Most of the posts I and other financial bloggers write are typically focused on individual stocks or ETFs and managing active portfolios.
For those folks who are more conservative investors, those whose main investment vehicle is a 401K, for example, the techniques for portfolio management might be a little different.
The news of stock markets falling and pundits predicting recession is disconcerting to professional investors as well as to those of us who are watching our balances in an IRA or 401K sag.
What approach should the average 401K investor take?
Let's assume that the investor is contributing on a regular basis to one of these retirement accounts. There are two questions that the investor needs to ask:
1. Should I stop putting the regular contribution into stocks?
My feeling is that investors making regular contributions are being handed a present by the markets. Every week the market goes down, these investors are lowering their average cost. When markets recover, as they eventually will, the equities bought as the market was going down will suddenly look like bargains.
My advice, then, is to keep on contributing regularly and be sure that a good percentage of those contributions are going into stocks, not stable value funds.
2. Should I sell a large portion of the stocks or mutual funds already in the portfolio?
Those 401K investors who have access to a stable value fund should take advantage of it now. A stable value fund guarantees principal and pays a modest interest rate. In these times of falling interest rates on treasury bonds, getting the risk-free 4% or so that stable value funds pay is not a bad deal.
If a bear market is underway, it is a good idea to lighten up on stocks. So I would suggest putting up to 50% of the portfolio into a stable value fund but certainly no more than 50%. This percentage allows an investor to preserve capital and sidestep some of the gyrations we are seeing in the markets these days. But an investor needs to leave a reasonable amount of stock in the portfolio in order to take advantage of the rally that will eventually signal the end of what today looks suspiciously like a bear market. Many studies contend that powerful rallies after major downtrends account for a large part of portfolio gains. For this reason, the investor needs to keep a sizable portion of stocks in the game.
In terms of deciding what to sell, the investor may want to trim each individual position rather than totally liquidate some and keep the rest intact. This decision depends on whether the investor is happy with the current allocation or whether there are some clear under-performers that could be removed entirely from the portfolio.
When the up trend seems to be confirmed and market stability returns, an investor can begin to deploy some of the cash in the stable value fund back into stocks and mutual funds.
This may sound like market timing but it is simply a method to react to major turning points in markets. It is a strategy that can be done incrementally. Worried about the market? Park a little in the stable value fund. Still worried about the market? Park a little bit more in the stable value fund. Market going up and you are worried you are missing the rally? Move a little out of the stable value fund. And so on.
The goals of this strategy are twofold:
First, to smooth out some of the volatility you may derive from staying in stocks day in, day out. You will miss some of the upside of the initial bull market rally but you will have hopefully missed some of the losses of the bear market downdraft.
A second goal is to preserve capital in uncertain times. When markets do rebound, the portfolio won't have to make up so much lost ground just to get back to break-even.
And keep in mind, a stable value fund isn't dead money. Though a conservative investment, it generates interest and ensures that there will be at least some gains, more than likely enough to at least keep ahead of inflation.
So be careful and take the steps needed to ensure a healthy and prosperous retirement.
UPDATE: I received a comment that was vehemently in disagreement with my general thesis in this post about using a stable value fund for capital preservation. My response is that the funds seem to be quite conservative and shouldn't be too exposed to the current turmoil in credit and securitized mortgage markets. David Merkel, who writes for Real Money, has some thoughts on the subject ("Unstable Value Funds?") that seem to confirm my opinion. He also provides further detail on how the funds work in the event they do encounter trouble: ie, returns reduced, principal preserved.
In any case, thanks to Anonymous for the comment which got me thinking and doing further research.
For more on this topic, read Part Two.
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