Five Tips for Surviving a Downturn

With global equity markets spiraling lower, investors’ nerves are understandably on edge as they watch their account balances shrink by the day. But while bear markets can be disquieting, they are inevitable, and your behavior now—during the tough times—can have a major impact on your long-term success as an investor. Here are a few tips for successfully navigating a downturn.

1. Don’t Give in to Your Fears
While the current economic situation is certainly serious, the constant drumbeat of bad news can make the situation seem overwhelming, and it’s understandable if some investors are getting a little panicky. Unfortunately, some have begun to express their fears by ditching their equity funds, as IMA statistics show equity fund redemptions have been sizable thus far in 2008.

But as we all know, panic rarely leads to good decisions, and it’s likely that many of those investors will live to regret that move. While cashing out might initially make you feel like you’re taking steps to protect your wealth, it brings with it a whole new set of worries. Most notably, how will you determine when it’s safe to get back into the market? If you wait too long, you could miss out on most of the recovery.

Studies have repeatedly shown that the odds are stacked against market timers because missing just a few of the best and/or worst days can have a major impact on your results. For example, in his book More Than You Know, Legg Mason’s Michael Mauboussin examined what would happen if an investor missed the best and worst 50-day periods on the S&P 500 from January 3, 1978 to October 31, 2005. During that time, the index generated average annual returns of 9.6%. But missing the best 50 days (out of a total of over 7,000), reduced the average return to just 2.2% and missing the worst 50 days increased the return to 18.4%.

Recently, a study (“Black Swans and Market Timing: How Not to Generate Alpha” by Javier Estrada) examining 160,000 daily returns across 15 international markets found that if you missed the 10 best days, your portfolio would be worth 50.8% less than a buy-and-hold investor. If you missed the 10 worst days, your portfolio would be worth 150.4% more. The point is that only 10 days out of 160,000—less than 0.1% of the days—made a huge difference. So the odds of cashing out in time to miss the worst few days and getting back in time to catch the best few days are extremely low. Alliance Bernstein CIO Ranji Nagaswami made the same point at the Morningstar conference this year: Over nearly 40 years, she noted, global equities have returned an average of roughly 0.90% per month. However, in 90% of those months, returns were essentially flat. In just 10% of them, the average return was 7.5%.

Our favorite fund managers are those that have the discipline and conviction to stick to their strategy through thick and thin. We think investors should adopt the same mindset. Develop a long-term investment plan, if you haven’t already, and stick to it. When times get tough, remind yourself of your long-term goals and remember that even though stocks can experiences some gut wrenching short-term gyrations, their direction has been broadly higher over time, which brings me to my next point . . .

2. Focus On the Long Term
It’s easier to keep your head during a downturn if you take a long-term view. If you are investing in the stock market, your time horizon should be five years at the very least. (If a financial goal is less than five years away, you shouldn’t be in stocks at all, but rather short-term bond funds or cash reserves.) What matters is how your investment performs over your entire investment horizon, not what it’s done today, last week, or over the past couple of months.

If you step back and look at equity returns over longer time periods, the picture is far less bleak than the one painted in the first half of 2008. For example, since it’s inception in 1969, the MCSI World Index has generated average annual returns of over 9% (in local currency terms). Moreover, over rolling 10-year periods, the index has produced average annual returns less than that only a third of the time. In addition, the index has never generated an average annual loss over those rolling 10-year horizons.

3. Maintain Reasonable Expectations
If you understand in advance how your fund is likely to perform during difficult market conditions, you’re less likely to overreact when it hits a rough patch. While there’s certainly no guarantee that a fund will behave as it has in the past, historical results can be instructive in setting expectations. For example, if your fund manager plies an aggressive strategy and the fund has experienced above-average volatility in the past, you shouldn’t be surprised when it hits the skids during a bear market. If you understand how a fund is likely to behave and you’ve been honest with yourself about your risk tolerance, you’ll be less likely to ditch a good fund when times get tough.

4. Stay Diversified
Diversification is the best defense against market gyrations. For a quick illustration of the power of diversification, let’s take a look at some Morningstar category averages. The average UK Large-Cap Blend fund has dropped almost 14% so far this year, but the average fund in the Morningstar Sterling Cautious Balanced category, which invests in an assortment of equity (with typically less than 40% in equity) bonds, and cash, has limited year-to-date losses to just under 7%.

Of course, the appropriate asset mix for you will depend on your time horizon, risk tolerance, and investment goals. But in general, you can lower the overall risk of your portfolio if you own a mix of asset classes that are largely uncorrelated with one another.

If you already own a diversified portfolio, remember to evaluate your results by looking at your entire portfolio, not each investment in isolation. Behavioral finance has shown us that investors have a tendency to look at each of their investments individually, and that can cause them unnecessary grief and even lead to bad investment decisions. After all, even the best funds are likely to experience bouts of underperformance. However, if you are properly diversified, that poor performer is likely to be offset by another fund that is thriving.

5. Keep Costs Low
Costs are always a key factor to consider when selecting a fund, and the advantages of low expenses are even more apparent when average returns shrink. That’s because as returns decline, expenses erode a growing portion of your returns. It’s easy to get complacent about costs when the market is riding high. Back in 2006 when the average Morningstar UK Large Blend gained 31.9%, the median retail TER of 1.58% represented 5% of the average return. But just one year later, the category average was just 5.4%, and that same 1.58% TER represented well nearly 30% of the average return. And that’s not even considering the impact of any upfront sales charges.

Many experts think we’re likely to see modest single-digit equity returns for the next few years on average. Under those circumstances, expenses loom large. It pays to keep fund expenses low so that more of your portfolio’s returns end up in your pocket.

If you need another reason to pay attention to costs, our studies in the U.S. have shown that costs are a meaningful predictor of future performance. We’ve found that the cheapest funds are likely to outperform more expensive competitors.

For more on the importance of expenses, see my colleague Chris’ Traulsen’s recent article on the subject.