By RESHMA KAPADIA and MATTHEW HEIMER
Almost every investor knows how it used to work. At big brokerages and storefront adviser offices, financial pros taught their clients the mantra "Buy and hold." Stocks and other assets performed best, they argued, when investors picked good ones and left them alone for years, riding the markets' ups and downs while their portfolios thrived. And certainly, there was proof of its success: Warren Buffett, for one, grew incomparably rich owning companies for darn near forever.
And then it stopped working. The crash of 2008 wiped out at least $2.2 trillion in investor wealth, and investors who didn't adjust their strategies have found themselves regretting it, falling behind even after the recent rebound. For Rob Hoxton, who began his career as an adviser in West Virginia in the early 1990s, seeing the long-haul approach fail was an existential shock -- "like finding out your dad is really a woman," he says.
What changed? Between 1989 and 2007, according to the World Bank, the market value of U.S. stocks more than quintupled, to $20 trillion -- as good a reason as any for investors like Hoxton to trust buy-and-hold. But some of that growth was fueled by workers who were pumping money into stocks for the first time, as corporate America replaced pensions with 401(k)s. And many economists now think that growth boom was an anomaly -- a "Great Moderation" in which recessions were unusually mild. Going forward, the economy may grow more slowly; like a low-flying plane, it'll feel more turbulence when it hits air pockets. "If you believe the world is on a bumpy journey to a new normal, then the bumpy journey will require adjustments," says Curtis Mewbourne, managing director at investing giant Pimco.
We set out to draw up an investing blueprint for bumpy times, one that offers fresh ideas about what assets to buy and when to sell. Our strategies avoid the pitfalls of passivity without going overboard -- after all, mucking with a portfolio too often can be as bad for your returns as buying and holding too long. The ultimate goal: to survive and thrive when the next crisis comes along.
Don't Be Afraid to Trade
As badly as the crash spooked investors, it arguably spooked their financial advisers even more; after all, advisers' pay often declines when their customers' portfolios shrink. Little wonder, then, that in a recent survey by insurance company Jefferson National, two-thirds of the advisers polled said they were increasing their use of "tactical asset management." That's an investing philosophy that essentially dictates that when the market moves, you move your money. But perhaps surprisingly, it isn't a dictate that most investors follow. According to a study by the investment firm Vanguard of 3 million retirement-account holders during the period from 2006 through 2010 -- a stretch that included two bull markets and one enormous crash -- 60 percent of the investors made no moves at all in their portfolios.
Reacting -- And Coming Out Ahead
It's never easy to be contrarian, but over the past decade, it would certainly have paid off. An investor with a $1 million portfolio who adopted a strategy of buying stocks during market dips would have come out almost $100,000 richer than one who bought only on the upswings. (See chart.)
The problem, of course, is that when investors respond to the headlines, they often do so in self-defeating ways -- selling their stocks during a steep market drop, for example, when prices are near their lowest. Tactical management, in contrast, involves dodging losses in more sophisticated ways. The label covers many strategies, but it typically involves designating as much as 30 percent of a portfolio as "go anywhere" money. Tactical managers often rotate these funds as needed through several kinds of assets whose prices move independently from U.S. stocks, among them commodities, foreign stocks, cash and real estate investment trusts. To be sure, the majority of the portfolio is still sitting in staid, stable investments like index funds. (For some smart index fund picks, see page 59.) But the theory is that strategic trading in the remaining portion can help a portfolio lose less when stocks fall. "Our primary goal is to preserve wealth, and these tactics go a long way in doing this," says Jeffrey Sullivan, a managing director at HighTower, a national advisory firm based in Chicago.
Several dozen mutual funds and exchange-traded funds are now putting similar tactics into practice. Because the field is relatively new, however, the jury is out on how well these strategies work. A 2010 study by Morningstar found mixed results: Some tactical funds with strong returns, like Pimco All Asset and GMO Global Balanced Asset Allocation III, did well because of the financial strengths of the companies they invested in, but the study found little evidence that trading strategies themselves improved their results. And fees for some other tactical funds are higher than average -- not surprising, since more trading translates into more transaction fees.
For those looking for a simpler approach, however, some experts believe that a disciplined strategy of buying during market downturns and taking profits during bull markets can give a portfolio a decided boost. To test the disciplined-timing theory, we assembled a hypothetical portfolio that held just two funds: a low-fee stock index fund and a low-fee bond index fund. Whenever the Nasdaq stock index fell by 10 percent or more, we rebalanced, moving some money from bonds to stocks; when the index rose by 25 percent, we moved money from stocks to bonds.
The idea is to impose a simple discipline on a portfolio -- to make sure that an investor never sells during a panic or buys at the peak of a bubble. That makes our approach contrarian, but it paid off in our test: Over a 10-year period ending this spring, it beat the market by more than five percentage points, a $50,000 difference in a $1 million portfolio.
Step By Step Plan
1. Set your baseline. Decide on the mix of stocks, bonds and alternatives you'd like for your portfolio. A young couple might opt for 80 percent stocks, 10 percent bonds, and 10 percent alternatives and cash; someone closer to retirement might go 50, 30, 20.
2. Watch for triggers. Pick a stock index to follow, and pick either a recent market peak or a market bottom as the starting point from which to calibrate trades in the future. When the index rises 25 percent from a low, investors can rebalance their portfolios by selling some stocks. When it falls 10 percent from a high, they can use cash or sell off other assets to buy stocks.
3. Watch the "safe" stuff. Though bonds' prices aren't as volatile as stocks', investors can also buy bonds on dips and sell them on spikes. Investors can watch the Barclays Capital U.S. Aggregate Bond (AGG)
4. Get tactical. Safety seekers who want to use alternative investments to hedge against risks can sign on with tactical-management mutual funds or advisory firms, which often rely on frequent trading to juice returns. Most of these funds do not have long track records, however, and some have higher fees than the average actively managed mutual fund.
Make the World Your Oyster
Imagine if you only bought stocks that start with the letters A to I," says Burns McKinney, manager of the Allianz NFJ Global Dividend Value fund. It sounds illogical and self-defeating, a bit like boxing with one hand tied behind your back. And a growing number of advisers and analysts think that's essentially what the majority of American investors are doing -- by investing only in U.S. stocks. Indeed, only 40 percent of Americans own any foreign stocks or bonds at all.
That's a pity, because research suggests it pays to be a globe-trotter. During the past decade, a 60-percent-stock portfolio with one-third of its stocks invested abroad would have outperformed a 60-percent-stock portfolio that held only U.S. stocks by 1.2 percentage points a year, according to research firm Ibbotson Associates -- a difference of about $200,000 over those 10 years for a $1 million portfolio. Many pros say they're turning to foreign stocks and bonds to cash in on burgeoning growth in countries like China and Brazil. With global-minded financial advisers leading the way, the assets in foreign and global funds have risen 80 percent since the end of 2008, to $2.1 trillion, according to fund-research firm Lipper. "The writing is on the wall," says Robert Russell, president of advisory firm Russell & Co., which oversees $500 million.
Of course, that writing comes with footnotes and fine print. Foreign stocks tend to be more volatile than U.S. shares -- they took a bigger drubbing in the financial crisis, for example, then rebounded faster. And in the age of globalization, studies show, stock markets in different countries are more likely to move in tandem than they did in the past. Many managers now think that simply buying foreign shares and sticking with them won't work in the long term; indeed, many global-allocation mutual funds regularly shift their assets among U.S. and foreign markets, moving when one region seems over- or underpriced. Over the past three years, the $54 billion BlackRock Global Allocation fund has had as much as 21 percent of its assets in foreign bonds; currently,that's down to 15 percent. Where is manager Dennis Stattman focusing now? The U.S.; after the strong performance of many foreign markets since 2008, he explains, blue-chip American stocks are cheap by comparison.
Step By Step Plan
1. Break down your portfolio. Advisers and planners suggest keeping between 35 and 50 percent of your stock holdings in foreign companies. But an all-U.S. stock portfolio may already have foreign exposure -- almost half the revenue of the companies in the S&P 500 comes from overseas, according to Standard & Poor's.
2. Get the whole world. Many advisers recommend balancing emerging stocks with stocks from the developed world (think Europe, Japan, Canada and Australia), which tend to be less volatile. Global-allocation mutual funds offer investors one way to get that diversification.
3. Don't forget bonds. Foreign bonds can have attractive interest rates -- short-term Australian government bonds now pay more than 5 percent, for example. It's also relatively rare for the prices of foreign bonds and U.S. bonds to move in the same direction at the same time. And analysts say many overseas bonds carry less risk than U.S. bonds offering similar rates.
4. Keep it in balance. Just as with U.S. stocks and bonds, big spikes in the prices of foreign stocks can be a signal to sell some shares and rebalance a portfolio. Indexes to watch include the MSCI Emerging Markets index and the Dow Jones Global Total Stock Market index.
Own More "Alternatives"
The financial crisis did more than just shred the mystique of the buy-and-hold era; it also left many investors skeptical of the idea that stocks, bonds and cash were enough to see them through to the finish line. After all, stocks and bonds both took huge tumbles simultaneously, and low interest rates during the recovery made most people's cash holdings about as profitable as a pet rock. Those trends are fueling demand for a wider array of assets -- from long-short funds, which can improve their returns by betting against stocks, to commodities, which tend to rise when stocks fall. The financial-services industry has responded quickly by launching new funds. Over the past four years, the number of ETFs and mutual funds that focus on alternative assets has more than doubled, and the assets they manage have tripled, to $138 billion.
In some ways, Main Street investors are just following their big-boy brethren; institutional investors, including hedge funds, university endowments and corporate pension funds, have always played in these pools, and they've been committing more money to them since the crash. But for smaller fish with, perhaps, tens of thousands instead of millions to invest, entry into the alternative world can be trickier. Alternative ETFs have made it much cheaper to buy into, say, the commodities market, but their volatile returns have scared off some investors. Others have found it easier to buy alternative investments through advisers, who can pool their clients' money to reduce the cost of buying assets like gold or real estate. Rick Kahler, a Rapid City, S.D., financial planner who manages more than $150 million, puts about a third of his clients' portfolios in four to six alternative asset classes; he says his clients' assets are already back at their precrash highs, not counting new contributions. "Our investors that stayed the course didn't lose a dime," he says, though he admits, "they didn't make a dime either!"
One alternative asset that's been drawing increasing attention from advisers is the managed-futures fund. These pools of money essentially trade so-called futures contracts, which set prices for various kinds of commodities. They can either buy futures or short them, betting that their prices will fall. In a recent survey of investment advisers by Morningstar, managed futures stood out as the favorite alternative investment, and it's no wonder: The Newedge CTA index of futures funds has more than doubled since 2000 -- while the S&P 500 has essentially been flat -- and it kept rising during the worst of the crash. The pools are pricey, however. Futures fund managers typically charge hedge fund-like prices -- as much as 2 percent of assets, plus up to 20 percent of the profits each year. And, of course, there's no guarantee that their run of success will continue, cautions Diane Pearson, a financial adviser at Pittsburgh, Pa.-based Legend Financial Advisors, which manages $380 million and has been using managed futures for the past five years. "You need to be flexible," she adds. "You have to actively pay attention and make changes."
Step By Step Plan
1. Fill your bucket. Some investors and advisers are putting as much as a third of their portfolios in alternative assets such as commodities and real estate. But studies suggest that an allocation of just 10 percent can be enough to significantly improve a portfolio's overall performance.
2. Consider ETFs. Exchange-traded funds, baskets of securities that trade like stocks, make some alternative assets available to investors for relatively low fees; the number of alternative ETFs has more than quadrupled in the past four years. But advisers and consumer advocates warn that the funds can be very volatile.
3. But ask for help if needed. Many investors buy alternative assets through advisers, who can spend more time monitoring the investments and can move from one asset class to another quickly if markets shift.
4. Manage your future. Managed futures, which allow investors to bet on commodity prices, fared well in the crash. Investors took note, parking $267 billion in assets in such products by the end of 2010, up 19 percent from the year prior, according to research firm BarclayHedge. Management fees can be high, with managers often collecting 2 percent annually plus a share of the profits.