Whoa! Could this be another stock market bubble? A minor correction in January has been more than offset by February's gains, so we've enjoyed an uninterrupted rising market since August 2012. Until now, the market has never experienced a 12-month period without at least one 10 percent or greater downdraft.
So what's an investor to do? Well, we can start with learning something from hindsight -- and the 20/20 vision it affords us. I picked up one of two dozen pairs of drugstore reading glasses scattered around the house and started reading Adam Smith's book, "Super-Money," which chronicles the bubble of the late 1960s. As for the bubbles of the late '90s, and 2007, I can write my own book about them.
As it turns out, bubbles are all the same. They actually offer advantages to investors. For an all-stock portfolio, however, bubbles are not equal opportunity providers of irrational exuberance. This sets up a chance to rebalance into some of the investment styles that have not shared the benefits of a rising market.
Take the Fairholme Fund (FAIRX) for example. This was the darling of the early 2000s as it concentrated investments in a small number of giant financial services firms. Through 2007, its results far surpassed those of more diversified large-cap value mutual funds. We know how that turned out. Just before the financial services industry suffered a complete collapse, taking Fairholme with it, banking represented almost 40 percent of the entire value of our 500 largest companies.
In retrospect, wouldn't it have been smart to start taking some chips off that table and deploy them incrementally into a combination of small-company and international funds? Who could have known?
As it turned out, the S&P 500 Index produced a 10-year return, ending December 2010, of zero percent per year. A mix of a variety of investment styles actually earned roughly 6 percent per year during the same 10-year period -- which included the greatest market crash in 70 years.
In 1999, large-cap growth mutual funds gained 60 percent that year alone. Small-cap value funds earned exactly zero. The following year, large-cap growth lost 32 percent and small-caps value funds gained 30 percent -- a 62 percent flip-flop from one year to the next between the two different investment styles. Think about the smug satisfaction gained from taking a few chips off the table of a winner and adding them to a relative "loser" -- either in the late '90s or in 2005 to 2007.
Adding bond funds to the rebalance exercise can accomplish even more in the way of protecting against the downside, but those still saving for retirement shouldn't overdo it. You don't have to.
The "sweet spot" for a bond component is about one-third of a portfolio. This reduces expected average return by just 1 percentage point -- from 10 to 9 percent. This is maximum protection for a minimum amount of opportunity cost (the missing 1 percent is a "lost opportunity"). At a 50-50 mix of stocks and bonds, the expected return drops to about 7.5 percent and the protection against the downside is not that much greater.
So here are last year's winners: Small-Cap Index up 37 percent and S&P 500 Index up 32 percent. By comparison, the Vanguard's International Stock Index was up 15 percent and the REIT Index was up 2 percent. If we're looking for relative losers, it gets even better. Precious Metals funds dropped about 35 percent last year, so I just couldn't resist.
Bubble or no bubble, the biggest mistake anyone could make is taking their chips entirely off the table because they fear a repeat of 2008. No matter what happens, the average person will need to have a 50 percent component of common stocks in their portfolio throughout retirement to combat inflation. As long as you're not in assisted living, you're a long-term investor and can forget about trying to time the market. Use what might be today's bubble as a trigger for rebalancing.
Stephen J. Butler is CEO of Pension Dynamics. Contact him at firstname.lastname@example.org or 925-956-0505.