By Stuart Ritter on February 14, 2011
More than two years ago—as global stock markets were in what surely felt like a free-fall to many investors—a well-known TV stock commentator sounded a strikingly strong alarm warning viewers to take any money out of the stock market that they might need within five years and put it only in absolutely safe investments. That sentiment was shared by some other market pundits as well. Of course, it has not yet been five years, but how has that advice played out since that day, October 6, 2008, through 2010?
Short-term Treasury bills—a risk-free investment in terms of principal value—had a total return of 0.4%. Although U.S. stocks continued falling sharply for six months after that alarm was sounded, they have returned 25.3% since then. (See chart.)
Source: T. Rowe Price
And a portfolio of 20% stocks, 50% bonds, and 30% cash—T. Rowe Price's recommended allocation for those who may need their assets in five years—returned 13.4%. The point is that making knee-jerk investment decisions in the midst of a market crisis can backfire and undermine a sound long-term investment strategy. At the time 2008 was scary for many stock investors and, as a result, the temptation to take action—particularly by fleeing stocks entirely for cash—was strong. Nonetheless, subsequent market movements underscore precisely why it is so difficult to make such sweeping predictions with much accuracy.
Taking one element and making predictions based on it is not an appropriate approach to investing. For one reason, prognosticators' views are often biased by recent events. After a big slide in stocks, pronouncements to "get out" become loudest. And we tend to give them credence because it's easy, in hindsight, to find all sorts of advance warnings of the crisis that we feel we should have seen. We ignore that there almost always is great uncertainty about what will happen next.
For another reason, changing your asset allocation in response to market events actually requires two decisions and two actions—what to sell and what to buy. In this case, we were told to sell stocks, but what to buy? The implication was to go to cash. And in just a little more than two years, the performance differential of stocks over cash has totaled almost 25 percentage points. With a sudden shift in asset allocation, you could be right, but the consequences of not being right could be huge.
In this case, investors may have ended up selling after much of the downturn and missing out on a significant stock rebound. Such failed efforts at market timing underlie national studies that show mutual fund investors' average returns often lag those of the individual funds they are invested in. The best course is for investors to use the time horizons of their goals as a guide to their asset allocation strategy. T. Rowe Price's framework suggests that those saving for specific goals more than 15 years away would start out virtually 100% invested in stocks and reduce that allocation over time in favor of more bonds and cash as they get closer to their goal. The key is sticking with the strategy, even in the face of significant shorter-term challenges.