How far down do you expect the market to go?

I just retired and the recent decline has made we change my idea of how I should invest my retirement accounts. I need income from these investments to live on but realize I can't put all my money in bonds or Cd's or I will probably run out of money due to inflation. What do you suggest I do? Wait for the market to go up again? How far do you think the market is likely to fall before the next bull market starts?

We have been managing money for retirees since 1983 and this is the sixth bear market we have experienced. I hate them all as they fill people (especially retirees) with doubt and anxiety, often causing people to panic and put all of their money in "no-risk" investments.

I have no idea how far down this decline may go but I can share some averages. Since 1960 there have been 10 bear markets (based on the Dow Jones 30 Industrial Index) with average losses of 30%, and a worst loss of 45.1% in 1973. But the majority of investors are not likely to experience those kind of declines as they have their portfolios balanced between stock and bond funds. A popular combination of stock and bond funds, among our clients, is a 50% stock and 50% bond asset allocation. During all 10 of those bear markets this combination (50/50) has limited risk within the limits of most investors we meet. In the market decline from October 9, 2007 through June 30, 2008, the 50/50 split of stocks and bonds lost less than 6.5% in our tax-deferred accounts. That loss is well within the expected one year loss of that combination.

I believe every risk-averse investor should determine their limit of loss they are willing to accept and still stay the course. Once that risk limit is established an investor should go ahead and make their financial commitment. Many are uncomfortable with a lump sum investment and find dollar cost averaging over a period of time, often 12 to 24 months, more acceptable. But be aware that the losses of any combination of stocks and bonds are likely going to hit your portfolio, possibly after you have patiently dollar cost averaged over many months.

I was just reviewing the buy and hold returns (after fees) of our privately managed tax-deferred accounts for the 10 years ending June 30, 2008. For those with high risk tolerance an all equity portfolio compounded at 9.5% compared to 7.3% with a 50/50 stock bond combination. Two percent is a lot to give up over an extended period of time but worth the greater peace of mind a retiree will likely feel with the bond protection.

Those returns may not feel like home runs but they were better than most experienced during the period. Over those same 10 years the S&P 500 compounded at 2.9% and one-month T bills at 3.7%

How does your Asset Class Rotation strategy compare to No Load Fund-X?

In your recent online timing workshop you explain a simple do-it-yourself Asset Class Rotation strategy. How does it compare to the upgrading system used by No Load Fund-X?

Both the do-it-yourself Asset Class Rotation strategy and Upgrading System used by No Load Fund-X attempt to move into the best performing funds based on recent performance. The portfolio that NLFX has recommended for most investors is their Higher Quality Stock Funds Portfolio. This strategy, as well as the Asset Class Rotation strategy discussed in my online workshop have about the same level of risk as the S&P 500 Index. In the presentation I noted that the results of most systems of this type are very similar, so it won’t surprise you to discover the returns of these two systems are about the same.

The following are the 1, 5, 10, and 15 years track records through the end of 2007. The NLFX results are from The Hulbert Financial Digest. The asset class rotation results, and step by step instructions, are found in the workbook for my online workshop.

Both systems are entirely mechanical so there is no magic. The magic, as usual, is the willingness to maintain a mechanical system.

With the market in freefall, why not move to cash?

With all of the problems our economy faces and the market experiencing one of the worst June’s since 1930, why doesn’t it make sense to move to cash? One of the best known advisors (Richard Russell) says he has all his money in gold and cash. I’m not comfortable with gold but the cash is sounding very good right now.

If I assume you are a young investor the answer is easy. Cash (money market funds, CDs, short term bond funds, etc.) are all great places to store money on a short term basis. But cash is a terrible place to store money for the long term. So, my first question is whether the investments you are asking about are short term or long term? If they are long term you should celebrate the opportunity to invest in stocks at reduced prices. In fact, the lower the market goes the greater the long term opportunity.

According to studies by DALBAR, the majority of investors put their money into mutual funds when markets are relatively high, and either sell or stop investing when markets are low. Intellectually we know that’s backwards but emotions are much stronger than our intellect. Dalbar’s long term studies indicate that the average investor makes about 60% less than the market. And much of that difference is the result of wanting to find somewhere safe to invest when the market goes down.

Investing is a risk driven process. When the economy is doing well, stock prices reflect that success with higher prices. At the point companies and the economy are doing well, and the market is high, the expected rate of return is relatively low. When companies and the economy are struggling, the risk is higher, as well as the expected rate of return.

If you think about the higher long term rate of return on value stocks, compared to growth stocks, I think it will become clearer. Value stocks are normally companies in trouble or in a part of the market investors find unappealing. The extra 2 to 5 percent long term return of value over growth (1927-2007) is believed to be the premium for accepting the additional risk.

If I assume you are a retiree facing the emotions of a bear market, my advice is very different. The same losses and opportunities that may benefit a young investor can be devastating to someone living off the proceeds of their portfolio.

Retirees should focus more on defense than offense. Most of our retired clients have a combination of equities, for growth, and fixed income for stability. All of our research has shown clearly that there is a need for some equity in a retirement portfolio, if for no other reason than producing returns that make up for the cost of inflation and taxes.

The key to success for most retirees is to find the mix of fixed income and equities that will meet their need for return, within their risk tolerance, and give them a feeling of security and safety during a normal market decline. This asset allocation decision is one of the most important commitments an advisor can help an investor make. If this is done properly the investor will make it through a market decline without panic. If this is not done properly, an investor may sell at or near a market bottom, only to find they no longer trust the market and have to rely on fixed income securities for the rest of their retirement. And in most cases, that’s the worst decision they can make.

My hope for you is you will find a long term answer to your question. If you continually look for a new answer every time the market makes a big move, I fear you will end up looking like the DALBAR averages.

Should I add Vanguard Energy Fund to my portfolio?

I have used your Vanguard 60/40 Portfolio for the last 5+ years. I am considering making one small change. It seems with the growing demand for oil, I should have a portion of my portfolio in the Vanguard Energy Fund. Do you agree? If you do, what percentage of the equity portion do you suggest?

I have had this question on a regular basis for the past 25 years. The question is normally focused on a sector that has performed well in the most recent period. Although this question is about the energy sector now, the other three sectors that have most often been suggested are technology, health care and financial.

I understand why these sectors seem like natural additions to an otherwise broadly diversified portfolio. They represent sectors that have had long periods of out performance and have common sense reasons why they should give higher than average returns.

Okay, let's say they fulfill your expectation. What will it likely mean to your overall return? If a broadly diversified all equity portfolio earned 12%, a 10% addition of a sector that produced a 15% return would increase the total portfolio return to 12.3%. If the sector compounded at 20% the total portfolio would return 12.8%.

The additional .3% to .8% is not a minor increase. Over a lifetime the additional return grows to a significant amount of money. But the additional return does come at higher risk as sector funds are much more volatile than funds diversified over many industries.

How have these favored sectors performed over the long term? The 10 year return (ending June 11, 2008) for Vanguard Health Care (VGHCX) was 11.5% and Vanguard Energy (VGENX) 20%. Vanguard does not have a financial or technology sector fund with a 10 year record but Fidelity does. Fidelity Select Financial (FIDSX) produced a 3.6% return and Fidelity Select Technology 7.7% over the 10 years. The average return for the four sector funds was 10.7%.

If I decided to overweight the equity portion of my portfolio, I would add an asset class that has a higher probability of excess returns. My fund choice would be Vanguard Emerging Markets (VEIEX). Over the 10 years this volatile fund compounded at 15.8%.

It's always easy to know what we should have done in the past. The challenge is to know what will work in the future. I suggest you stick to the simple asset allocation represented by our broadly diversified portfolios. Yes, I know that's very boring but I believe boring is beautiful when it comes to investing.

How do I get back into the market?

I sold my funds late last year and the first quarter results convinced me I made a smart move. Now that the market has recovered I'm not sure whether I did the right thing but I'm sure the day I decide to go back in, the market will go down again. What should I do?

You have a clear set of choices. You can continue to time the market based on your feelings, in which case I have no idea what to suggest. The second obvious choice is to time the market using someone else's feelings or judgement. The third choice is to time the market using a mechanical timing system so judgement is no longer a part of the in or out decision making process. The fourth choice is to buy and hold a broad range of equity and fixed income asset classes, balanced to achieve your goal for return along with staying within your maximum exposure to loss. All of these approaches have challenges. The only ones I can find comfort in are the mechanical buy and hold and timing strategies. We have written dozens of articles on buy and hold and a handful on timing. If you have an interest in using a mechanical approach to timing I hope you will listen to my 90 minute timing presentation that will be available online within the next 2 weeks.

What I wish most of all is that you find a level of trust in an investment strategy so you can quit worrying about the normal ups and downs of the market. When I started our company 25 years ago my goal was to help investors find peace of mind along with a piece of the action. I hope you find that balance so you can sleep well, eat well and live well.

Should my portfolio have more in international stocks?

I have followed your asset allocation recommendations for almost ten years. Since I started following your advice you have recommended 50% of the equity allocation be held in international stocks. I recently read that international stocks now represent more than half of the global markets. Are you considering adding more international stocks to your portfolio?

At the end of the last decade the U.S. stock market represented 48% of the global market capitalization. By the end of 2007 the percentage fell to 31%.

We do not intend to change our balance of U.S. and international equity holdings. Our portfolios have never been weighted by market capitalization. If a portfolio is weighted by market capitalization, not only would there be 69% in international equities, but most of the investments would be in large growth companies. This portfolio would likely have more volatility and lower returns than our recommended asset allocation.

Our recommended equity portfolios are built using similar percentages of non-correlated asset classes, each asset class having a long history of producing high units of return per unit of risk. This means our portfolios have much higher percentages of small and value stocks (in both U.S. and international markets) than would be represented if we use market capitalization as the basis of our recommendations. Over several market cycles I believe our equity asset class weighting will add 2% to 4% a year, compared to a capitalization weighted portfolio, without taking more risk.

Also, as hard as it may be for investors to believe, just as small cap stocks came roaring back after their 1969-1974 blood bath, just as value stocks came back after their 1995-1999 under performance, just like gold came back after 20 years of poor returns, U.S. stocks will likely out perform international stocks again. It's the nature of markets.

Which is better: Fidelity or Vanguard?

I have been investing my IRA at Fidelity for almost 20 years. I have been happy with the results but I wonder if I could have done better. I am adopting your approach to spreading my portfolio among the asset classes you recommend. The final question I face is whether to leave the money at Fidelity or move to Vanguard. How much more money do you think I will make if I transfer my IRA to Vanguard?

Of course I can't know for sure what the future will bring. One huge advantage Vanguard has over Fidelity is lower expenses and that appears to be the main reason for the difference in their returns.

The Hulbert Financial Digest has been independently tracking our Fidelity and Vanguard portfolios for over 10 years. According to the Hulbert results Vanguard wins by a margin that should motivate you to strongly consider the move.

For the 5 and 10 year periods ending December 31, 2007 our Fidelity Equity Portfolio made 19.2% and 9.3% respectively. For the same periods our Vanguard Equity Portfolio made 20.4% and 9.6%. There was a similar difference in the balanced portfolios (60% equity/40% bonds) as well. The Fidelity Balanced Portfolio produced 13.2% and 7.9% for the 5 and 10 year periods. Vanguard results were 14.3% and 8.3%.

I also favor Vanguard because it has a larger stable of index funds. Yes, it's possible actively managed funds will do better than index funds, but unlikely.

For those of you tracking our DFA results, our actual after-fee returns, were 21.1 % and 10.7% for the 5 and 10 years ending December 31, 2007. If you are not familiar with DFA I suggest you read "The best mutual funds: DFA or Vanguard?"