William in Reading, Pa., doesn’t think the market is crashing tomorrow, but he does think there’s a disaster ahead, and soon.
Like many investors, he’s been nervous for a while now, though he managed to participate fully in the market’s strong returns of 2013, but he has also been reading some of the sentiment suggesting that trouble is coming, pieces that suggest the current market trend looks alarmingly like 1929, the “Great Crash” that didn’t feel so great.
An investor in his 40s with a fund portfolio who does “not want to see my plans to retire in 20 years messed up by a crash,” William is mostly alarmed because in 2008 — when he did not foresee a crash coming — he “stayed the course” and it took his portfolio about four years to recover.
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So William asked what he should do as the market moves toward the minefield he has come to believe is unavoidable.
It’s a common question for investors who have been buoyed by the market’s recovery from 2008, but who are scared by what they are seeing at least in headlines and analysis.
And while investors like William want names of funds to consider for bad market conditions, the real answer comes in a question: Have you considered what happens if you’re wrong and the market doesn’t implode?
I’m not a market forecaster or a market timer, but I’m enough of a market historian to know that doomsayers have called for at least 20 or 30 of the last three market crashes, and that optimists have ridden to the lows of terrible markets like 2008 with a goofy smile on their faces.
The question is whether any nervous investor considered the opportunity costs and consequences of making the wrong call.
William wants to miss out on a crash, but being too defensive and missing a rally can have just as much long-term impact on his portfolio.
Nervous investors have a strong case for adding a bear-market fund, but going all-in on that call is tough to live with. As bad as most investors feel when asked about the last decade, most probably fail to realize that, according to Morningstar, the average bear fund has been up just one time in the last 10 calendar years.
That one year, of course, was 2008, when the average bear-market fund gained about 30 percent. But if that big one-year gain persuaded people to buy into bear-market funds after the crisis of 2008 had ended, they suffered an annualized average loss of 33 percent over the five years since.
If the pick, instead of a bear-market fund, is for gold, the category average is better, but not fantastic. Morningstar shows the average gold fund as being up in five of the last 10 years, delivering an annualized average return of 4.25 percent.
Many investors — William among them — finished 2013 wondering if diversification worked because of how strong domestic stocks were compared to the rest of the world in 2013.
And just around the time they were thinking that they should go whole-hog into U.S. equities, the market took the bloom off that rose (though William confessed to still being mostly in domestic stocks, which is why he is so concerned about a crash).
Making a market-timing call requires good timing — not perfect, but good — at both ends of the deal, because if you buy in late, after the rise has started, or sell out only after a decline becomes apparent, you’re not achieving the classic “buy low, sell high” paradigm.
There’s no denying the hero stories of investors who have made it work; those guys routinely crow about their successes on chat boards, but those wins are not the norm.
Likewise, the industry buzz has been on “alternative investments,” which sounds exotic, but basically applies to anything outside of stocks, bonds and cash.
The category also includes strategies that, in theory, work in virtually all market conditions — absolute-return funds, long/short, managed futures and market-neutral issues and more — but the reality is that those fund types have not proven to be consistent moneymakers; they rise and fall with market trends pretty much like everything else.
There’s no real proof that an all-alternative portfolio is a good long-term strategy.
“There are valid reasons why you should have alternatives — and perhaps lots of alternatives — in a portfolio,” said Tom Courtney, chief investment officer at Exencial Wealth Advisors. “But most of the money that has gone into that space has gone in as a way to avoid markets and to pick up return somewhere else. You shouldn’t be investing in alternatives if you just want to avoid equity markets and gain return elsewhere.”
“Stay the course” and “diversify” may feel like unsatisfying investment advice, but if William — and others like him — was sure of the call he’s making, he wouldn’t be seeking out affirmation for his hunches.
If he is unsure, sticking with diversification — missing out possibly on maximum gains, but also avoiding potential maximum losses — is the right way to go no matter what he thinks will happen next.
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at firstname.lastname@example.org or at P.O. Box 70, Cohasset, MA 02025-0070.
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