Investors have been worrying about it for years, and it finally happened. After racking up stupendous stock market gains in the late `90s, we have been horribly disappointed in 2000. The big indexes, such as the Dow and the S&P 500, have all spent months in the red.
Sure, there have been bright spots, especially the double-digit gains registered by small and mid-size stocks. Some narrow sectors have had an extraordinary year. Natural-gas stocks were up about 70 percent by late September.
But how about that Nasdaq? After soaring 86 percent in 1999 and 24 percent in the first 3 months of 2000, that market’s composite index finished the third quarter 27 percent below its all-time high. Some of the great tech stocks of 1999 became this year’s dogs. Microsoft Corp., which gained 68 percent last year, finished the latest quarter off nearly 50 percent. Amazon.com gave up all of last year’s 42 percent gain.
All in all, 2000 serves to reaffirm a basic investing truism that seemed all but forgotten at the tail end of the last decade: In stocks, you can make it big — and you can lose it, too.
Most investors are familiar with the long-term statistics they know that stocks have generated average annual returns of about 11 percent during the 20th Century. Over long periods, the stock market’s scary fluctuations aren’t very important, we are told, and stocks are the best bet for long-term investors.
But what if stocks are in a swoon when you need your money? If we have had years of above-average profits, can’t we also have years of losses?
Yes. After the 1929 crash, the Dow didn’t set a new high until 1954. And stocks virtually stood still from 1966 to 1982.
The low-inflation, low-interest-rate, high-productivity, post-Cold War environment of spreading capitalism and burgeoning free trade still seems good for stocks. But in a year like this, it is worth looking at ways to hang on to what you’ve got.
First and foremost: If stocks head south, you shouldn’t panic, because the plunge shouldn’t affect any of the money you will need for years.
As a rule of thumb, money you will need during the next five years for a new house, college bills, retirement or any other essential purpose should not be in stocks.
Money you will need soon should be in a series of bonds or certificates of deposit that will mature as you need it. Or it should be in a safe money market fund.
This is old advice, but I suspect that in the late 1990s many investors got careless as they got greedy.
In fact, keeping significant sums of money out of stocks makes sense even if you won’t need cash in the foreseeable future.
Consider these alternate $100,000 portfolios:
The first is 100 percent stocks. If stocks rise 11 percent a year for 20 years, the portfolio will grow to $806,000.
The second is 70 percent stocks and 30 percent super-safe U.S. Treasury bonds. If stocks rise 11 percent a year and bonds return 6 percent for 20 years, the portfolio will grow to $660,000.
Sure, the all-stock portfolio did better, but it would do worse if stocks took a long-term slide. The nearly seven-fold gain of the mixed portfolio isn’t bad, especially considering that the bond portion of that portfolio, worth $96,000 after 20 years, offers a lot of security in a downturn.
If stocks plunged when you retired in 20 years, you could pay living expenses out of bond proceeds first, buying time to await a stock market rebound.
If stocks plunged earlier, you could cash in some bonds, and use the money to pick up stocks at bargain prices, turning a downturn into an opportunity. If you buy something for 75 cents instead of a dollar, and you’re able to sell it for dollar later, your 25 percent discount turns into a 33 percent profit. Buy at half off, then sell at full price, and your return is 100 percent.
While stocks have indeed averaged 11 percent annual returns in the 20th Century, even a long-term investor cannot be sure of averaging 11 percent a year.
The century-long statistic masks many severe and prolonged downturns along the way.
A recent study by the Leuthold Group, a Minneapolis market-research firm, found that the century had 20 bear markets, defined as stock index declines of 20 percent or more. On average, it took three years and two months for stocks to recover enough to break even — to rise again to the peak they had reached before the decline.
Breaking even means returns since the start of the downturn have finally improved to zero. At this point, they still have a long way to go to again tally 11 percent a year.
The Leuthold Group also looked at how long it took after the start of a bear market for stock returns to recover enough to beat the gains offered by risk-free Treasury bonds held over the same period.
The average catch-up time was a little over five years, but investors can’t count on that. From the 1968 peak, which was followed by a 36 percent stock market plunge, it took stocks 17 years to catch up to a safe Treasury investment.
Now, back to that 11 percent annual return we’ve all been conditioned to expect. How long does it take, following the start of a bear market, for annual returns to rebound enough to again average 11 percent?
Eighteen years, according to the Leuthold study.
That’s because, after the 20 percent plunge that defines a bear market, it takes abnormally large gains to get the average annual return back up to 11 percent. It’s as if you expected to return to a 50-50 average in flipping coins 10 times, having just flipped three tails in a row.
To get back to 50-50 that fast, five of the next seven would have to be heads. That’s unlikely; it might take 20 flips to get back to 50-50, perhaps many, many more.
Bottom line: You can’t count on 11 percent a year. You could suffer a devastating downturn on the eve of retirement, and not enjoy significant gains again for the rest of your life.
There are, fortunately, some ways to improve the odds of remaining financially sound, ranging from the simple to the more exotic.
Have a plan. Many investors simply reach for the biggest returns they can get. With a good plan that pins down your future financial requirements, you can figure the rate of return it will take to get there at your savings level. If 8 percent returns will do it, you don’t need to take the risks involved in reaching for 12 percent. You can afford to put a bigger portion of your portfolio into safe storage — in a money-market or bond fund.
Save more, save longer. A slight increase in the amount saved every month can give you a much bigger nest egg in the end. You can get the same result by saving longer.
Dollar-cost average. This means investing equal amounts of money at regular intervals, such as every month, regardless of whether prices are up or down. The same sum will buy more shares when prices are down, boosting your average rate of return over the long term. It won’t hurt as much when stocks fall below their peaks if you’ve built up outsized gains before then.
Use stop-loss orders. Savvy investors don’t wait for a market collapse to dump stocks. They tell their brokers ahead of time when to bail out. When a stock’s price slides to a preset level, this automatic order to sell is triggered.
Sell short. This method for making money when a stock price falls isn’t for rank amateurs, but everyone should understand how it works. The investor borrows a block of shares from a broker, and sells them at the current price. The investor hopes to buy shares at lower prices later to repay the loan. The profit is the difference between the sale price and purchase price.
