"Buy and hold is dead." "Now's the time to buy gold." "Target date funds have been a total failure." "The only way to protect your assets is with our deferred income annuity."
If you're like me, you've seen the rush to judgment about the stock market crash by both pundits and opportunists. But what can we really learn a year later, after the initial shock has worn off and we have the opportunity for more measured study? Plenty!
In this month's newsletter, I'll share my philosophy and strategies on investing for retirement, both of which have been influenced by studying the effects of the stock market crash of 2008-2009 and prior downturns. These ideas aren't new--they're classic asset allocation and investment strategies. The lessons taught to me by my grandfather, who was a stockbroker in the Great Depression, apply very well to the most recent meltdown--and most likely will continue to apply as we all attempt to protect ourselves from future meltdowns.
The New GoalMany investing strategies focus on building wealth, which is an appropriate goal during your wage-earning years. As you approach retirement, I advocate that you shift your attention to building reliable sources of lifetime income, no matter how long you live and no matter what happens in the economy.
With this goal in mind, let's get started on ...
The Recession-Proof Investing Strategies
If you're within ten years of retirement or are already retired, it's critical to strike a balance between protecting against two potentially significant risks: market losses and inflation. Here are two investing strategies that address this goal:
1. Manage your risks through asset allocation.
2. Shift to investing for income.
Because I want to make sure you thoroughly understand these strategies, I'll discuss the first strategy--managing your risk through asset allocation--in this month's newsletter and cover the second strategy in the November issue. As you'll see, both strategies involve an important personal characteristic: patience.
First, let's gain some insights from history. Each year, I update a chart that comprises the annual stock market returns from the S&P 500 index since 1926. The chart is too large to insert in its entirety in this newsletter, but you can take a look at the complete chart on my website. After looking it over, you'll see that 2008 was the second- worst year on record (1931 was the worst).
The chart also illustrates what I call the "stock market double whammy." When you take a close look at the chart, you'll see that there have been approximately twice as many "up" years as "down" years, and that the "up" bars go up about twice as high as the "down" bars go down. If you believe the stock market will come back from its big drop in 2008-2009, you have history on your side and you just have to wait for the up years to return.
How long will you need to wait? The table below shows the length of time it took the market to recover from prior severe downturns (defined as a drop of 20% or more in the S&P 500 index). The first column shows how long the downturn was--from the high to the low in the S&P index--with the second column showing the exact percentage of the loss. The third column shows how long it took for the market to go from the low back to the previous high, i.e. the length of time investors had to wait for recovery.
Months to Recover from Prior Stock Market Crashes
Length of
Downturn |
Percent
Loss |
Months to
Recover |
| 1929 - 34 months |
- 83.4% |
151 months |
| 1946 - 6 months |
- 21.8% |
35 months |
| 1962 - 6 months |
- 22.3% |
10 months |
| 1968 - 19 months |
- 29.3% |
9 months |
| 1973 - 21 months |
- 42.6% |
21 months |
| 1987 - 3 months |
- 29.5% |
18 months |
| 2000 - 25 months |
- 48.9% |
54 months |
In the worst case--back in the Great Depression--it took the market more than 12 years to recover. But if you average all the recovery periods, it works out to just about three-and-a-half years. If you're in your 50s, 60s or 70s now, you'll most likely still be alive in three-and-a-half years--even in 12 years. So you have the time to wait, particularly if you have other sources of financial security as advocated in this newsletter and in my books.
The Importance of Diversification
One of the most critical elements of managing your risks is to make sure you diversify your investments across different types of assets. Why is that so important ? It helps reduce your overall risk, which helps mitigate the risk of different types of economic challenges. Because each asset class behaves differently in diverse economic climates, you'll want to invest in a mix of stocks, bonds, real estate and cash. If you're leery about choosing the right mix, there are mutual funds available, such as target retirement date funds or balanced or asset allocation funds, that provide the type of diversification you're looking for within one investment.
Need evidence that diversifying across asset classes is a good strategy? The behavior of the stock market in 2008 provided just such a lesson. Let's look at the 2008 returns of various Vanguard mutual funds that have different asset allocations to see why diversifying is a good objective. I selected these particular Vanguard funds because they're widely used and their return history is readily available on the internet.
2008 Returns of Various Vanguard Mutual Funds
| GNMA (100% government bonds) |
7.22% |
| Treasury money market |
2.10% |
| Wellesley Income (1/3 stocks, 2/3 bonds) |
-9.84% |
| Wellington (2/3 stocks, 1/3 bonds) |
-22.30% |
| S&P 500 Index Fund (100% stocks) |
-37.02% |
| REIT Index |
-37.05% |
| FTSE All World Ex-US Index |
-44.09% |
Because of last year's stock market activity, the year 2008 represents a possible "worst case scenario" for potential future losses in the stock market. But when you're trying to decide how much risk you can tolerate, don't look simply at percentages. Instead, ask yourself how much money you can afford to lose. For instance, suppose you had invested $100,000 in each of the above funds at the beginning of 2008. Could you afford to lose the amounts shown on the following chart?
2008 Losses on $100,000 Invested in
Various Vanguard Mutual Funds
| Wellesley Income (1/3 stocks, 2/3 bonds) |
- $9,840 |
| Wellington (2/3 stocks, 1/3 bonds) |
-$22,300 |
| S&P 500 Index fund (100% stocks) |
-$37,020 |
| REIT index |
-$37,050 |
| FTSE All World Ex-US Index |
-$44,090 |
What Should You Do?
My years of actuarial experience and research on investing helped me develop the following guidelines: People in their mid-50s and beyond should consider investing no more than two-thirds of their money in the stock market--to protect against market losses--and no less than one-third of their money in the stock market--to protect against future inflation. This range is well represented by the Wellington fund (two-thirds of its assets are invested in the stock market) with a 2008 loss of $22,300, and the Wellesley fund (one-third of its assets are invested in the stock market) with a 2008 loss of $9,840. While these losses were definitely hard to bear, most people can recover from such losses, particularly if they have reliable sources of retirement income in addition to their investments.
Unfortunately, before the stock market losses last year, many people were chasing high returns and had high allocations to stocks. When warned about the risks, they didn't think that stocks could drop as far as they did in 2008. As you can see from the above table, such investors experienced large dollar losses.
An important step to take before you invest a single dime or decide to modify your investments: Stop and think about how much money you can tolerate losing. This will help you work out the asset allocation that's right for you. Need more help figuring out just how to invest your money? Consider this advice I got from my stockbroker grandfather: Invest amounts you can't afford to lose in bonds and cash, whereas invest in stocks only the dollar amounts you can afford to lose 50% or more of. In addition, when you're considering how much you can afford to lose, consider all your financial resources, such as Social Security, pensions or annuities, your house, etc.
What Did You Really Lose?
It's also critical to think about what you really lost when the market went into a downturn. Let's say you had $400,000 invested in the stock market and you "lost" $100,000 last year. You're probably feeling overwhelmed because you think there's no way you can make up that loss. But what you've really lost is the income that $100,000 could generate. A reasonable estimate would show that this income might be 4% or 5% of your losses, or $4,000 to $5,000 per year (see my March 2009 newsletter for more on this). That's not as bad as you thought, I bet. And if you consider this amount to be what you'd have to earn in part-time wages each year to make up for your investment loss, earning those few thousand dollars buys time for your retirement investments to bounce back. Now you've got a more realistic--and more positive--way to view this challenging situation.
Nerves and Patience Needed!
Investing for retirement also requires the nerves and patience to ride out downturns, and the 2008-2009 downturn is providing a good lesson on why this is important. Let's take another look at the previous table, now updated for year-to-date gains through September 30, 2009.
Year-to-Date Gains Through 9/30/2009 on $100,000 Invested on 1/1/2009 with Various Vanguard Mutual Funds
| |
2008 Loss |
2009 Gain |
| Wellesley Income |
- $9,840 |
$11,261 |
| Wellington |
-$22,300 |
$13,217 |
| S&P 500 Index fund |
-$37,020 |
$12,155 |
| REIT index |
-$37,050 |
$11,847 |
| FTSE All World Ex-US Index |
-$44,090 |
$19,261 |
In less than one year, the market has rewarded our patience and is starting to come back. The Wellesley fund (invested one-third in stocks) has recovered all its losses and more, while the Wellington fund (invested two-thirds in stocks) has recovered almost 60% of its losses. The S&P 500 and REIT funds have recovered about one-third of their losses, while the FTSE fund has recovered 44% of its losses. Only time will tell if and when we will fully recover from all our losses during 2008.
There are scores of statistics that examine rates of returns over long periods of time; such studies have examined every 10-year period, every 20-year period and so on. For most 10- and 20-year periods, portfolios with higher allocations to stocks have had higher historical returns than bonds and cash investments. This has been the traditional justification for significant allocations to stocks for long-term investments, such as retirement savings.
Of course, there have been times when portfolios with higher allocations to stocks have had worse returns when compared to those invested in bonds and cash--and the stock market crash of 2008 provided one of those "occasional" times. For the 10 years ending December 31, 2008, the return on stocks was negative, and stocks lagged behind all other investments. The key question is this: Will the stock market recover again? Will the U.S. economy recover? I don't have a crystal ball--and neither does anybody else-- but you might take some comfort that this has happened before and the stock market recovered to go on to new highs.
So if you can learn to ride out the negative periods, you'll most likely be rewarded by hanging in there for the long term. And that's why I'm hedging my bets: I'll continue investing in stocks for the potential of long-term growth, but I'll limit my investments in stocks so that if they continue to do poorly, it won't ruin me. And I'll have other sources of retirement income that aren't as susceptible to market fluctuations.
Wrapping Up
The crash of 2008-2009 has certainly shaken the confidence of millions of responsible, hard-working Americans who've diligently been saving money for retirement. I even heard someone recently say:
"My 401(k) is now a 201(k)!"
Most people lost only 20% to 30% during 2008, not 50%. So your 401(k) is now a 301(k), not a 201(k). In other words, most of us still have 70, 75 or 80 cents on the dollar--bad news, of course, but at least we aren't at zero. We can and will recover. In fact, with the year-to-date gains we've seen this year, you might actually have a 401(k) again!
And yes, we've all been hit hard. But our only option is just to do the best we can going forward. Start by assessing the real damage that's been done: How much retirement income have you really lost, taking into account your 2009 gains? Then think about how much investing risk can you tolerate and allocate your assets accordingly.
Finally, don't put yourself in a position that makes it necessary for you to chase high returns with high allocations to the stock market. Adopt other strategies--maxing your Social Security benefits, having income from a pension or annuity, minimizing your living expenses, keeping active in the job market--that leave you less vulnerable to stock market crashes. Plan so that you'll have the income you need from your retirement investments with realistic, achievable returns from a prudent mix of stocks and bonds. The asset allocations suggested earlier--between one-third and two thirds of your assets in stocks-- have this goal in mind.
It all comes down to this: Thoughtfully plan your asset allocation considering all your financial resources, and then invest with confidence and peace of mind.
P.S. While we're on the theme of learning from the stock market crash, it's also a good time to announce my latest book, titled Recession-Proof Your Retirement Years. Please see the write-up at the top of the blue column at the right for more details.
