photo by adam.dras
Over the past year investors have been affected by what some describe as “the perfect storm“. On Wall Street the S&P was at 666 at its low, now it has rallied 58% from that point. For those that have weathered the storm it’s time to assess what lessons can be learned.
Below are excerpts from an article on CNNMoney.com by Penelope Wang.
The worst financial meltdown since the 1930s began, you’ll recall, with a bang. Early September 2008 the housing crash led to the federal government’s takeover of mortgage giants Fannie Mae and Freddie Mac — whose dividend-paying stocks were a cornerstone of many retirement portfolios.
The five following lessons from the Crash of ‘08 will help you strengthen your finances going forward — and should limit the damage in the next crisis, wherever and whenever it may come.
Lesson 1: Asset allocation still works — just don’t expect a guarantee.
In the wake of the crash, you may have concluded that asset allocation — the traditional strategy of diversifying among stocks, fixed income, and cash — is a bust. After all, your U.S. and foreign equities and all sorts of bonds lost money last year.
“The basic principles of asset allocation need to be revised,” says MIT finance professor Andrew Lo. He and other experts argue that since market volatility is rising, you must now own other assets — such as hedge-fund-like investments — in addition to stocks and bonds to manage risk. And you must be prepared to shift your mix tactically from time to time. “You need to be proactive and adjust as the market changes,” he says.
And if you look at the numbers, you’ll see that proper diversification did you considerable good in this meltdown.
Lesson 2: The world is riskier — and will stay that way.
Remember the Great Moderation? The phrase describes the recent quarter-century period when economic growth looked limitless and the long-term risk in stocks seemed to be disappearing. Between 2003 and 2007, for example, the Chicago Board Options Exchange Volatility Index (VIX) — a well-known gauge of how risky investors think the market is — hovered in the 10-15 range. That was down considerably from the index’s historical average of about 20.
Risk, of course, returned with a vengeance. Last October, at the height of the banking crisis, the VIX hit an all-time high of 80. Today the VIX has fallen back to around 25. The question is, should you brace yourself for more nerve-jangling spikes? Yes, according to many investment pros, including Yale finance Professor Roger Ibbotson, founder of Ibbotson Associates.
Revisit your investment mix to make sure you’re taking on an appropriate amount of risk in light of your financial goals and your tolerance for more market shocks.
Lesson 3: Real diversification is harder to achieve than it looks.
The best way to avoid too much exposure to any industry or asset — especially frothy ones — is to drill down in your portfolio to see what you actually own. Another idea: Stick to index funds. As noted, an S&P 500 or total stock market fund can’t keep you from getting caught up in the market’s momentum. But it’s always clear what index funds own, because they mirror well-known benchmarks for which information is readily available.
Of course, owning different stock funds — be they actively or passively managed — won’t adequately diversify you, since most equities are positively correlated. Translation: They tend to move in the same direction. And correlations among assets have been growing, as global markets are now intertwined.
Lesson 4: Recognizing a bubble is hard. Hedging against one is harder.
“To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong,” said then-Federal Reserve chairman Alan Greenspan in 1999. He should know how hard that is: He failed to detect two of history’s frothiest markets — in tech stocks and in housing.
The one sure hedge: a healthy dose of cash, an asset all but forgotten during the boom. Don’t ignore it now.
Lesson 5: You can’t time the market, but you can time yourself.
Every year that passes is another year you get closer to retirement. Over time this will require you to dial back the percentage of your nest egg that you hold in equities.
Then there are circumstances specific to you and your family. Sure, your allocation may have been right when you last rebalanced your portfolio. But what if your employer has run into financial problems recently and you fear losing your job? What if your spouse is coping with a medical emergency, or you’re now financially responsible for an aging parent?
If you’re dealing with these kinds of situations, it’s more important to preserve your principal and build up some additional cash reserves than to earn the highest possible returns. In that case there’s nothing wrong with shifting some of your equities into safer, more liquid investments.
This is not a repudiation of asset allocation, but a recognition that your life has changed. And it’s that kind of timing that will guide your portfolio safely through good times and bad.