NEW YORK (MarketWatch) — One of the most frequent questions about indexed investing is: Why should I hold on when the market tanks? Why not bail out and get back in when things settle?
The usual answer is that nobody can time the market, except by dumb luck. By the time you throw in the towel you are likely to already have substantial paper losses. Then,you probably will be gun shy about getting back in when the market turns. Plus, if you are using exchange-traded funds, you will shell out more commission fees with every transaction.
An indexed investor manages the degree of risk he is taking by means of asset allocation rather than market timing. The mix of assets determines the risk of the overall portfolio, which typically is less than it would be with any single asset other than bonds. Asset diversification does not always work as desired. But a thin cushion is better than none.
Let’s go to the stats, as the sports announcers say. The Dow Jones U.S. Index — which underlies the iShares Dow Jones U.S. Index Fund IYY -1.81% — plunged 55% from its high point on Oct. 9, 2007, to its nadir on March 9, 2009, on a total return (dividends included) basis. This was a devastating drop that terrorized investors; many of them still avoid the stock market, and if they were only in stocks this is understandable.
Suppose, however, that our indexed investor was 60% in stocks and 40% in bonds, represented here by the Barclay’s U.S. Aggregate Bond Index. In this case, the 17-month nightmare would have been somewhat less horrendous. This portfolio sank 31.4% between those dates, again on a total return basis. That is bad enough but considerably better than the all-stock holding.
Actually, bonds were a true diversifier because their prices rose 7% during the period as interest rates continued to drop. Other asset classes, such as non-U.S. stocks, commodities and commercial real estate, were not so fortunate.
For our indexed investors we conjured a portfolio comprised of 27% U.S. stocks, 33% Dow Jones Global ex.-U.S. Index, 30% U.S. bonds and 5% each in the Dow Jones-UBS Commodity Index and the Dow Jones U.S. Real Estate Index. This portfolio is much more diversified, but four of its five components were gored by the bear market.
This portfolio dropped 40% from top to bottom — nine percentage points more than the 60-40 portfolio but 15 percentage points less than the all-stock version. As an aside, this portfolio peaked 16 days later than the others, though it bottomed at the same time.
Time in the market
So diversification mitigates pain. But how much does that matter if a third or more of your portfolio is vaporizing? That judgment is up to each investor, of course, but an indexed investor who stays put does not have to worry about when to climb back in.
That is important because some of the strongest market moves occur early in a recovery when shell-shocked sideliners are still wondering if it is real. One month after bottoming, the Dow Jones U.S. Index was 27.5% higher on a total return basis. Six months later it was 56.5% higher; a year later, 75.5%. Missing out on some or all of that rebound prolongs your recuperation period.
The Dow Jones U.S. Index recovered its 2007 total return peak on March 13 of this year. Of course, Europe’s travails sent the index back down again, but that’s the start of a new cycle.
Diversified portfolios did much better. The 60-40 portfolio reclaimed its total return summit on Nov. 4, 2010, and as of June 7 was up an additional 9.5%. The five-asset portfolio fully recovered on April 20, 2011, but had slipped back by 3.9% on June 7. The recoveries were as much a function of the depth of the bear-market declines as they were of subsequent asset-class performance.
It pays to hold on, even when the floor seems to fall out underneath the market, for three main reasons:
1. With a diversified portfolio, you will mitigate your losses. As a result, you will be in better position to recover more quickly.
2. The burden of market-timing decisions — both moving out and then back in — is lifted from your shoulders.
3. You will not miss out on the strong initial moves of a market’s early recovery.
The indexed investor hangs on because doing so is in his best interests. And the “I should have stayed in/gotten back in/stayed out” remorse is eliminated.
The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.
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