Purdue News
Purdue News
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July 10, 2002 How to invest in a bear market: diversify, avoid false prophets, invest for the long runWEST LAFAYETTE, Ind. – A Purdue University finance professor says there is one very important thing for the long-term investor to do in a stock market beset by corporate scandal, accounting doubts and CEO chicanery.
"Nothing." That's according to Michael Cooper, who teaches investments at the Krannert School of Management. Cooper's "nothing" comes with an important proviso – that the investor is already following his basic rules for prudent investing in any market: – Develop at least some understanding of the risk-reward trade-offs among stocks, fixed-income investments (bonds, CDs, and money markets) and real estate. Stocks tend to have a higher reward over time than other assets, but have more risk (more up and down movement in the value of your investments). In general, if you have a longer (shorter) investment horizon, you may be comfortable investing more of your portfolio in higher (lower) risk assets. Many online brokerage cites now have free investor profile questionnaires that help you determine how much of your portfolio should be in stocks, bonds, and other assets. –Understand that it is hard to profit from the prophets (stock analyst recommendations). Most studies show that it is very hard to beat the general stock market by investing in individual stocks that "experts" recommend. This is especially true when trading costs are included. In addition, most studies show that "actively" managed mutual funds, or those that try to pick which sectors or groups of stocks will outperform the market, also do not beat the market. This information has important implications: 1. For most investors, do not invest in individual stocks, and do not attempt to frequently trade individual stocks, in hopes of large, quick gains. One recent study from the University of California at Berkley examined the records of 35,000 individual investor accounts at a large brokerage house. The researchers found that the portfolios of single men underperformed those of single women by 2 percent to 3 percent per year. Why? Men tend to be overconfident and trade more. "Trading is hazardous to your wealth," Cooper says. "Out of 60,000 households, those that trade the most underperformed the market by 7 percent per year." There's no safety in consensus, either, Cooper says. "The average investment club results lag the market by 3 to 4 percent per year." 2. Do not invest in funds that charge "loads" or other fees that can exceed 5 percent. Studies show that 93 percent of mutual fund money is held in actively managed funds. This is not prudent; funds with higher fees do not on average outperform low-fee, similar risk index funds, and oftentimes, higher expense-fee funds actually underperform low-fee index funds. 3. Instead, invest in index funds. Index funds typically charge no load and have low annual expense fees. Which types of index funds you invest in should be determined by your own comfort level concerning risk; in general, if you have a longer time period horizon until you need your savings, invest more in stock index funds. But remember, index funds typically invest in hundreds or even thousands of stocks – so you will be diversified, which virtually eliminates individual firm risk, such as the recent Enron and WorldCom fiascos. –Understand that the current "crises of confidence" in the markets, emanating from investors’ perceptions of the accounting related problems for Enron, WorldCom and other firms, is not a marketwide phenomenom. And, regardless, a well-diversified investor, who holds a portfolio of index funds, is not going to be affected by a few "bad apples." –Understand that the current bear market is not that bad from a historical perspective. Year-to-date, the S&P500 is down approximately 17 percent, and the NASDAQ index is down about 30 percent. Those may seem like large losses, especially in light of the last decade of 20-25 percent annual increases. But historically, the market has experienced prolonged down periods. For example, in the early 1970s, a portfolio of large cap stocks, similar to the S&P500 Index, experienced a number of years of negative total returns. But one must resist the temptation to exit the market when the market is doing poorly. Typically, the market will rebound with a big positive year after the bad years, and an investor who pulls out might miss those big positive years. The bottom line on how to invest in a bear market: – Diversify your investments by investing in low-fee index funds according to your risk tolerances. – Invest regularly, don’t attempt to time market swings, and remember that you are in it for the long run. –Over the long-run, your investments will likely give you a good return over inflation, but remember that the intervening years will be volatile, especially if you have a heavy concentration in stock funds. Writer: J.M. Lillich, (765) 494-2077, mlillich@purdue.edu Source: Michael J. Cooper, (765) 494-4438, mcooper@mgmt.purdue.edu Purdue News Service: (765) 494-2096; purduenews@purdue.edu
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