Diversity best hope in bear market

PERSONAL FINANCE

July 15, 2008|By EILEEN AMBROSE

It's official. We're in a bear market.

Now what?

If you have done all those boring things that financial planners nag about, like making sure you have a diversified portfolio, you should be in good shape to weather the downturn. You might even be in a position to snap up bargains in the stock market while prices remain low. But if all your money is tied up in a narrow selection of stocks, you may be in for one of those hard lessons that bear markets deliver.

A bear market is generally defined as a 20 percent decline from the most recent market high. The S&P 500 index, retreating from an October record, slipped into bear territory last week. The week before, it was the Dow Jones industrial average.

Every bear market is different.

"The similarity is that bear markets usually revolve around excess in some way. The area that gets hit the hardest is where the excess took place," says Christine Benz, director of financial planning at Morningstar Inc.

The last bear market of March 2000 to October 2002 was triggered by the burst of the technology bubble. This time around, the excess occurred in real estate and in financial companies that got burned in the mortgage mess and subsequent credit crunch.

You can't avoid bear markets, but you can try to lessen their impact.

Typically, bonds perform better in bear markets, and safety-conscious investors might want to stick with a mutual fund invested in short-term U.S. Treasuries, says Jerry A. Miccolis, a senior financial adviser with Brinton Eaton Wealth Advisors in New Jersey.

Commodities, too, reduce the threat of inflation that usually accompanies a bear market, he says.

Small investors can get exposure to commodities - oil, gas, precious metals, textiles, wheat and corn - through mutual funds or exchange-traded funds that track commodity indexes.

Often consumer staples will shine in a down market because consumers still buy food and other basics in bad times, says David Kathman, a Morningstar fund analyst.

But this downturn hasn't been exceptionally good for manufacturers of consumer staples because their profits are being squeezed by higher commodity prices, Kathman says.

Investors, looking at returns for the past year, might be tempted to put money in so-called bear funds that are designed to go up when the stock market goes down, Kathman says. That would be a mistake. The time to invest in these funds is when the market is near the top, not during a bear market, he says.

The best way to survive a bear market, though, is sticking with the basics of asset allocation and diversification.

Asset allocation is the percentage of stocks, bonds and cash you hold based on the years you have to invest and how much risk you realistically can handle.

A retiree, for example, might choose a mix of 60 percent stocks and 40 percent bonds. A new college grad might invest all of her 401(k) money in stocks because she won't need that money for decades and can afford more risk for the prospect of higher returns.

In fact, young workers investing in a 401(k) can benefit from a bear market, says James Hardesty, president of Hardesty Capital Management in Baltimore. They will end up buying more shares because the prices are low, and they will have many years for those shares to appreciate.

The other crucial piece to building a portfolio to weather bad times is holding broadly diversified securities so that if one sector goes down, others may go up and soften the blow. A well-diversified stock portfolio includes shares in foreign and domestic, growth and value, and large, medium and small companies.

A tendency in down markets is to just hold cash, waiting to jump in when the market recovers. But no one knows when that will happen. And the biggest jump in a recovering market could happen so quickly, that you miss out on it.

Rather than sit out a bear market, some suggest trolling for bargains.

"I wouldn't be bashful about putting money in the market," says Chuck Carlson, chief executive officer of Horizon Investment Services in Indiana. He's not convinced we're in a bear market yet, despite the 20 percent decline.

With stock prices low, now is the time to "upgrade" your portfolio with good stocks that might have been out of your reach before but are suddenly affordable, Carlson says.

Even though you can't control the market, focus on those things that you can control that can affect your portfolio's overall performance, says Morningstar's Benz. That includes mutual fund fees and trading costs.

How will we know when the bear market is over?

"There is no magic formula," Hardesty says.

But he's predicting an average bear market, with a 28 percent decline and lasting no more than a year.

We'll have to wait and see.

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or at eileen.ambrose@baltsun.com

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