This year’s stock market isn’t what it seems.
“It wasn’t supposed to be this way!” That’s the refrain from many investors who are looking at a U.S. stock market SPX, -0.91% decline so far this year of about 13% (the numbers change daily).
Even worse, the total bond market is down — around 9%. That certainly wasn’t supposed to happen. After all, when stocks head down, bonds are supposed to rise in value, smoothing the path.
And to cap it all off, there’s all the news this year. Maybe THIS TIME, the world really IS headed for a cliff — or multiple cliffs.
I’m not saying I believe that. But it can seem that way.
So what should an investor do? I think there are two basic choices.
One: You can commit yourself to reacting to the daily and weekly noise of the market and the news, then do whatever your friends and the talking heads on television advise.
This route is easy, you will have lots of company, and you might even derive some short-term comfort from all that camaraderie.
Two: You can commit yourself to making and following a long-term plan based on the lessons of history and all the tools available to investors these days.
If you choose the first course, I can’t help, and you don’t need what’s in the rest of this article.
The second path isn’t always easy. But it’s the right one, and I’m here to give you what you need.
What’s happening now is mild compared with past stock downturns. The S&P 500 lost 37% in 2008. In 2000 through 2002, the successive annual losses were 9.1%, 11.9%, then (as if investors hadn’t been sufficiently punished) 22.1%.
The index had two double-digit losses in the mid 1970s…and the Dow Jones Industrial Average DJIA, -0.76% of 30 stocks fell a heart-wrenching 22.6% in a single day in 1987.
In every case, the market came back and hit new highs. That was the reward for investors who could look beyond the immediate pain.
This is the way that progress is supposed to happen. New things replace things whose time may have passed, and the process is necessarily painful.
If this had not occurred over the past 50 years, IBM IBM, -1.11% would today be the biggest technology company. You might have cellular phones, but they would all be owned by AT&T T, -0.45%, and you would have to lease them. The monopoly phone company wouldn’t have any incentive to offer you lower rates.
And if that isn’t scary enough, Richard Nixon would still be president.
Nevertheless, investors need a blueprint to get through the tough times.
Most readers of this article likely have at least a decade of investing ahead of them. If you are among them, I believe you should make a lifetime commitment to owning equities to provide long-term growth.
One good choice is a lifetime portfolio filled 100% with equities. If you have the patience and faith to let your investments suffer temporarily through downturns and bear markets, everything we know from history suggests equities will continue to bounce back and reach new highs.
If that feels too risky, another excellent choice is a lifetime commitment to having half your portfolio in equities and half in fixed-income funds. This will give you a smoother ride — but probably lower returns over the very long term.
I don’t want to bury you right now with numbers to show what has happened in the past with these combinations. You can study the data for yourself, including eight other equity/bond variations, in this table.
Instead, let’s walk together through the how-to of doing this.
When I came into the business in the 1960s, the conventional wisdom called for owning about 10 to 20 individual stocks that you would hold for life: companies like General Motors GM, -1.09%, Ford F, -1.53%, IBM, and maybe an upstart like Xerox XRX, -0.60%.
Some years later, the prevailing recommendation was to own dozens or even hundreds of companies through mutual funds. The gradual advent of index funds made this practical and inexpensive
By the end of the 20th century, the accepted wisdom was that you should own the largest and most successful U.S. companies, through the S&P 500 index.
If you think about it, this approach makes good sense. You will own small parts of many companies that are being run by people who are working hard to make them successful.
As an equity investor, you face two risks:
- Market risk, the potential (or certainty, actually) of a decline in the overall market;
- Stock risk, the potential that an individual company will fail.
You’ll always have market risk. But if you own hundreds or thousands of companies, that second risk is gone. Whew.
However, investors who relied totally on the S&P 500 got a rude awakening in the first decade of this century, with two ferocious bear markets.
The solution to that was more diversification, the details of which were formulated and taught in the 1990s by academic researchers. I learned of this research in the mid-‘90s and began passing the word: Invest in small companies as well as large ones, value stocks as well as popular growth stock, international stocks as well as those located in the United States.
I’ve recommended this approach for many years, and I still believe in it.
But further research suggests you would have received very similar returns from a much simpler approach that includes only four U.S. asset classes. (And for whatever it’s worth, the four-fund combo is down only about 4% so far this year — an unusual case in which it’s almost exactly the same whether 100% equities or 50%.)
Obviously, I have no way to know what the future holds.
In my view, the right way to deal with this year’s market is to make a permanent commitment to those four asset classes, for either half or all your portfolio. That is likely to serve you well through whatever ups and downs lie ahead.
Doing this does not require talent. It doesn’t require a college degree or advanced computing skills. It does not require successfully predicting the future in any way.
As I mentioned earlier, the main things it requires are faith and patience. You can’t buy those traits; you must supply them yourself.
With that commitment, many combinations of funds and asset classes can work. I discuss some of these ideas with Daryl Bahls and Chris Pedersen. You’ll find that conversation here in a podcast, and here in a video.