Rethinking the Game Plan

There’s nothing like a bear market to test an investor’s ability to tolerate risk.

Stuart Siegel, a 47-year-old Los Angeles resident, readily admits he failed that test.

“I think I’m pretty typical,” Siegel said. “My thought was to be aggressive, earn as much as possible and retire early. I was reaching for the moon.”

Now Siegel is fixated on how to protect his nest egg from additional losses--not just in the near term, but in bear markets that may be far in the future.

“I lost 45% to 48% of my portfolio before I realized that I don’t have the stomach for this,” Siegel said. “I will never do that again.”

As the longest market decline since the Great Depression ground its way through the third quarter, millions of Americans learned the same cruel lesson. Following advice about how much risk the “average” investor should be willing to accept in return for stock market rewards, they discovered too late that they aren’t “average.”

As a result, Southland financial planners say, 5% to 30% of their clients have pulled out of the stock market in recent months rather than face the prospect of further losses. And the planners are loathe to stop them, even though many believe that stock prices are, finally, getting close to a bottom.

These planners, who once thought young investors with lots of time could handle lots of risk--particularly when these investors described themselves as risk tolerant--now think that they and their clients underestimated their threshold for pain.

“The market is showing us that the reality of living through a bear market is a lot different than reading about it in a book or financial magazine,” said Christopher Orndorff, managing principal at Los Angeles investment firm Payden & Rygel.

The number of people bailing out of stocks--investors on balance pulled money out of equity mutual funds at a record pace this summer--has taught planners that they need to be more forceful when explaining market risks to their clients.

Classic asset allocation models, which typically recommend that investors have a significant percentage of their money in stocks even as they approach retirement, are still valid, planners say.

But some also say they have become less inclined to talk their clients out of portfolios that the planner might consider too conservative, assuming the stock market will someday recover.

“I do believe that asset allocation will work long-term. The problem is that the stomach cannot always handle the long term,” said Linda A. Barlow, a financial planner in Santa Ana. “We don’t deal with computers. We deal with live bodies, and they are having a hard time holding on.”

Many investors have been victimized by their faith in market “truths” that turned out to be half-truths. If you’re trying to develop an investing game plan that reflects the lessons learned in the last two years, without becoming overly fearful of the future, recognizing these half-truths may help you prepare yourself for whatever markets bring next:

Half-truth: Risk and reward go hand-in-hand.

Real truth: Only some risks are rewarded.

Throughout the 1980s and 1990s, investors were both warned about stocks and lured into them with the promise that financial markets reward those who take risks, said Christopher Jones, executive vice president of financial research and strategy with Financial Engines, an investment Web site based in Menlo Park, Calif.

“But there are good risks--the kind that you get compensated for--and there are bad risks,” he said. There still is ample reason to believe that, over time, you will be fairly compensated for taking the risk of owning a diversified portfolio of stocks. But the odds are far lower that you’ll be well-rewarded for the risk of holding just one stock (say, your employer’s), or a portfolio concentrated in one industry.

This is the trap that snared Siegel. He thought the risk of being 100% invested in a mix of technology stocks was just a bit higher than the risk of being fully invested in a diversified portfolio of stocks. Moreover, he thought his portfolio would perform better, on average, over time, because he was taking more risk than the average well-diversified investor.

“It’s the concept of no-pain, no-gain,” said Alan Skrainka, chief market strategist at brokerage Edward Jones & Co. in St. Louis. “But the risk-reward principle only applies to diversified asset classes and only over a long period of time.”

Despite many investors’ temptation to keep shrinking away from equities, Skrainka argues that each additional losing month in the market boosts the odds that new buyers will be well-compensated for the risk they’re taking, over the long run.

When you are surrounded by bad news--the country may go to war; Wall Street and Main Street are beset with scandal; corporate profits are down; the economy is tenuous--investors perceive the stock market as being a very risky place. As a result, stock prices are lower, and their potential for appreciation is greater, Skrainka said.

“Bear markets all follow the same script,” he said. “They start when you’re surrounded by nothing but good news and are convinced that stocks can do nothing but go up. They end when you’re surrounded by bad news and convinced that putting money in the stock market would be a terrible idea.”

Skrainka’s advice for true long-term investors: “Grit your teeth and write a check to your favorite mutual fund.” But stick with a diversified approach, he cautions.

As many people found out too late, “Being all in technology stocks is a terrible idea, because you are taking on all kinds of risk that’s just risk,” said Financial Engines’ Jones. “It’s unlikely that you are ever going to get compensated for taking that chance.”

Half-truth: If you have a lot of time, you can handle a lot more risk.

Real truth: If you have a lot of time, your portfolio can handle more risk, but whether you can live with it day to day is another issue.

In the 1990s, many investors believed that if they had a 20-year or longer time horizon, they could comfortably handle the ups and downs of the stock market along the way. So, the argument went, true long-term investors could afford to keep virtually all of their savings in stocks, with the idea of maximizing returns.

That may well be accurate in theory, said Jones. But in practice it only works if an investor is so steadfast that he or she can handle losing more than 50% of his or her portfolio without bailing out or shifting strategy. And the market of the last two years has shattered the illusion that the vast majority of investors are that impervious to pain.

“It seems to me that all our investors have a dollar amount in their heads. If their investments fall below that number, they can’t stand it,” said Laura Tarbox, a Newport Beach-based financial planner. “We are getting much more careful about asking people just how much they’re prepared to lose.”

That has led to a new appreciation of the importance of non-stock assets in portfolios--bonds, money-market accounts, real estate, etc.--even for investors with very long time horizons.

Mark Brown, a financial planner at Denver-based investment advisory firm Brown & Tedstrom, says he turns down potential clients who aren’t willing to diversify. No matter how willing investors are to tolerate losses, keeping all of their money in stocks is a recipe for disaster, Brown said.

“I don’t want to live in a world where my clients are so on the economic edge that they’re all basket cases,” he said. “Every portfolio needs shock absorbers.”

Broad diversification was an unpopular message when stock prices were rising rapidly, said Louis Barajas, a Los Angeles financial planner who focuses on Latino clients. Diversification was seen as nothing but a drag on returns.

“When everybody else was earning 20% a year, our clients weren’t,” he said. “We had them in six or seven asset classes that weren’t doing as well as stocks. But now we’re looking good. Diversification works better in a down market than it does in a good one.”

It isn’t enough to put assets in different investment classes--such as stocks, bonds, cash and real estate--planners stress. Investors need to diversify within those asset classes too, Orndorff said.

For example, fixed-income holdings should consist of a mix of government bonds, corporate bonds and mortgage-backed securities, many financial advisors say.

Stock portfolios always should include shares of big companies and small ones, growth stocks, value stocks and foreign stocks, across an array of industries.

Half-truth: Historical performance is an indicator of future returns.

Real truth: Historical performance is just an indicator of past performance, especially when “history” is only a few years long.

Most investors have heard the caveat that “past performance is no guarantee of future results.” But during the bull market, advertisements and analyst reports trumpeting any star mutual fund manager’s stellar 12-month or five-year “track record” seemed much more compelling investment guides.

Few investment pros dispute that market history can be instructive. It provides a glimpse of average returns for various asset classes. It tells volumes about volatility, and gives an idea of what to expect in the way of long-term returns for different markets.

But investors can be easily misled by focusing on the fairly recent past, which is what “historical performance” came to mean to many in the late 1990s.

“We all become victims of our most recent experience,” Orndorff said. “If you were talking to someone in 1980, they would say that inflation is a real problem and stocks are miserable investments. If you were talking to someone in 1999, they would say inflation is dead and you should throw all your money in equities--they never go down.”

Stock returns in the late 1990s were abnormally high by historical standards. Meanwhile, market volatility was abnormally low. For many investors, that made the concept of market risk hard to grasp.

Investors thought the question of volatility was simply whether they’d earn 10% or 20% on their stocks in a given year--when it really meant that their portfolio could be cut to ribbons, Brown said.

The last bull market also threw off computer programs designed to pick the right asset allocation for financial planners’ clients, Orndorff noted.

“A lot of people would blindly feed data into these programs, not realizing what an aberration the 1990s were,” he said. “The models look for investments that have high returns and low volatility, so when you feed in just that recent stock market data, the program is going to tell you to put more and more of that asset in the portfolio.”

Much longer views of market performance give a more accurate picture.

The more than 75 years of market statistics compiled by Ibbotson Associates, for instance, show that long periods of abnormally high stock market returns tend to be followed by periods of abnormally low returns.

“You have to try to ignore recent history and look out over a much longer period of time,” Jones said.

History says the stock market eventually will recover from its current despair. But history also says any recovery in the near term may be weak because of the hangover from the 1990s boom.

Investors whose financial goals are shorter-term in nature must take that possibility into account when designing or redesigning a portfolio, financial pros say.

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Kathy M. Kristof can be reached at kathy.kristof@latimes.com.