Basics for Capital Market Exposure

Earlier this year I wrote an article called Reflecting on the R Word. The “R” word was of course Recession. After more than four years of a rising stock market, I was finding in discussions that many people were losing perspective and forgetting lessons learned about a market economy, the ups and downs of capital markets, and the principle of diversification.

The article was a reminder about basics.

• Economic cycles move in phases—growth, peak, decline, trough, growth, etc.—though the duration of the cycles vary.
• Stock markets, and therefore investment values, rise and fall.
• The historical trend of both economic cycles and capital markets is upward, contributing to the increase in society’s wealth and well-being.
• To manage the ups and downs, investments should be diversified by asset class and aligned with personal goals and needs.
• Finally, one should choose money managers who have records of performance through several market cycles.

Given recent market volatility, it is time to expand on these points to help you think about your investment makeup.

By the second week in August the Dow Jones Industrial Average had dropped more than 7% from its peak in July, erasing many gains for the year. While U.S. stock market performance has been slightly positive for 2007, it has not been positive for those who sold their long-term holdings during market swings. As one pundit put it, “when the market moves back and forth like this [with 200-300-point swings on several days], it is a sign that the small, naive investor is giving over wealth to the large, experienced investor.” The point is that those with experience know to ride out short-term swings, while those whose stomach makes decisions often sell at a low.

If we stepped onto an elevator and I told you it was likely to “plunge,” you would probably think of catastrophe. When you hear that the Dow Jones Industrial Index “plunged” 200 points, keep in mind that represents roughly a 1.5% decline. Plunge?!

When you are feeling queasy aboard a boat in rough water, what advice do experienced sailors give? Look at the horizon. Ignore the waves nearby, and look farther ahead with a longer perspective.

I have a client, a 70-year-old single woman, who in the past year inherited almost $1 million from an aunt. Her aunt built a modest fortune during her lifetime starting with a single investment after a trip from Michigan to Florida. Driving through Georgia she had smelled an incredible sweetness in the air that she couldn’t forget. Now my client is the beneficiary of that experience; she would have been considerably less comfortable today had her aunt not invested in Coca Cola and held on for the long term. I called last week to reassure her about her investment portfolio. After I had delivered my careful speech, she said, “David, my aunt always told me ‘when the market goes up you say Ahhhhhhhhhh; when it goes down you say Ohhhhhhhh—and hang in for the ride.’”

These are reminders to stick with your plan. But it’s important to review your plan periodically in light of changing conditions and any change in objectives. Here are the questions I’m answering when I look at your situation.

Do you have a target investment policy? This is one that establishes model allocation percentages of fixed-income and equity asset classes based on your personal return needs and risk tolerance.

Do your current asset allocations match your model? You might find out, for example, that you are taking more risk than you want.

Is your model allocation appropriately spread among sub-classes of assets? Examples include short and long term bonds; corporate and government bonds; domestic and foreign bonds and equities; large and small companies; value- and growth-oriented investment styles.

Are you addressing the primary impediments to growth of your assets and net worth? They are not market volatility and the inevitable declines that occur over time; they are inflation, taxes, investment expenses and personal consumption habits.

Are your investments directed toward your long-term goals? If so, you should be well positioned to ride out any downturn. If not, how can you get positioned to do so?

This is all fairly basic stuff. But paying attention to the basics pays off…in portfolio value and as importantly in peace of mind.