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What’s an Investor To Do?

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Two and a half years into what the Wall Street Journal recently called the worst bear market in fifty years, many investors are rightfully concerned. Losses have been gut wrenching. More than $7.7 trillion vaporized since March 2000. The S&P 500, once considered by many as the complete, single decision portfolio has fallen more than 40%. The NASDAQ, beloved by the new economy gurus, has all but melted down. Even great firms like Microsoft, Disney, and GE are down more than half. And then there is Enron, WorldCom, Quest and the Dot.bomb crowd.

The numbers are dismal: On July 18 the New York Times reported the Standard & Poor’s 500-stock index is now at its lowest level since June 1997 and is down 44.5 percent since its high in March 2000. The Dow Jones industrial average is at its lowest level since October 1998 and off 31.6 percent from its high in January 2000. The NASDAQ composite index has not been this low since May 1997 and is down 73.9 percent from its peak in March 2000.

What’s an investor to do?

Advice in the media generally boils down to either stay the course, or bail out before it gets worse. It’s not that simple. Doing something out of pure frustration isn’t the answer, and hoping that a defective portfolio will recover is delusional. Doing something is easy, doing nothing is easy, but doing the right thing takes a little more effort.

Doing the right thing isn’t dependent on what the market did last month, or last year. It’s consistent whether the market is up or down. And, doing the right thing isn’t dependent on a market forecast. If accurate reliable market forecasts were available, nobody would have had a problem in the first place.

So, let’s get back to basics. Before doing anything, take the time necessary to inventory your current financial situation, objectives, risk tolerance and time horizon. Your course of action must be decided based on your unique situation. There is no one-size-fits-all answer.

Then examine your current portfolio. Does it meet your needs? Is the ratio of stocks to bonds appropriate for your liquidity needs and risk tolerance? Is the duration of the bonds short enough to avoid capital risk? Are the equities properly diversified? What are the turnover ratio, total annual expenses, and tax exposure of the portfolio? Are you using any available tax deferred or tax-free accounts to their maximum advantage? If you don’t know or don’t like the answers to these questions then some changes are in order.

If your portfolio has taken a serious hit, or is down more than you can tolerate, then it probably wasn’t properly designed in the first place. This misery was almost wholly avoidable.

Diversified equity portfolios have performed admirably to preserve capital during these trying times. But, diversification means more than a few stocks, or even the S&P 500. It means diversification across national boundaries, between large and small stocks and across the growth-value spectrum.

An appropriate asset allocation between your equities and high quality short-term bonds should prevent losses in excess of your risk tolerance and give you the liquid resources necessary to ride out even severe and extended global market disruptions.

Time to go back to the drawing board?

While we are firm in our conviction that a properly designed portfolio should be held for the long run, we also believe that a poorly designed portfolio should be upgraded at the very first opportunity. A well-designed portfolio is always better than a poorly designed one.

The portfolios with the highest pain quotient are the ones with the highest concentration in large company growth and tech. These two sections of the market are still grossly overvalued compared to historical measures. To put it gently, waiting for them to recover is not the highest probability of success.

At first glance, this advice might seem to violate the buy and hold philosophy that we preach. It does not. We are not advising you to exit the market. We are urging you to purchase the portfolio with the highest probability of meeting your goals. If that means dumping a poorly designed portfolio to purchase a better one, so be it.

Many investors find it difficult to sell a portfolio at a loss. One good way to determine if you need a better portfolio is to mentally convert it to cash. Then, if you can imagine yourself standing there holding the cash, ask yourself if you would invest in the same portfolio. If the answer is no, then its time to trade up to a better one.

Can you afford your advisor?

Finally, its time to decide if a change in management is appropriate. If you or your advisor bought into the new metrics/new economy hype, chased last years best performers, took concentrated bets on individual stocks, sectors or markets, failed to prudently diversify, confused a bull market with investment genius, didn’t match your portfolio with your risk tolerance, or neglected to control costs and taxes, then perhaps new management is in order. You can’t afford to repeat those mistakes.

Portfolio management requires discipline, knowledge, and access to high quality investment products, experience and objectivity. If your advisor doesn’t measure up, get one that does.