Stocks are down about 20% from their highs, and even the bravest investors might be tempted to cut their losses. Here's why that's not a winning strategy.
By Stephen Gandel, Money Magazine senior writer
Last Updated: June 27, 2008: 6:55 PM EDT
NEW YORK (Money Magazine) -- Worst month for stocks since the Great Depression. A bear market. Oil blows past $140. These are the times that try long-term investors' souls.
Consider the response from Ram Ganesh, 31, who started investing in stocks only a year ago. Watching his portfolio rise for most of the year, Ganesh thought he had the market figured out. "All my readings about Warren Buffett were really paying off," said Ganesh, a software engineer who lives in Seattle.
But in the past few weeks, his portfolio is down $3,500, a significant hit to his modest $20,000 account.
Ganesh bought shares of General Electric earlier this week thinking he was getting a bargain. But the stock is down another $2 since then, and that has Ganesh thinking he should sell, not just GE, but his entire portfolio.
"Being in the market feels like gambling now," he said. "Not sure I believe in buy-and-hold anymore. I wish I had gotten out two weeks ago."
Of course, Ganesh's gut reaction - and probably your own - is the exact wrong one.
First of all, it is notoriously tough to get in just before rallies and out before selloffs.
For example, sell out now and you may miss the rebound. In 1974, the Dow Jones industrial average plunged 30% in the first nine months of year, only to rebound 16% in October. Similarly, stocks jumped 21% in 2003, after three years of big loses.
"When markets recover, they recover quickly," said Steve Bleiberg, in charge of investments for the global asset allocation program at Legg Mason.
Second, stocks are actually a better deal - maybe even "safer" - than they were a year ago. And they look exceedingly cheap compared to 1999, the height of the stock-market mania.
The price-to-earnings ratio of the S&P 500, based on corporate bottom lines of the past twelve months, is 20% lower than it was at the beginning of the year, and half of the 31 multiple it was back in 1999.
"In the 1990s, the market had a lot to drop," said Christopher Cordaro, a financial planner in Chatham, New Jersey. "This time we only started at a middle level and are already down."
Still, sticking to stocks can be tough in times like these. Here are four steps you can take to keep you finger off the sell button.
"In hindsight, this is likely to be a buying opportunity," said Harold Evensky, a Coral Gables, Florida financial planner. "What part of the worst case scenario is not already priced into stocks today?"
Remember your investing goals
The problem is big market drops like these make us forget the real goal of all our savings and investing. That's to stash away enough money to maintain your current standard of living in retirement.
Much more important than your monthly balance, is the one you see 10 or 20 or 30 years from now, when you actually need that money. In that time, stocks will go up and down and up again. So the fact that your 401(k) is down 20% from what it was eight months ago may not have much baring on what you will have in retirement.
Put today's economic peril in perspective
Before you panic over today's headlines, and how far stocks could fall, consider the relative health of today's economy.
In the early 1970s, economic output was falling. But today, despite the sluggishness, GDP is still inching ahead.
In the early 1980s, unemployment hit 10.8%. Today, the rate is 5.5%, or about half that.
Inflation topped 12% in the 1970s and 14% in the early 1980s. Today, it's at 4%.
Calculate how much have you really lost
Even if you have all your money in stocks - which probably is not, or shouldn't be, the case - the recent market downturn has really not hurt your savings that much, at least when it comes to how much you will have in retirement.
Consider someone in their 30s making $50,000 a year with that much in savings.
Before the market downturn, that person, with regular deposits in their 401(k) plan, was on track to have accumulated $1.6 million by the time of their retirement at 65.
How much will that person have now that the market has plunged 20% into bear territory? $1.5 million.
Of course, the closer you are to retirement the larger a market downturn hurts you. That's because the market may not recover by the time you need the money.
A recent study by T. Rowe Price showed that the chances of you running through your retirement savings rose from 13% to nearly 50% if the market increased less than 5% during the first 5 years of retirement. Still, we've been in a bear market for less than a year. So you still have four years to recover.
What's more, 5% over five years is not a high bar, and you don't have to sell all of your stocks to lower the ups and downs of your portfolio. T. Rowe recommends you hold 55% of your portfolio in stocks at retirement.
Find something to do
Want to feel like you're at least doing something? Strategist Robert Arnott of Research Affiliates in Pasadena, Calif., says you need to revisit whether you portfolio is really diversified.
And Arnott says diversification doesn't mean 70% stock and 30% bonds. He says you should consider shifting your new deposits into commodities and overseas investments.
He currently thinks emerging markets are a good play. T. Rowe Price International Discovery (PRIDX) invests in countries like Brazil and China, the economies of which are growing much faster than the United States is growing.
Harold Evensky agrees that commodities could be a good addition to your portfolio if inflation continues to rise. The iShares S&P GSSI Natural Resources Index (IGE), which is an exchange traded fund, can give you exposure to the commodities sector for a low management fee.
Another way to protect your retirement portfolio is to buy Inflation Protected Treasuries or TIPs. They are Arnott's preferred inflation defense. And had you bought TIPs a year ago, you would be already counting your gains. The iShares Lehman TIPS Bond (TIP) is up 14.4% in the past year.
