What to Do in a Market Where Anything Can Happen
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Four-plus years after the financial crisis, and you can't tell whether or when the economy and the markets will return to normal, whatever that is.
Instead, we seem suspended between debt crises and central bank interventions at one pole and signs, however uneven, of a real U.S. rebound on the other. Here's the rub with uncertainty, though: It's always with us.
"Things are no more uncertain today than they were in the past, but we feel that way because we're still recovering" from the trauma of 2008, says Meir Statman, a behavioral finance expert at Santa Clara University. "We have to accept that things can go wrong. All we can do is manage the uncertainty, not prevent it."
Smart managing of uncertainty -- and its attendant risks and opportunities -- is what Money's investor's guide is all about. The stories focus on specific moves to make in today's environment.
First, a look at the big picture: the three most dramatic scenarios for the markets and economy in 2013 and beyond (spoiler alert: They're not all bad!); then, who will have the most at stake in each; and how you should prepare for the possibilities and manage the realities.
POSSIBILITY NO. 1: The long-term returns for U.S. stocks and bonds turn out to be dismal
A galaxy of investing stars, including Pimco's Bill Gross and GMO's Jeremy Grantham, have warned of below-average returns over the next few years -- or even decades, in Gross's view. The culprits: slow U.S. economic growth, weak consumer spending, and rising health care costs for an aging population.
Add it all up, and stock returns are likely to average 4% to 6%, compared with their historical average of 9.8%, says another star pessimist, Research Affiliates chairman Rob Arnott.
Fixed-income returns are also under pressure. Over the past 30 years, bond prices soared as interest rates fell from double digits to just 1.6% for the 10-year Treasury. Game over: Bonds are likely to deliver, at best, their yield to maturity, rather than their historical average of 5.4% a year for intermediate issues. And when interest rates rise, as they will eventually, prices will fall and fixed-income investors will suffer losses.
Who is most at risk: Lower investing returns would be bad news for all of us, of course, but the prospect is especially daunting for those aiming to retire in the next 10 or 15 years. A couple of percentage points less in average return over two or three decades means your retirement portfolio will likely be 25% to 35% smaller than it would have been.
WHAT TO DO:
Go on savings overdrive. The only sure way to make up, at least in part, for lower returns is to save more. So put away at least 15% of your income. Max out your 401(k) contribution, of course: "A no-brainer," as Boca Raton, Fla., adviser Mari Adam puts it.
If getting the rest of the way there seems daunting, remember that "power saving" for bursts of a few years can make a big difference. Research firm Hearts & Wallets found that about 40% of successful savers -- those who built nest eggs equal to 10 times their pay -- did so by saving 15% of their incomes or more for up to 10 years.
Keep more of your return. You can't afford to give your earnings away to the tax man or the money manager. Put investments that throw off a lot of capital gains or dividends, such as real estate investment trusts and taxable bond portfolios, into a tax-sheltered account.
Tax-exempt municipal bond funds and stock index funds, which generate few capital gains, are best kept in taxable accounts. And know this: Assuming a 7% return, switching $25,000 from the average stock mutual fund that charges 1.4% of assets to an exchange-traded equity index fund that charges 0.2% nets you an extra $20,000 over 20 years.
POSSIBILITY NO. 2: A 2008-style financial crisis and bear market come roaring in
Whatever moves Washington makes in the next few months, there are no quick solutions to the $16 trillion of federal debt. Across the Atlantic, deep divides in the eurozone between creditor and debtor nations stymie solutions, and more of the continent is drifting into recession. "The U.S. and European debt problems present significant risks to the economy through at least 2013," says Thomas Forester, manager of Forester Value.
Related: Why market timing is so hard
Of course, there are plenty of other events, some you can think of, others that would be a complete surprise, that could trigger a financial panic and tumbling world markets.
Who is most at risk: A severe bear market, if you're just starting out in your career, is a good thing. It is especially damaging, on the other hand, when you're about to retire or have hung up the briefcase recently. Since you have little opportunity to rebuild your savings, you can end up facing a menu of unappetizing options: postponing your retirement, retiring anyway and taking the chance that you'll run out of money in your old age, or cutting your withdrawals materially.
WHAT TO DO:
Lean toward low-risk assets. Dividend-paying stocks and alternative assets such as commodities and real estate have delivered returns similar to the broad market over the long term, yet with less risk.
In fact, an analysis of the lowest volatility stocks, published in The Journal of Portfolio Management, found that between 1968 and 2005 these equities delivered returns one percentage point higher on average than the overall market with 25% less risk.
Of course, since 2008 safety-seeking investors have been rushing into these investments, which is likely to limit the potential for future outsize gains. If you are near or in retirement, though, goal No. 1 is to inflict no harm, so it makes sense to tilt toward safety.
A moderate-risk investor might hold a 50% stock/50% bond portfolio well into retirement, says Portfolio Solutions adviser Rick Ferri. Your asset mix might include 30% in U.S. equities, including high-quality dividend-paying stocks, 15% in foreign equities, and 5% in REITs.
In fixed income, you would avoid long-term bonds, which are most affected by interest rate moves, and spread your holdings among intermediate issues (30%), high-yield securities (10%), and TIPS, Treasury bonds that offer inflation protection (10%).
Adjust to the times. When you were working and got a bonus, you spent more. When times were lean, you spent less. Keep doing that once you stop working.
"It's important to revisit your retirement plan and make adjustments when necessary," says T. Rowe Price financial planner Christine Fahlund. Her company found that retirees who cut their nest egg withdrawals by 25% for three years after the two bear markets of the past decade significantly improved the chances of making their money last 30 years or more.
POSSIBILITY NO. 3: Surprise! Everything turns out fine
All those dire forecasts? They could be way off. Even a top-performing money manager like Gross is, at best, a so-so prognosticator of market returns. Studies have repeatedly shown that economic and market predictions usually miss the mark. Between April and November 2008, the Federal Reserve Bank of New York's research staff estimated that the chance of a severe recession was less than 15%.
Even if an economist makes a big call correctly, he or she isn't very likely to get the next one right. A 2010 study by researchers at Oxford and New York University found that the forecasters who correctly predicted an extreme event were often the ones who had the worst overall track records.
Outside the ivory towers, there are plenty of signs that the economic recovery -- and long-term investment returns -- will end up better than you might expect.
Housing foreclosures have fallen to a five-year low. Consumer confidence has rebounded to its highest level in four years, in large part because of an improved job market. And companies continue to innovate in everything from energy to genomics to nanotechnology. All that innovation may even spur a new economic boom, says Vanguard chief economist Joe Davis. "We have a lot of headwinds to get through, but over the next five to 10 years, the economy is likely to rebound stronger than expected," says Davis.
Of course, to benefit from this renaissance, you would need to be invested in stocks.
And there's the rub: Over the past year, as the S&P 500 returned 15%, nervous investors have continued to pull money out of U.S. equity funds. The numbers since stocks bottomed in March 2009 are eye-popping: U.S. equity fund net outflows total $179 billion. Much of that cash has ended up moving into bonds, which has helped Pimco Total Return, with $285 billion in assets, balloon into the nation's largest mutual fund.
Who is most at risk: For those in their twenties and thirties, an aversion to stocks would be particularly costly, since they would miss out on decades of compounded returns.
Unfortunately, young investors are also among the most risk-averse today -- nearly 40% say they'll never be comfortable buying stocks, compared with 29% of all investors, according to surveys by MFS Investments. Alas, the alternative -- building the nest egg you need with only cash and bonds -- requires extreme levels of saving over the long term: 20% of income or more.
You could also save less but work longer before retiring. Both strategies are plausible, but they carry their own risks. Will you be able to sock away so much your entire career? And what if you're no longer healthy enough to keep working until, say, age 70, a too common occurrence among retirees?
WHAT TO DO:
Walk before you run. The young and fearful should take a gradual approach to the market, says Rob Oliver, a financial adviser in Ann Arbor. This isn't what standard investing theory would tell you is optimal, but it beats sitting in low-yielding cash.
Invest regular amounts each month into a balanced or target-date retirement fund, which holds a mix of stocks and bonds. A 50% stock/50% bond portfolio has returned 5.6% a year after inflation during economic booms, according to Vanguard, while during recessions, it returned only slightly less, at 5.3%.
Yes, a 50% stock allocation is low for someone in the early stages of a 40-year work life. So once you find that you can handle that modest level of risk, gradually boost your stock allocation to 70%. And when the inevitable bear market comes along, buy when the goods are on sale.