Investor's Business Daily
Market's Sell-Off Got You Worried?
Tuesday January 8, 5:56 pm ET
Doug Rogers


Market slumps often take big chunks out of the value of stock funds, tempting long-term investors to take remedial action. They might want go to cash. They might feel compelled to rotate to defensive areas like bond or value funds.

It's probably a big mistake -- not so much the move, but the timing.

Since the market's high in October, the Nasdaq composite is 14% off its high. The S&P 500 is down 11%. And the average U.S. diversified stock fund tracked by Morningstar was off 9.57% for the three months ended Jan. 7.

But whether you're a pedal-to-the-metal growth investor or a follower of modern portfolio theory with assets spread from here to kingdom come, reacting to short-term market fluctuations can be harmful to your financial health.

Why? Because it increases your chances of buying high and selling low. And that just about guarantees worse results than a long-term buy-and-hold strategy.

Timing disrupts the natural process of compounding earnings, and bad timing destroys it. Take a fund that earns an average annual 10% a year. It may fall 10% or more in any given year and rise 12% or more in other years.

If you're like most knee-jerk investors, you may sell after a fund has fallen 10%, 15% or 20%. You may save your portfolio from further decline of 15%, 10% or 5%.

But when do you get back in? Investors ruled by emotion often won't re-enter until the market or a leading fund is up 10% or 20% from the bottom. That's a lot to leave on the table after taking a 10% to 15% hit.

After a double-digit rise, how much more can you expect the market to rise before it noses over into another correction?

Smoothing The Ride

And make no mistake, timing fund buys and sells to beat the market is not easy. Fabian Wealth Strategies of Costa Mesa, Calif., uses moving averages to determine when to enter and exit funds in portfolios. The Fabian compounding plan has generated a solid average annual return of 12.11% over the past 30 years. Along the way, it's avoided some nasty dips.

But since the end of 1999 -- near the start of the crippling 2000-02 bear market -- the compounding plan's annual return averaged -0.45%.

What if you had tried to buy and hold? Since March 31, 2000, through Dec. 28, 2007, the average U.S. stock fund tracked by Morningstar Inc. delivered an average annual return of 3.35%, while the S&P 500 came in at 6.35%.

The best many advisers hope to do is smooth out the ride so their clients will see a 10% decline when the market is down 20% or more.

There is a price: upside potential. No system is perfect. Most will get you in either before or after the low and get you out either before or after the high. So instead of a gain from, say, a low of 10 to a high of 20, you're more likely to get a gain from 12 to 18.

Defensive timers argue that their way serves the purpose of keeping their clients positively engaged in the market. They can sleep at night. They never have to explain to their spouse that they lost 30% or more of the nest egg, with hollow-sounding promises that it's only temporary.

But savvy investors know there is gold in volatility -- even for buy-and-hold investors. Sitting through corrections and bear markets can do wonders for your financial health, as long as you're in a properly diversified portfolio.

Many stock funds fit this bill, including many growth funds and funds based on the major market indexes.

Look what happened to the average U.S. stock fund over the past 10 years, which included the worst bear market in a generation. It returned an average annual 6.8%. That was below the S&P 500's long-term average annual gain of closer to 10%. But U.S. stock funds still beat bond funds' average annual 4.52%.

If you had held on to a diversified portfolio, you would have done better than just about any other strategy. All it took was guts and knowledge.

Why does buying and holding a diversified portfolio work over the long run? Because every bear market is followed by a bull market that pushes values to new highs. And much of the gain often comes in a quick, initial spurt upward.

So if you're a long-term investor in a diversified portfolio and are biting your nails over the market's recent sell-off, what's your best more?

Probably sticking with your plan, whether it's buy-and-hold or another approach that's gotten you through tough times in the past.