Short-term View: Tough Quarter!
Long-term View: Outstanding!
There was nothing pretty about the first quarter of 2008 for stock investors. Additional fallout from the credit crunch continued to batter economic expectations, and along with them, the stock market. Lipper Inc. reported the average mutual fund lost -10.6% during the quarter, the worst quarterly result since July-September 2002, the darkest days of the last bear market. Unfortunately, SMI readers were taken along for a similarly wild ride.
Just-the-Basics investors lost a market-like -9.4%, while Fund Upgrading investors saw losses of -10.4%, similar to the experience of the average mutual fund. That most Upgraders were coming off significantly better-than-market gains in 2007 helped ease the sting a little, but not much.
While steep losses amidst volatile conditions are never fun, they can be instructive. Stressful market conditions often reveal whether an investor's stock/bond allocation is really in keeping with their true risk tolerance. It's easy to think your risk tolerance is high when the market is going up. But negative volatility tends to clarify the picture quickly.
As the "1st Quarter 2008" line in the full performance table illustrates, throttling down your portfolio allocation by reducing stocks and adding bonds has a powerful stabilizing impact on returns during market downturns. For example, shifting from 100% stocks to an 80%/20% mix would have reduced an Upgrader's losses in the first quarter from -10.4% to -6.5%. Of course, as the next three rows of the table show, that downside cushion comes at a price: lower gains when the market advances. However, the bottom row of the table shows that the reduction in annual rate of return isn't terribly severe when shifting your allocations in 20% intervals. If you found it difficult to stay the course last quarter, it's worth considering whether tweaking your allocations might be helpful.
First quarter reviews are always interesting because they coincide with major turning points in recent market history. Eight years ago, the bull market of the late 1990s reached its peak near the end of the first quarter of 2000. Five years ago, in late March of 2003, the market completed its retest of the final bear market low (the official bear market bottom was in October of 2002, but the March retest brought the market close to that low point). So looking at results for periods ending March 31 shows us roughly how well different strategies have performed since each of the market's last two significant turning points.
Note the two lines in the table that show our portfolios' performance since these two major turning points. Clearly, both Just-the-Basics and Upgrading have done quite well relative to the market over both the past 5- and 8-year periods. Just-the-Basics has benefitted from a higher allocation to small-company stocks than the Wilshire 5000 "U.S. Market" benchmark, as well as from having a foreign component during a stretch when foreign stocks have performed a bit better than domestic stocks.
Upgrading's longer-term performance has benefited from these same small- and foreign-stock trends, though there's clearly more to its performance story than that. Whether looking at the 5-, 8-, or 10-year periods, Upgrading's returns simply dwarf those of the market.
The past five quarters offer some insight into how Upgrading establishes such strong long-term performance. Last year, Upgrading was able to ride various market trends to significantly higher gains than the market achieved (14.3% vs. 5.7%). Yet in the first quarter of 2008, when the market's direction turned 180 degrees, Upgrading was able to keep losses to within a percentage point of the overall market's level.
As a trend-following system, Upgrading won't typically insulate us from losses when they come up suddenly, as they did last quarter. It takes a sustained change in market trends for Upgrading to respond and shift its holdings. That means that Upgrading does offer some downside protection, but only when downturns are sustained, usually over multiple quarters. We saw that in 2000-2002, when Upgrading outperformed the market by an average of 10 percentage points per year.
So while Upgrading won't necessarily protect us from every squall that blows across the market's surface, it has established a track record of earning considerably higher returns than the market during strong periods, losing less during sustained downturns, and normally holding losses fairly close to market levels during short-lived declines. That's a powerful long-term combination for those with the willpower to hold tight during the occasional market storms. As the "dollar profits" line of the table shows so vividly, developing the confidence to stick with Upgrading through good markets and bad can substantially alter your financial future for the better. As Austin points out in Lost Decade? Not for SMI Investors, that's a long-term perspective worth getting excited about! 
 |
Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds. |
- Lost Decade? Not for SMI Investors
- Overview of SMI's Upgrading Strategy
- Overview of SMI's Just-the-Basics Strategy
- Performance History
- Adjusting Your Allocations For 2008's Market Probabilities
- How to Make Rational Investing Decisions
- Subscription Information
- Got a question or comment about this article? Discuss it on our Message Boards.
