Market fund (VBMFX), and the Vanguard Prime Money Market fund (VMMXX).

The return for "typical" portfolio in the latter half of '08 would have been -15.9%, not annualized.

The return for "bear market adjusted" portfolio over the same period would have been -11.2%, not annualized.

Nor has the first month of 2009 started well for stock portion of either portfolio. As of 1-30, the above 3 funds would have shown total returns of -.084% (VFINX), -.007% (VBMFX), and +0.0016%(VMMXX) (all not annualized). So, combining the results over just the last 7 months, the typical portfolio would have lost 19.6% while the bear market adjusted portfolio would have lost relatively less at 14.1%. These losses are also not annualized; if they continued at this pace over a full year they would start to approach double these amounts.

Let's see what these loses translate into in terms of actual dollars. Suppose your entire investment portfolio in mutual funds was worth $100,000 on July 1, 2008. Had your portfolio been similar to that of the typical investor you would now have $80,337 left; an investor following the bear market adjusted portfolio would have $85,893 left. The difference is $5,556 less now remaining for the former investor than the latter. If you had even more than $100,000 invested, the difference is proportionally greater. And, if your original allocation was even higher in stocks than 60% (some people might still have 100% of their total investments in stocks), your "paper" portfolio losses in during this admittedly short period would be far greater.

(You should note that for the 4th Qtr of '08 and the 1st Qtr of '09, my Newsletters recommended a further lowering of your stock allocation below the 45% used in the above calculations to 42.5% and 37.5% respectively. I also recommended a raising of your bond allocations from 35% to 40% and then 50%. Had one made these modifications, their portfolio losses thus far would be have been considerably less than those shown above.)

While negative returns are obviously never pleasant when a bear market hits, losing less, even if it is just "on paper", can make a big difference. Less loses may help you better withstand the ravages of the bear and enable you to have greater resistance to the urge to sell.


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