March 22, 2001

After the plunge in stock market values during the past two weeks, what is an investor to do?

As a rule, emotions are the enemy of good investment decisions. When you feel exhilarated and are bragging to everyone about how your wealth has grown, and they are bragging to you, then the markets probably are overvalued. When you are deeply depressed and hit the remote when the news turns to the stock market, then you should be preparing your new investment strategies.

This is why financial planners want investors to follow rules. By putting a fixed dollar amount into the markets every six months (or whatever interval is appropriate for you), you will buy a few shares at high prices and a lot of shares at low prices. More importantly, you will remove emotions (and all analysis) from your investing.

By periodically rebalancing the weighting of your portfolio among investment sectors, you will be selling some of your winners and investing in some overlooked sectors. Of course, you will also suffer a tax action if your investments are not sheltered from taxes in a 401K, IRA, or other tax deferred investment vehicle.

Of course, you will need to decide what investment sectors should be in your investment basket and periodically change them as conditions change, you age, or financial goals are met. For example, young people should be more aggressive in their investments than retirees. A bad year for the youth will be overwhelmed in the long run.

Since 1800, there has never been a single 20 year period when stocks were lower than twenty years before. The youth will have several of those twenty year periods, the retiree might have no more. This is why protection of principle should be more important for the elderly. Twenty-somethings might have very few investment bonds while retirees may have mostly investment or near investment grade bonds.

(The youth should have some emerging market and high yield bonds, however, to offset some of the stock market risk. While the stock market has been swooning, emerging market bonds have been soaring in the past six months.)

On the other hand, diversity can lead to higher returns over time for the same amount of risk. This was lost in the four years between 1995 and 1998, when large cap stocks, led by technology stocks, were the best performers every year. In 1999, the winner was small cap growth stocks while small cap value stocks put in the best performance in 2000.

Except for that four year period, when technology and large cap stocks outperformed all other investments, investors would have benefited from a more balanced investment portfolio.

Recently, international equities have performed much more closely to U.S equities. For example, the worst performing significant stock market in 2000 was in Korea, where stocks fell 55 percent in value. The best performer was Denmark, with only a 12 percent gain. Five years ago, the 50 percent declines would have been coupled with 50 to 100 percent gains somewhere in the world.

Until a greater diversity in performance reappears at the international level, most investors probably should lower their holdings. After all, if the dollar is strong, the dollar value of even the best markets abroad will not be large. However, if you believe the dollar will be weak (a position I have maintained for more than a year without success), then some increased international holdings could be beneficial.

But what should you do today, when your 401 has shrunk to a 201? If you are unbalanced because you previously chased the winners you should restore diversity to your investments. A U.S. large growth equity and an international growth equity fund does not provide diversity. Small cap value funds and large cap growth funds are diverse. A few bonds and even some cash equivalents might add even more diversity, especially for the older investors, who hold most of the wealth.

You should not let your feelings dictate your investments. If Cisco was a good growth stock last year when it was selling at 200 times trailing earnings, it still deserves consideration at 35 times trailing earnings. Indeed, you should look at all your holdings and decide whether you think they will perform well from current levels. If you bought a $200 that is now $2, is it a viable company without additional cash injections. Will the injections materialize? If not, sell.

In short, right after you finish your taxes, look at your investments. Forget about what happened to them in the past year. Are they diversified? Would you buy them at today's prices? Has the stock market decline exposed other treasures that looked unreasonable when you last invested?

But most important, continue to follow your investment program. (For what it's worth, my stock market model now says the U.S. equity markets are 7 percent undervalued.) A recession already is priced into this market. I personally am looking forward to the investment opportunities that currently exist, at least in my mind.


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