Fear Another Cruel Summer? You May Want to Repack Your Portfolio
“Those who forget the past are condemned to repeat it.” With this phrase in mind, let’s think back a year.
It was around this time last year when the irresistible force of the bull market ran headlong into a seemingly immovable object: the global financial crisis.
Stocks, and stock mutual funds, suddenly became very resistible to many investors.
After the market peaked on July 17, 1998, the Wilshire 5,000 total stock market index sank 22% in the following 57 trading days.
Was it the end of the world? No. From the depths of that frightening dive the market bounced back about 50% in six months.
But stocks’ plunge clearly caught many vacationing (and, let’s face it, lackadaisical) mutual fund investors off guard. While most fund investors stayed cool, many panicked. Gross stock fund redemptions soared to $53.1 billion last August.
Fast-forward to the present. By coincidence, the market peaked at exactly the same time in July this year as it did last year. By midweek last week, the Standard & Poor’s 500 blue-chip stock index was down 10% from its high, before bouncing back later in the week.
Is history repeating itself? This time, the background is different. It’s not the threat of a global depression that has investors worried. It’s Alan Greenspan and the threat of rising interest rates.
Why stocks are going down can make a big difference in how you react. The problem for many investors is that the knee-jerk reaction to any major decline is panic.
So if you’re heading out for vacation, it’s a good time to ask yourself: Are you comfortable with your investment portfolio? Can you afford to leave it on autopilot?
If you decide it’s prudent to try to preserve some of your gains, lower your general risk level or put yourself in a better position to buy stocks at what may be lower prices ahead, there are some simple steps you can take:
* Imagine a worst-case scenario. How much of a loss in your stock portfolio are you prepared to weather? A 20% decline? 30%? Maybe 40%?
Every investor has a different threshold for pain. It’s better to know yours well before it’s tested.
Many long-term investors who put a pencil to the numbers in advance might decide that even a 20% decline in their portfolio isn’t a reason for action.
Do you have time to wait for the market to come back? If you don’t, then you may well need to rethink your entire portfolio allocation.
* Raise your cash levels. Some investors believe that to maximize their portfolios they must invest every last dime they have. Of course, this is a dangerous strategy. At the very least, outside of retirement savings you should maintain an emergency fund (in a money market account or other short-term account) to cover expenses for one or two months should you get injured or lose your job.
Beyond that, in your investment portfolio cash can come in handy in a rocky stock market, notes Ron Meier, professor of investment planning at the College for Financial Planning in Denver.
Maintaining some percentage of your portfolio in a money fund, for example, can serve both defensive and offensive purposes. It will cushion your overall portfolio should the stock market fall, and it will give you ammunition if, as Meier says, “buying opportunities present themselves.”
How much cash? Certainly not a huge sum. Having 5% to 10% of your portfolio in cash would give you at least some capital to put to work if markets dive.
If you don’t want to sell any of your stocks or funds but you want to raise cash nonetheless, there’s another option, at least in your taxable (non-retirement) accounts: Stop reinvesting dividends and capital gains. Tell the fund to send you the proceeds in cash.
* If purchasing new stock funds, think dividend yield. In the 1990s, many investors have focused exclusively on capital growth, ignoring dividends.
But stock funds that target companies paying above-average dividends offer a buffer of sorts. “Funds that pay out decent dividend yields tend to go down less in down markets than ones that don’t,” says Meier.
In August 1998, the average stock fund with an annualized dividend yield in the 3% to 4% range lost less than 10% of its value on a total-return basis, according to fund tracker Morningstar Inc.
By contrast, stock funds with dividend yields in the 2% to 3% range lost, on average, 11.2%. And funds yielding less than 2% lost considerably more--an average of 16.7%.
Morningstar counts 150 stock funds today yielding 3% to 4%. Many, of course, are more conservative growth-and-income or equity-income funds.
* Think about bonds--but shorter-term issues. Bonds offer a way to shift a portion of your portfolio more toward capital preservation than appreciation.
Bonds aren’t growth investments. You own them for interest income--and because they tend to be less volatile than stocks.
But with interest rates rising this year with the strong economy--and no guarantee they won’t rise further--bonds can be poor investments.
Why? When market rates rise, older bonds carrying lower fixed rates fall in value. And sometimes, that drop in principal value more than offsets the interest earned on the bond in a given period. Interest plus principal change is “total return.”
In this environment, experts say, you’re better off sticking with shorter-term bond investments, because they are much less susceptible than long-term bonds to heavy principal loss from rising rates. That makes sense: With a bond that matures sooner rather than later, you’ll get your money back faster to reinvest.
Example: The Vanguard Long-Term Treasury bond fund is down 7.9% this year (total return). The firm’s Short-Term Treasury fund, though lower-yielding, is up 0.3%.
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Do you have ideas for mutual fund and 401(k) topics for this column? Paul J. Lim can be reached at paul.lim@latimes.com.
