5. You Have More Options Than Just Sucking It Up and Accepting Losses

“The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.”

John Maynard Keynes, 1923

By now the peril of buying individual shares has been well-established. Now investors have another choice.

1. You can give up and not play the game at all, and withdraw all your funds from the market in favor of cash instruments such as money market funds.
2. Or, you can keep socking money into a 401(k) or retirement IRA, never check the statements, and hope it all works out without any active decisions on your part.

Both solutions are dangerous. Unfortunately much of what investors have learned is that one has to be “in it to win it,” referring to being invested in stocks, so to speak. Anything else is assumed to be short-sighted.

The gestation of this notion comes, in part, from Dr. Jeremy Siegel, a professor at the Wharton School of Business. Siegel is known for his book Stocks for the Long Run, which suggests that stocks are the best investment, bar none, over the long haul. Various writers and analysts have already pointed out some of the flaws in his research. More often than not, he has been proven right, even if one restricts the data used to the years dating from 1926 to the present, which use the well-known Standard & Poor’s 500 stock index, and ignoring the spotty records available back to the beginning of the 19th century. Dividend-paying stocks held for the long term are expected to be superior to bonds and all other investments. This hasn’t been true all of the time, but it’s not entirely incorrect.

I’m not here to argue for or against the work of Dr. Siegel—others have pointed out some of the inconsistencies in the older data, which relies on certain assumptions about dividends that may not be accurate. Regardless, it isn’t so much the idea as it is the application of it, or rather, the misapplication of it. Well-researched, good ideas have a way of being perverted into something less than the sum of their parts. When Dr. Siegel published Stocks for the Long Run almost 14 years ago, he used historic figures to prove that stocks had long been the best long-term investment. That held true even as the U.S. became a more mature economy. But what is the long term? Five to ten years isn’t, assuredly. Fifty or more years is a good definition of “long term,” encompassing most of an investor’s lifespan.

This book is not attempting to whitewash the reality that equities, over time, will eventually outperform the other common investment, bonds. But equities can be problematic over the short and even medium term. Short-term investors should probably stay away from equities in the first place, as you’re talking about money that you’ll need in two to five years. The question becomes less clear with a medium-term horizon, which can be defined at about 12 to 15 to 20 years.

But it is this idea—that dividend-paying stocks will outperform bonds and all other assets over the long term—that has changed into something more insidious as a result of a lengthy game of “telephone” that stretches from those who have read or are otherwise familiar with Dr. Siegel’s work, to those who have not really read much of it, to their clients and viewers of CNBC, who think they get the idea of it, but really haven’t heard much else. Instead of thinking stocks are the best investment over a long period of time, investors have substituted the bastardized idea that stocks are the best investment, all the time. And that includes those stocks that do not pay dividends, when stocks that do not pay dividends tend to do even worse than other stocks.

This unwavering belief in the market’s prowess gained currency through the late 1990s and most of this decade as a result of the growth of what some could call “free-market fundamentalism,” whereupon passive decisions by a “market” are viewed as superior to those made by an individual in all facets of society, but particularly in investing. Over that time, investors absorbed phrasing from the Wall Street lexicon—buying on the dips, stocks for the long haul—and substituted common aphorisms for judgment and an understanding of their own goals, the assets they own, and what they want out of their retirement. Who needs to answer such questions when you can simply buy stocks and hold them forever?

As a result, statistical analysis morphed into shorthand: Stocks were always the best investment. Investors were to hold stocks, regardless of what happened to their value over a period of years. Stocks were never to be sold, and in fact the only active decision one should consider making would be to buy more stocks when the market invariably fell. Proof of this can be found in the number of mentions of the phrase “buy and hold” in a Dow Jones Factiva search of magazine and newspaper articles dating to 1970. The phrase appears nearly 65,000 times! But the frequency of the phrase’s use increases dramatically. In the 1980s, “buy and hold” appears in articles just 746 times. But in the “aughts,” the phrase is referenced more than 55,000 times. One has to adjust to the possibility of greater duplication of articles as more media outlets are included in such a search, but it cannot be argued that this philosophy was drummed into the investor experience in the last decade.

The same can be said for “buy on the dips,” the self-serving cliché that investors should look to stocks that have fallen from their heights and jump back in because they are undervalued. Again, this can be taken to ludicrous extremes. In the late 1990s, when I wrote for TheStreet.com, I conducted online chat sessions with investors eager for advice about the path of the markets. Because of TheStreet.com’s rules prohibiting journalists from offering advice about individual shares, I was limited in what I could say about specific stocks. But I did at least make sure to tell investors asking about once-hot Internet stocks that had fallen to a fraction of their previous value that just because a stock’s price has declined dramatically, that did not make it a value proposition.

Still, “buy on the dips” persisted. In the 1980s, the phrase appears in a Dow Jones Factiva search a total of 28 times, and many of those articles do not even reference the stock market. The notion exploded in the 1990s, and there are 771 mentions of this phrase in magazine and newspaper clippings, according to Factiva.

In the last decade, this philosophy, once the province of investment professionals using various metrics such as earnings multiples and earnings growth to determine the value of the stock, made its way into the mass market, and there are more than 1,000 mentions of this phrase in the 2000s. The decade begins with an article in the Newark Star-Ledger, dated January 5, 2000, noting the burgeoning sell-off in stocks (one that was set to turn into a 90 percent decline in the technology-heavy Nasdaq Composite Index), with this advice: “Don’t panic and don’t be swayed by big point moves up or down,” counseling to “stick to your investment strategy, realizing that investments in stocks are generally for the long run, from two to five years.”¹

Ugh. That quote is a perfect example of the distillation of everything investors and less-informed writers absorbed during the bull run—it’s just enough information to suggest the writer learned something about investing, but what he learned was enough to misrepresent the idea of long-term strategy. Taking apart that statement, there’s very little in terms of advice that’s useful to an average investor. Panicking, of course, is never advised, but a more alarmist perspective for the average person would have helped to get them out of the market in the early stages of the burst of the technology bubble. Even worse is the statement that suggests stock investments are generally for the long run, which the writer defines as “from two to five years.” If the reader listened to this, there would be a catastrophe, of course. While statistics are on the side of those who claim stocks are the best investment for a multidecade period, stocks have often been the worst investment around for a vast number of two-year periods and plenty of five-year periods. Anyone trying to save money for an imminent purchase would have had better luck gambling it somewhere.

Conventional Wisdom? Yecch

The last 20 years and particularly the last decade or so has been a time of what many called the “democratization” of the equity markets. But democracy, as politics shows, is messy and involves emotional decisions by a horde of people who sometimes don’t have all the facts—what people absorb tends to run in the realm of cliché, or talking points, really.

Retail investors became attuned to these shorthand philosophies at the exact time it proved fatal: The nasty tech-led bear market of 2000-2003, and the even more harrowing experience in 2007-2008. Denise Shull, president of Trader Psyches, who studies the emotions behind investing, says that a good reason that people believe such mantras “is we believe in experts—particularly when we don’t know a field. The market is very mysterious—because everyone forgets they are betting on other people—and so people are generally inclined to believe in conventional wisdom more than they would otherwise be.”

For the most part, conventional wisdom stinks when evaluating individual purchases in the market. The popular phrase used to describe social and sexual behavior that sprung up in the 1960s, “if it feels good, do it,” is deadly in the stock market. Usually, if it feels good in the stock market, avoid it at all costs. Rob Arnott of Research Affiliates puts it this way: “The markets don’t reward comfort. They reward discomfort.”

The essential meaning and usefulness of the “stocks for the long run” phrase had been lost, and instead investors responded in an even more damaging fashion. Schooled to believe they should hold their investments regardless of the situation, they, in a fit of stubbornness reminiscent of Pickett’s Charge, gallantly stuck to their guns in the face of falling portfolio values—until that panicked, emotional moment when they attempted to achieve catharsis by selling all of their assets. This last moment, naturally, was probably the best buying opportunity for investors. Invariably, investors who nervously unloaded the losers from their portfolio at their lowest value probably later compounded this mistake by buying after said stocks rebounded substantially.

Human nature being what it is, people can only follow a discipline that’s based on well-worn mantras for so long without some sort of documentable evidence. The phrases “buy and hold” and “buy on the dips” may be translatable into actionable intelligence when accompanied with charting technology, fundamental evaluation of companies or markets, and knowledge of economics, but by itself, it merely represents a combination of hope and expectations based on past experience. Eventually, that’s not enough, not when an investor is staring at a 50 percent slump in her portfolio. Naturally, emotions finally take over—and the person in question sells at the worst possible time. You’re not alone, as professionals do this too; financial advisors who are primarily charged with helping clients effectively allocate assets rather than pick stocks have not been shown to be any better at timing the market than anyone else. (And on top of that, they’re charging a fee for their services, which means they’re making the same bad decisions you’re making and charging you money for it...where do we sign up?)

Where does such a panicked reaction come from? There are two culprits. The first factor is that investors, new to the market, strode into equities without much of a road map, and without having experienced the pain that accompanies a long period of poor performance in stocks. Just 19 percent of Americans owned stocks in 1983, down from 25 percent in 1970, according to the Federal Reserve’s survey of consumer finances, reflecting a decline in popularity of investment clubs after a long period of lousy performance in the stock market.

By 1998, a total of 63 percent of Americans owned stocks, either directly or through mutual funds and retirement accounts. Those investors experienced years of low volatility and high returns—in fact, during that decade, the market went about seven years without once experiencing a 10 percent correction, according to researchers at Birinyi Associates in Westport, Connecticut.² That’s an unprecedented level of stability, and it nearly repeated that trick after the lows of 2003, when markets went up, once again, in a steady, unwavering fashion until reaching its pinnacle in October 2007. Since investors were already using the rationale that the losses of the technology bubble were “deserved” because of the inherent ridiculousness of the Internet bubble, they didn’t look at that as much more than a speed bump. With that kind of stability, everyone looks like a genius, and everyone is schooled in the belief that the market has an inherent grounding, when in times of turmoil it does not—thus leaving investors unprepared for when the market starts to go against them for an extended period of time.

The second factor—which stems from the first—is a lack of discipline, which comes from investors not having learned when the proper moment is for such reevaluation of one’s assets and one’s allocation. Having not ever learned the proper way to examine a portfolio, investors assume that their only recourse is to continue to hold their assets without any changes, even in the face of terrible portfolio performance. This is the equivalent of being told to “suck it up” by a tough-minded eighth-grade gym coach when you’re doubled over in pain after running several laps.

But sucking it up is not an option. Not when it’s your money. Sure, it would be ridiculous for investors to sell assets at the first sign of trouble; for one thing, it would be prohibitively expensive due to trading costs, and secondly, it would drive a person crazy trying to keep up with every move in the market. But research does show the benefit of some active involvement in one’s portfolio, to the point of intervening and selling assets that have performed well, in addition to unloading those that have not done as well.

Here’s the rub: It’s hard to figure out when to sell, so the choice comes down to a person’s own goals and a bit of understanding of what’s happening in the market. This has turned out to be very difficult because the signs that exist when stocks have hit unsustainable levels are often ignored by investors who myopically believe markets will continue to sustain rallies.

For those who shrug this off and boldly suggest they can see the turns coming, consider this: The Dow Jones Industrial Average peaked at an all-time high on October 9, 2007, having surpassed the 14,000 level. That was two months before the official onset of the 2008-2009 recession, a time when investors theoretically should have been lightening up their portfolio, which is something very few were doing.

But most investors are unable to predict when sectors are going to turn. Professionals offset this by steadily pruning positions that they believe are going to fall out of favor in coming quarters due to changes in the economy, and add slowly to other positions that they believe will perform well as demand picks up or slows down. Again, this can all go wrong if bad bets are made—the aforementioned Bill Miller of Legg Mason bet on a rebound in financial markets that was not forthcoming and believed certain stocks were undervalued even though they had declined substantially. He saw his portfolio decimated as a result. And you face similar challenges in trying to determine when certain industries are going to do well and when others will not.

Still, this does not mean that individuals cannot apply certain levels of active management to their portfolio. Investors have the ability to alter the mix of their investments—be it from sector to sector, or from asset class to asset class—in their IRAs or 401(k) plans without much trouble. These accounts, rather than accounts that would be subject to taxes and other costs, are ripe for shifting allocations because they are protected from taxes until the money is withdrawn. Within that, investors can either elect to rebalance their portfolio (some companies offer automatic rebalancing to pull back on certain funds that have had outsized gains), and they can also shift their contributions to take advantage of a downturn. This is another one of Jim Cramer’s ideas—figure out what your allocation to your 401(k) is going to be for the year (say, by looking at the allocation in your biweekly paycheck and multiplying by 26 to get the yearly contribution), and then bump up your allocation temporarily when markets experience severe downturns. This allows a person to buy certain investments at a cheaper price. Since 401(k) allocations can usually be altered as many times during the year as one wants, there are no additional costs, and investors are buying equities on the cheap as a result. In fact, the freedom afforded an investor in a 401(k) plan—which does carry some short-term costs—is perfect for rebalancing or shifting investments when troubles begin.

Unfortunately, most investors are terrible at figuring out when to get in and out of an investment, which is how the misapplication of the “stocks for the long run” mantra comes to bite them in the rear end. According to research from Birinyi Associates, the annual average return of the Standard & Poor’s 500 index is 8.71 percent. But according to Birinyi, the average gain for weighted equity mutual funds since 1962—that’s taking all actively managed mutual funds (not including index funds) and weighting the performance based on size of the fund, thus assigning more importance to the larger funds that continue to attract more assets—is a mere 1.18 percent.³ It shows that the largest funds—those that have welcomed more funds from investors—have done worse than the market in general.

This points directly to the individual’s inability to adequately assess what is and what is not overvalued—larger funds attract hot money as people try to chase performance, and as they get bigger, their performance suffers. It happened with Bill Miller’s Legg Mason fund, it happened with the Munder NetNet Fund, and it happened with other popular funds from Janus, Invesco, and companies that produced a winning streak that enticed investors to flock to these asset managers. John Bogle, who pioneered the index fund through his Vanguard Funds, points out that smaller fund managers—those that limit their size to something less than $500 million—can beat the market consistently if they’re adept enough at stock picking. Once they grow larger, they become a glorified, higher-cost index fund, and the costs of shifting positions becomes more prohibitive, eventually hurting returns just because of the sheer size of the fund. In addition, it’s the investors who come in late—the ones who cause certain funds to be weighted more heavily than others—who feel the most pain.

For individual investors, what makes more sense is to start with index funds. It forms the core of the strategy I’m suggesting, because it starts at the point that you, the investor, can most easily control: costs. The lower your costs, the better your returns are after the attendant fees that come with investing, and the easier it is to come close to matching a benchmark (even though, as we’ll discuss, that’s not really the goal, either).

Other than a number of hedge fund managers, there were very few with a reputation for stock-picking prowess that outdid Bill Miller, and his downfall illustrates the peril of following someone based on reputation, on star rating, or most importantly, on past performance.

David Loeper, president and CEO of Virginia-based Financeware, an investment advisory, says that investors “can play the roulette wheel” if they like through the use of active management, but it opens up someone to the risk of underperforming the market, and badly, after years of gains.

Loeper runs separately managed accounts for his clients, and he, like many others, is a proponent of using index funds for various reasons: lower costs, more attention given to asset class management and the goals of a client’s portfolio, but specifically points out that someone who invests in index funds or ETFs can only underperform by their fees, while someone who goes with active management runs the risk of falling far short while spending considerable costs to do so. With indexes, “there’s no chance of over-performing, but there’s value to not subjecting yourself to the risk of underperforming,” Loeper says.⁴

“A young person who started in 1997 and spent 10 years straight outperforming by 100 basis points just needs to underperform by 3.2 percent, and he has then completely wiped out the advantage of outperforming for the decade,” Loeper says.

In any investing environment, someone with a long-term horizon has to start somewhere, with a core portfolio of investments that are guaranteed to do as well as the market is doing. If you as an investor are not equipped—either with the time or the inclination—to buy individual stocks, and this book argues that for most, it is an impossibility, then one has to start with mutual funds or exchange-traded funds. With that in mind, index funds are the place to begin, but as we will see, they’re not all alike—not even close.

By now one reading this book might conclude that your humble author is something of a pessimist, given to spouting clichés such as, “You can’t fight City Hall,” and the like, given the view that most individuals cannot, on their own, best the average return in the equity market.

It’s true that some people indeed have shown prowess in constructing a portfolio that comes out ahead of everyone. Those are few, however—and it’s not just individuals, it’s the professionals as well. Several researchers, in a paper financed by the Swiss Finance Institute, took a look at about 2,100 actively managed funds and how they did between 1975 and 2006.

They found that beating the market consistently is nearly impossible. Through 1990, about 9 percent of the funds were able to stay ahead of the game. But through 2006, the percentage of those that could consistently offer returns that outdid the major averages amounted to 0.6 percent, which is basically nothing.⁵ Some of those that did beat the index also may have been getting lucky, which doesn’t speak too well for the abilities of active managers.

This isn’t entirely their fault. The study notes that about 1 in 10 were able to beat the market before expenses come into play, but that little bugaboo—the fact that managers aren’t doing this for charity’s sake—meant most of the rest of those that were actually outdoing the market were knocked out of the water once they paid themselves, their staffs, their research costs, their trading costs and other expenses. Overall, the researchers found that “the proportion of skilled fund managers has diminished rapidly over the past 20 years, while the proportion of unskilled fund managers has increased substantially.”

There are a number of stated reasons for the decline in investment-picking abilities. One may be that mutual fund managers of 30 years ago are akin to hedge fund managers and strategic investors of today, according to James Bianco of Bianco Research. Past generations of mutual fund managers amassed larger positions in certain companies and used their ownership to force changes upon management, thus potentially improving the performance of a company. That’s a role now left to private equity and other strategic investors—the Carl Icahns and Kirk Kerkorians of the world.

In addition, many mutual fund managers with real skill decamp to the hedge fund world, where they’re free to run smaller, more nimble funds and charge big fees to do so, while the mutual fund they left suffers in comparison. And the increasing ownership of equities among investors has made the market more efficient: Fewer stocks, particularly large-cap stocks, are mispriced, leaving less opportunity for investment managers to take advantage of value opportunities (unless they dive deep into the pool of small-cap or micro-cap stocks that can potentially provide home-run returns).

The legendary investor Benjamin Graham wrote the seminal Security Analysis in 1934 with his partner David Dodd, and the book, and subsequent publications, became the gospel for value investors such as Warren Buffett. Through painstaking work, the book argued, one could find undervalued investments that were mispriced due to lack of exposure or understanding, and exploit that to beat the markets. But late in his life, he, too, came around to the “efficient market” hypothesis, which says that stocks are on the whole pricing all relevant information into their value. This is what he said in an interview in 1976 with the Financial Analysts Journal, shortly before he died:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

These thoughts match what Charles D. Ellis, president of Greenwich Associates, said in an article called “The Loser’s Game” in The Financial Analysts Journal in July/August 1975. He stated that “the investment management business is built upon a simple and basic belief: Professional managers can beat the market. That premise appears to be false.”⁶

Index Funds: Not All Equal

As the Swiss Finance Institute pointed out, it seems as if the ability of managers to beat the market is getting worse, and part of that has to do with the saturation of information in the marketplace itself. Compared with the 1930s and 1940s, when a truly dedicated manager could separate himself from others through analysis and attention to all of his investments, the asymmetric advantage has all but disappeared, despite what the professionals in the brokerage and mutual fund industries would contend.

This brings us back to index funds. John Bogle, longtime head of Vanguard Funds, established the first true index fund in 1975, designed to track the performance of the S&P 500 index. The aim was simple: to provide the best performance at the lowest costs, referring to what he called “the great irony of investing”—that you “get precisely what you don’t pay for. So if you pay for nothing, you get everything.”⁷

He hasn’t been wrong. Vanguard’s Index 500 fund has mustered returns that have outpaced about 85 percent of the mutual funds in the last few decades. And that is, again, without doing anything but passive investing. That does not mean, however, that index funds are a monolith. There are nearly 200 index funds and exchange-traded funds tracking the S&P 500, and their performance does vary due to differing expenses underlying each of these funds. Some of the funds in question have surprisingly high expense ratios.

For instance, the Rydex S&P 500 “A” shares sport an expense ratio of 1.52 percent, according to Morningstar, the mutual fund research firm in Chicago. If it’s pointless to pay a lot of money for a fund manager who is at least trying to beat the market, it’s even more pointless to see returns eroded by a manager who isn’t even trying! Returns are drastically impacted by this as a result. Over the last five years through November 13, 2009, the annualized five-year return of the S&P 500 is 0.48 percent. The iShares S&P 500 index, one of the more popular exchange-traded funds that mimics the S&P, has a return of 0.45 percent, so it’s just a fraction behind the actual index, which makes logical sense.

The Vanguard 500 Index offerings come in several classes of shares; some of them, including the institutional shares, are actually outdoing the S&P by a few hundredths of a percentage point. The most well-known, though, the Vanguard 500 Index Investor Fund, established in 1976, has a total annualized five-year return of 0.40 percent. Naturally, it trails the S&P 500, but again, only by its costs.

The same can’t be said for others. There are a number of index funds, including some that have been around for a couple of decades, which are providing no benefit to picking an index fund. Dreyfus’s S&P 500 fund is up just 0.04 percent in the last five years; T. Rowe Price’s Index fund has a return of 0.25 percent over the last five years, owing in part to an expense ratio of 0.35 percent, more than double that of Vanguard’s 0.16 percent and more than triple that of Fidelity Spartan’s ratio of just 0.10 percent.

These differences are not trivial. An investment of $10,000 in a fund that compounds at an 8 percent annual rate—optimistic, but let’s go with it—will, after 35 years, be worth $147,853.44. Cut that down by half a percentage point to 7.5 percent, and that return drops to $125,688. And this isn’t even complicated—it’s not work at all to pick an index fund as it is to try to pick stocks. Losing money as a result of high expenses in a fund that’s supposed to be doing just what the most popular market barometer is doing is downright foolish.

Some say an index that tracks the S&P 500 is the wrong way to go in the first place, despite the S&P’s popularity as a market barometer. Burton Malkiel, author of A Random Walk Down Wall Street, argues that the transaction costs embedded in the cost of buying and selling issues that come in or leave the S&P 500 hurts returns. He suggests a broader index, such as the Wilshire 5000 or the Russell 3000, because those indexes cover a larger portion of the market. Because of this, the transaction costs are a bit lower, so the spread between the index’s performance and the returns of index funds is smaller. Secondly, the best outperformance in stocks is often found in the smallest issues. The S&P 500 accounts for about 75 to 80 percent of the market’s total capitalization, but it’s that other 20 percent that provides the most opportunity for big rewards, he argues.⁸

This assertion, however, is somewhat belied by statistics. The Wilshire 5000 and Russell 3000’s returns are on a par with the S&P 500 over the last two decades, so whatever difference comes from getting a benefit from having smaller companies in one’s portfolio is eroded by the poor performance of other components. An investor, however, who truly wanted to overweight growth companies could buy indexes that track the Russell 2000 along with a Russell 3000 index fund—this then overweights small growth-oriented shares, again, also for a low cost.

Others argue that indexes that are weighted in favor of capitalization—that is, the index is more directly influenced by the biggest companies in the index—are part of the problem. The Standard & Poor’s 500-stock index is a popular index, but a great percentage of the daily shift in the index is accounted for by several dozen of the largest stocks, such as Apple, Microsoft, Exxon Mobil, Wal-Mart and the other well-known names. Those investors argue that a “fundamental indexing” approach, one that is less sensitive to market capitalization and price, is a better approach. Rob Arnott of Research Affiliates has created a number of these indexes at his firm—they weigh stocks based on several criteria, including their underlying value, cash flow, sales, and dividends. How does this help? It avoids the problem of overweighting stocks that have run up dramatically and therefore become overrepresented in an index, like technology did at the end of 1990s and as financials did at the end of this past decade. “Each new day brings further empirical evidence that weighting securities by capitalization is the index fund’s Achilles’ heel,” he wrote in a January commentary. Of course, that presents the challenge for investors on how to avoid that as well (other than handing over money to Mr. Arnott, who, as smart as he may be, cannot manage the retirement funds of the entirety of the U.S. public). Investors can on some levels tackle this problem through equal-weighting of other types of indexes or ETFs of other asset classes or parts of the market, which we will discuss more later.

In addition, other asset classes are worthy of consideration, both in the U.S. and outside the U.S., that will help offset losses in other areas of one’s portfolio with a modicum of effort. Foreign stocks are occupying a larger place in investors’ portfolios in recent years for good reason, along with small stocks, long-term government bonds, short-term cashlike instruments such as Treasury bills and money market funds, and stocks invested in hard assets such as gold and oil, which tend not to react in the same way to the rest of the market.

So, what, then, can investors do to help offset their risk and protect their portfolio from losses? The passivity argument helps keep costs low, but in a nowhere market, it’s not all that useful, and you’re going to need more from your investments as you should. There are a number of possibilities. Some of these are easy. Rebalancing on a yearly basis in one’s 401(k) allocation is a snap—particularly for those who can do so automatically when they enroll in their plan. Establishing a level at which one should sell assets, such as ETFs or other investments, after a certain percentage loss is a bit more difficult, but there are strategies that attempt to go this way to keep losses minimal. (Anyone who immediately exited hot tech funds after it lost 15 percent of its value in 2000 saved themselves a lot of pain. The downside? When there are occurrences like the May 6, 2010 “flash crash,” when popular stocks were suddenly traded briefly at a penny, a level that would have triggered sales for many investors.) Keeping a bit of money in Treasury securities that track rising inflation can help guard some of the portfolio against losses.

Other strategies, which will be discussed, involve putting a cap on the losses one will tolerate before shares in index funds or ETFs are sold and allocating funds among a number of different asset classes, more than you’re used to doing in the past. Some of these ideas have their own pitfalls, and there are still plenty trying to come up with a better mousetrap that will solve everyone’s problems with a simple formula. No such formula exists.

There are other ways to keep one’s head up, avoid sticking it into the sand, while still avoiding panicked decisions, and a lot of this is learned behavior that comes from making mistakes.

More of this will be discussed in coming chapters, but first it’s worth looking at diversification. We need to go through how seemingly diversified portfolios can get crushed in a market where assets all move together at the same time—and figure out what assets will truly hang tough when all sorts of stocks or commodities are falling at the same time. Getting this right will keep you from lying awake at nights worrying about your purchases or have you stressed out in front of the computer when you have other things to deal with, such as a job, a home, and a family.

Boiling It Down

• You don’t have enough time to invest in individual stocks. Your time is better spent if you use it figuring out your diversification, what your goals are, and where your money should go.

• Stick with index funds instead of stocks. Start with the index funds that cover as much of the market as possible, because it decreases your weighting to the largest stocks—too much money allocated to big stocks sets you up for a fall if the market declines.

• Not all index funds are equal! Some of the best ones are the lowest-cost ones, because they’re returning more of the market’s returns to you rather than keeping it for themselves.

• You need to rebalance your investing assets at least once a year.

• Keep trading to a minimum in funds. Rebalancing at least once a year will be necessary, but the more you trade, the worse your performance due to transaction costs.

• Keep some money in safe Treasury securities.

• Don’t sit back and accept losses out of fear of missing later gains.

Endnotes

¹ David Schwab, “What’s an Investor To Do? Bulls Take a Beating,” Newark Star-Ledger, January 5, 2000.

² Author interview.

³ Birinyi Assoc., TickerSense blog, http://tickersense.typepad.com/ticker_sense/2009/11/mutual-fund-returns-dont-follow-the-heard.html.

⁴ Author interview.

⁵ Laurent Barras, Olivier Scaillet, and Russ Wermers, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” Swiss Finance Institute research paper series, No. 08-18.

⁶ Bogle Financial Markets Research Center, http://www.vanguard.com/bogle_site/lib/sp19970401.html.

⁷ John Bogle speech, May 15, 2006, http://www.vanguard.com/bogle_site/sp20060515.htm/.

⁸ Burton Malkiel, The Random Walk Guide to Investing: Ten Rules for Financial Success (New York: W. W. Norton, 2003).