How to Stay Tough in a Tough Market

In my last article I reviewed the 2011 events that have caused most asset classes to have negative returns this year. While you may feel a sense of hopelessness, there are ways you can make any market turmoil more bearable.

The recent downgrade by Standard & Poor's of the U.S. government's credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in bonds. Instead of bond prices going down, they went up! So even if Standard & Poor’s thinks we’re not AAA rated, you as an investor should still act as if we are. The “experts” got it completely wrong on this one.

While prices have been discounted to reflect higher risk, that's another way of saying expected future returns are now higher. And while media headlines proclaim that "investors are dumping stocks," remember someone is buying them. For every seller there has to be a buyer. When stock prices go down and people sell, someone else is on the opposite side of the trade and is buying — every time. There is no such thing as “orphan” shares — shares that no one owns. Long-term investors are often the ones buying. You should be part of that group.

For instance, in March 2009 — when market sentiment was last this bad — the U.S. stock market turned and put in seven consecutive months of gains totaling almost 80%. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery. When you buy stocks, you’ve actually bought risk, so you may as well stick around for the returns.

While stock markets have had a rocky time in 2011, bond markets have flourished — making the overall losses to a balanced portfolio more bearable. Diversification spreads risk and can lessen the bumps in the road. Financial crises cause all risky assets to go down together. What saves you and keeps you in the game are bonds — the best diversifiers of a portfolio.

The economy is only one of many factors that drive stock market returns. They aren’t perfectly related. Also, the world economy is forever changing, and new forces are replacing old ones. While advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving. Today’s losers might be tomorrow’s leaders. A globally diversified portfolio takes these shifts into account.

Just as you should temper your enthusiasm in booms, you should keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to significant market drops, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

As John Bogle, one of my investing heroes, said: “When reward is at its pinnacle risk is near at hand.”

We’ve had an incredible two years of market gains. A well-thought-out investment plan means that you should rebalance out of stocks during their climb upward (as in the past two years) to keep your risk appetite in check. Those rebalancing events mean that downturns should affect you less. If you’ve reached closer to your goals from the last two years of gains, then your need to take risk has dropped and so should your allocation to stocks.

Bogle also said “It’s always darkest before dawn.”

It’s when things look the gloomiest, when there’s a constant barrage of bad news, when you feel like your portfolio is falling off a cliff, that risk premiums — the returns of riskier assets such as stocks over safer assets — are the highest. Capturing those returns takes unwavering discipline since no one knows when those returns will come. So just when things look the darkest, realize that the first flicker of light may be just over the horizon.

The market volatility is worrisome, no doubt. Your feelings are completely understandable. But through discipline, diversification and understanding of how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and if you acknowledge your emotions without acting on them, relief will replace anxiety.

Your financial prescription: Stay tough in tough markets.

Markets are unpredictableQuitting the stock market now is like running away from a saleMarket recoveries can come just as quickly and violently as the prior correctionNever forget the power of diversificationMarkets and economies are different thingsNothing lasts foreverWords of wisdom from my hero