What to do When the Market Plunges

With the Dow Jones Industrial Average dropping more than 800 points Monday as the credit meltdown pushes the world’s economy into a recession, how should prudent investors respond?

More likely than not, the value of the stocks and bonds held in your company’s retirement savings account or your IRA are down.

If you’ve invested in a stock index fund based on the Standard & Poor’s 500, you’ve suffered a loss of roughly 35 percent since last October, the date economists agree the bear market began.

Depending on how long you’ve held your stocks, the average cost of shares in your account may be less than what you paid for them over time (the average cost basis).

That’s enough to make you want to cut your losses now and hold only cash or to cut back on what you’ve been setting aside as tax-deferred for retirement. But before you rush into these potentially disastrous decisions, consider the following:

Risk flattens over time. The worst one-year return for small company stocks over the past eight decades was nearly 60 percent. As you move out 20 years, the worst-case scenario for those stocks is a positive six percent, according to Ibbotson Associates, Inc.

True, although it has taken the S&P 500 on average 13 months to recoup losses completely, you may have to wait as many as three years for stocks to rebound and enter bull territory if past history is any guide.

Even still, over time, those who are willing to commit to a diversified, consistent long-term investment program will see their capital grow.

Why? As in life, so too, with investing. How many times have you been right—even with the most rigorous analysis to support your decision?

Timing the market is impossible. Though many hardcore investors think they can do this, the facts say otherwise. Studies show that investors who bail out of the market and then re-invest when the market recovers to pre-bear market levels do worse than those who remained fully invested.

Given that shares have likely priced in all available information about their worth, it’s unlikely that you have an edge in stock picking. That’s the point Princeton University Professor Burton G. Malkiel makes in his book, A Random Walk Down Wall Street.

Malkiel builds a strong case for index investing. Transactions costs are low, which can cut deeply into returns. All my investments are in index funds because Malkiel’s argument convinced me. The one time I saw an outsized gain with a stock pick was wiped out by a loss from what appeared to be a sure win until a lawsuit hit.

Through dollar cost averaging, too, your costs are spread out over time, benefiting from market dips. You buy more shares when the price is low and fewer shares when the price is high.

Diversification is a hedge against market irregularities. Given the turbulence in the markets, now is a good time to look at your portfolio’s diversity. A general yardstick to determine the percentage of stocks and bonds you want to hold is based on age.

If you’re 25, you may want to hold 75 percent in equities, with a good portion in the more risky small size companies that tend to experience the greatest gains and losses compared to blue chip stocks. Investing a percentage, too, in an international stock fund, will help you to profit from a global economy that is shifting away from the US.

Investment advisers differ about this formula though, with some arguing recently that you may want to hold a disproportionately higher level in fixed-income given the equity markets’ volatility, which one is today above historic peaks (CBOE volatility index).

The mix of stocks and bonds that you’ll choose will depend on your tolerance for risk.

So, looking ahead, here’s a checklist:

• Review your holdings now to determine if you are adequately diversified and if your holdings are appropriate given your tolerance for risk and your financial goals.
• Don’t give up saving, particularly if your employer matches your contribution to a retirement plan. Your nest egg will likely be your largest source of retirement income.
• Resist the temptation to cash out. Stocks over the long term, and I emphasize long, outperform other investments. But you may have several years of a bear market before you see any bounce in your portfolio’s performance.
• Seek out advice. Understanding how markets perform over time is important to help you make decisions.

James David Spellman is principal of Strategic Communications LLC based in Washington, D.C. and an adjunct professor at George Washington University.