03/26/2001

Living with a Market Decline

For about three years now, I have been writing all of my own articles to inform you of important financial issues. Certainly, at this time, there is perhaps no more important topic than the stock market's decline and how to respond to it. Just as I was about to put my own thoughts down, along came a very thorough article on just this subject. The article's title is "Living with a Market Decline," reprinted from The American Funds Investor. This is an investor newsletter supplied by American Funds (a family of mutual funds) The article, from the spring/summer 1998 issue and revised in May 2000, is so timely and so well done, I decided not to reinvent the wheel. Thus with permission from American Funds, I am providing you with the article, less pictures that could not easily be reproduced. (As a Financial Advisor for Waddell & Reed, I represent numerous mutual funds families in addition to my firms, including American Funds.)

I hope you appreciate the piece and that it provides you with needed guidance at this time. As always, if you would like to discuss you particular circumstances, please contact me.

Living with a Market Decline
Reprinted from The American Funds Investor

Stock market corrections are an inevitable part of investing. They're also the last thing most investors want to experience. Still, it's good to face the fact that market declines are a natural part of the investment process. While the unprecedented bull market of the 1980s and 1990s led many investors to conclude that stock prices would rise forever, recent market turbulence served as a wake-up call. Let's take a close look at just what market declines are -how often they've happened, why they've happened, how long they've lasted and what you can do about them. Although we can never know when a decline will occur, how you react to stock market declines will play a crucial role in your long-term investment success.

Strategies for Coping with a Market Decline

With market history in mind, how can investors cope with a market decline? Talk with your financial adviser .

The first thing investors should do during any market upheaval is sit down with their financial adviser to examine their investment goals, time horizon, risk tolerance and financial circumstances. Have any of these changed since the last time you talked with your financial adviser? Market declines may prompt you to re-examine your strategy, even though you might not want to make any moves. You might consider whether it's a good time to buy more shares of your mutual funds at lower prices depending on your personal situation. Keep a long-term perspective. If nothing has changed, then it may be a good idea not to alter your financial plan.

"To put it simply, don't quit," says James Dunton, an investment professional for Capital Research and Management Company. "History shows that the market does recover, so have patience. Ultimately, stock prices are tied to the underlying profits of companies. So think of real companies and their profit- producing capacity -instead of pieces of paper that people are trading in the marketplace. When there is a down market, you should ask: What is the likelihood that the long-term profit potential of these companies will be impaired?"

Maintain a diversified portfolio.

It's a good idea to spread your risks by investing in a carefully selected mix of mutual funds that invest in stocks, bonds and money market instruments. It's also wise to consider investing in an international or global fund. Although the U.S. stock market has impact around the world, other countries have tended to move in different economic and market cycles. Over the long term, international stock funds have often produced gains when U.S. markets were down. Of course, investing overseas entails additional risks, such as currency fluctuations and different accounting standards. You should discuss these with your financial adviser.

Invest regularly -- in bear and bull markets. Investing regular -– or dollar cost averaging -- can help take the emotion out of investing. This strategy calls for investing the same amount at consistent intervals, such as once a month or every quarter. With this approach, you don't have to guess which way the market is going -and you won't be waiting for the perfect time to buy. You also won't risk the possibility of investing all your money at the top of the market.

Although it doesn't guarantee a profit or protect against loss, dollar cost averaging is one way to take advantage of a down market. Since you are investing regularly, you end up buying more shares when the price is down. Instead of seeing a down market as a disaster to be feared, you can view it as an opportunity to buy good companies at lower prices through your mutual funds. Of course, to make this strategy work, you have to be willing to continue making investments when stock prices are declining and stock market news is negative.

Invest for income.

Income-producing investments can be an investor's best friend during market declines. After all, a dividend is yours whether the stock price is rising or falling. Investments that tend to fare well in market declines include stocks that pay high dividends, as well as bonds and money market funds. Even though most stock prices will be impacted by a bear market, this doesn't mean that the companies themselves are faring poorly. Historically, many companies have continued to pay dividends at the same rate during bear markets. So although your stock or mutual fund prices may be lower, your dividends may continue at the same rate. Bonds and money market instruments also produce a steady flow of interest payments and can cushion your portfolio during a stock market decline.

Consider the tax consequences of selling your shares.

If you have a taxable account, it is wise to evaluate the tax consequences of selling in a market decline. Many investors have experienced significant capital gains over the past 15 years in both stocks and bonds, so it is worth talking with your tax adviser to see how much tax you would have to pay before you decide to sell. The effect of taxes may offset any positive impact of selling.

If you talk with your financial adviser and make no quick moves, you may find that in the long run you, will end up better off. As Dunton says: "We invest with the intent of being long-term part-owners of the companies we select. We believe shareholders should think of their investments in the same way."

"It's the investors who get frightened into making big changes in the way they invest who have ended up with mediocre investment results," says Jonathan Pond, author of 3 books on personal financial planning. Investors who sell their stocks anticipating a decline -- or sell in the midst of a decline -- all too often "are disrupting their orderly plans to create wealth for their children's education or their retirement," adds James Dunton, in his 38th year as an investment professional for Capital Research and Management Company, investment adviser to the American Funds. Once an investor has sold stocks in an attempt to avoid a down market, the difficulty comes in deciding when to get back in. "No one rings a bell," says Dunton. "You run the risk of missing the next big move up."

Types of Stock Market Declines

One of the problems in dealing with a decline is that you don't know at first whether it's just a slight dip or a longer, more serious correction. A look back at stock market history* since 1900 shows declines have varied widely in intensity, length and frequency. Routine declines of 5% or more have occurred about three times a year and lasted an average of 48 days. In contrast, bear markets, when stocks fall 20% or more, have happened about once every 3~ years and have lasted almost a year on average.

Lessons form Market Declines

What lessons can we take from past market declines? First: No one can predict consistently when market declines will happen. It's easy to look back today and say with hindsight that the stock market was overvalued at a particular time and due for a decline. But no one has been able to accurately predict market declines on a consistent basis. In January 1973, a New York Times poll of eight market authorities predicted that the market would "move somewhat higher" in the future. The Dow industrials proceeded to decline 45% over the next 23 months. Then, although almost no one predicted it, the Dow rose 38% in 1975.

Second: Since 1982, market declines have been brief and, for the long-term investor, relatively painless. A longer look at history shows that long-term investors have come out ahead but that the pain has often been substantial. After the 1929 crash, it took investors 16 years to restore their investments if they invested at the market high. But after the 1987 crash, it took 23 months to get back. In 1990, it took only eight months. All cases assume dividends were reinvested. Third: Successful market timing during a decline is extremely difficult because it requires two near-perfect actions -- getting out at the right time and getting back in at the right time. Getting out of a bear market is easy -- all you have to do is sell. A common mistake investors make is to lose patience and sell at or near the bottom of a downturn. But even if you have decent timing and get out early in a decline, you still have to figure out when to get back in. A bear market is not usually characterized by a straight-line decline in stock prices. Instead, the market's downward trend is likely to be jagged -showing bursts of stock price increases, known as "sucker's rallies," and then declines.

Living with a market decline isn't easy, but if you understand these lessons, you'll be a more intelligent investor.

* As measured by the unmanaged Dow Jones Industrial Average.

Please send questions or comments to dcoffin46333@wradvisors.com.