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After disastrous fourth quarter, what next for mutual fund owners?

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There’s no sugarcoating what happened to stock mutual funds last year.

Wall Street’s deepest losses since the 1930s ravaged the fund nest eggs of millions of Americans. There was almost no place to hide.

The average domestic stock fund lost 36% in 2008, according to Morningstar Inc.

It was worse for foreign stock funds, which for five straight years through 2007 had posted much bigger gains than domestic funds -- in turn luring an avalanche of money from U.S. investors.

Last year, the average foreign stock fund crashed 44%.

The math is awful from here: If your fund fell 36%, it will have to rise 56% just to get back to even.

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In harrowing times like these, you may well question every rule you’ve ever heard about stock investing -- including whether it’s worth the risk at all.

Many professional financial advisors concede they’ve had to deal with some clients who wanted out of the market completely as share prices plummeted in recent months.

“Some people just pulled the plug and said, ‘I can’t take it anymore,’ ” said Emerson Fersch, a partner at Capital Investment Advisers in Long Beach. But most clients, he said, stayed put.

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Yet may investors understandably fear that this bear market is far from over. The economy fell off a cliff beginning in September, taking stocks with it, as the credit crisis mushroomed.

Although the market has edged up since late November, President-elect Barack Obama is warning that there’s no fast fix for this economic mess. Some experts say a recovery might not come before 2010, with ominous implications for corporate earnings, and share prices, between now and then.

How best to approach stock investing at this fateful moment in history?

Here are four questions that may help you focus your thoughts and decide what, if anything, you should do with your fund portfolio:

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Should you keep more of your assets in cash, period? The conventional wisdom is that cash doesn’t pay in the long run. It sure isn’t paying in the short run: The average money market fund yield now is a mere 0.7%.

But how many people only wish that, six months ago, they had sold some of their stocks and boosted cash holdings?

It may feel too late to be selling stocks or other investments now, of course. Yet there’s a practical matter here that trumps the investment orthodoxy that cash is trash: If stocks fall further, having a larger cash buffer -- a sum that you know won’t lose principal value -- would give you much more peace of mind about your ability to survive financially.

The old rule of thumb was that people should have enough in cash to pay for three to six months of living expenses. But in these hard times that may not be enough, said Norman Boone, head of Mosaic Financial Partners, a San Francisco advisory firm.

His advice to many clients now is to have enough cash to cover up to a couple of years’ worth of basic expenses. The bigger the cash cushion, the less likely investors will have to draw down their core portfolios, he notes: “It gives them more of an opportunity to be patient with the market.”

Building up that kind of cushion may be difficult for younger investors, however. If all or most of your investments are in a 401(k) or other tax-sheltered plan, to accumulate cash you might have to invest less in the plan and commit yourself to stashing the extra pay in a bank account or money market fund.

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A bigger cash cushion may be more important, psychologically, for older investors. If you can’t sleep at night worrying about your current asset mix, then you’ve already answered the question of whether you should hold more cash.

Should you focus on protecting more of what’s left of your core portfolio? For most investors, core assets are stocks and bonds. Those are the elemental portfolio building blocks.

And here’s the good news about 2008, despite all that went wrong in markets: Basic diversification worked. Although most types of bonds, other than U.S. Treasuries, fell in value as interest rates jumped amid the credit crunch, nearly all bond sectors lost far less than stocks.

The average bond fund that owns high-quality, long-term corporate debt had a negative total return of 5.6% last year. That was about one-sixth what the average stock fund lost.

“People who had real diversification took some punches, but they’re still standing,” said Neil Hokanson, head of Hokanson Associates, a Solana Beach wealth advisory firm.

Over the long run, returns on bonds significantly lag returns on stocks. That makes sense: Stocks are riskier, so they should deliver higher returns in time.

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So younger investors typically are advised to tilt their portfolios heavily toward stocks. They have time to wait for equities to come back from bear markets.

But for older investors, capital preservation is a much bigger issue -- and particularly after a year like 2008.

Only in times like this, “people find out that they’re either more conservative than they thought they were or they’re more aggressive than they thought they were,” said Rob Francais, a partner at wealth management firm Aspiriant in Los Angeles.

The simplest way to protect against deeper financial losses, without shifting to cash, is to raise your bond holdings while decreasing stock holdings.

Until last year, some older investors may have been happy with a classic asset mix of 60% stocks and 40% bonds. Now, if you feel the need to buffer your nest egg, flipping those percentages might make sense. With 60% bonds and 40% stocks, you’d still have a substantial bet on economic growth, but with a large bulwark in case stocks dive again.

Even if the stock market gets back, over time, to producing annual returns averaging 10%, you should weigh equities’ inherently high risk against the lower risk of a diversified mix of income-producing bonds. Interest yields are far higher than they have been in many years.

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You can earn an annualized interest yield of 5.7% on a high-quality bond fund such as Dodge & Cox Income. The effective returns on tax-free municipal bond funds may be even higher, depending on your tax bracket. And if you want to go further out on the risk limb, many junk bond funds are yielding 10% or higher.

Compared with the risk of stocks, “if you ask people if they’d be happy with 5% to 6% returns on fixed income assets, many would say yes,” Hokanson said.

Should you change your mix of stock funds? With most stock fund categories down drastically in 2008, there isn’t much point in discussing how large-cap growth (off 41%) fared better than mid-cap growth (off 44%). The difference is just splitting hairs.

What will stand out for many investors, however, is that most foreign funds fell much more than domestic funds. That defied many analysts’ predictions at mid-year that foreign markets had better prospects than the U.S. market, a forecast predicated on the idea that overseas economies were “decoupling” from the U.S. economy.

So much for that theory.

But the strong dollar also was a factor in hammering foreign market returns for U.S. investors. The global panic over the credit crisis drove many investors into the perceived haven of the dollar. The greenback’s rally devalued U.S. investors’ foreign holdings.

Cases in point: The British stock market fell 31% last year when measured in pounds. But measured in dollars the loss was 50%. Mexican stocks lost 24% in pesos but 40% in dollars.

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If you want to bet that the rest of the world, or at least much of it, has better long-term economic growth potential than the U.S. there’s an argument for buying into depressed foreign issues now.

Hokanson figures that emerging markets, in particular, have the key ingredients needed for economic success over time: young populations, rising consumer demand and good credit profiles (i.e., the countries are net creditors, not debtors like the U.S.).

His investors own funds such as Matthews Asia-Pacific (down 37% last year) and the iShares MSCI Emerging Markets index exchange-traded fund (ticker symbol: EEM).

Still, he said, “we’re not in a hurry” to boost foreign holdings given the risks the global economy faces this year.

Francais of Aspiriant said his firm was thinking a lot about the long-term implications of the U.S. government’s growing involvement in the economy, and what that might mean for markets.

One argument is that the government’s increasing role could be a depressant on private-sector growth.

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“We’re asking, how does that impact how we might allocate assets in the U.S. versus abroad?” Francais said.

Should you dump some of your fund losers? When nearly every stock fund is in the red, “loser” is a relative term.

But one simple test is to check your fund’s performance in the fourth quarter, full year and last three years against its Morningstar category average. If a fund has performed worse than its average peer in all three periods, you should at least try to understand why.

It could be, after reviewing the stocks the fund holds, that you’ll want to keep it. But if you decide to sell and shift the money to a better fund, this is the kind of market environment that provides a “free upgrade,” said Russ Kinnel, Morningstar’s director of fund research in Chicago.

If a fund is owned outside a tax-deferred account, and you sell at a loss, you can use that loss to offset any capital gains you have this year (or carry them forward for future gains).

What’s more, Kinnel notes, because of the declines most stock funds suffered last year, many of them now have internal losses to use against future capital gains. That may help limit taxable capital gains distributions to shareholders this year and perhaps beyond.

Another benefit of the bear market: As fund assets overall have declined, some well-regarded funds that had long been closed to new investors have reopened.

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Capital Investment’s Fersch said he bought into Sequoia Fund in 2008 after the portfolio -- a classic “value” stock fund -- reopened for the first time since 1982.

Although some analysts question whether Sequoia still has the magic that made it famous, the fund’s loss of 27% last year was far smaller than that of most of its peers.

It was that kind of year.

tom.petruno@latimes.com

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