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Stay the course?

Chris Farrell Nov 21, 2008

Question: Hi, Chris. Like everyone else, my company retirement savings plan is way way down–56% off, to be exact. I’m 38 so I don’t need the money right now, but it is incredibly painful to keep shoveling money into this hole. Through a generous company match, I’m investing almost 30% of my income into an target date (and therefore aggressive) mutual fund. I’ve heard you say that we should all just keep investing through the ups and downs but is that still true in this prolonged crisis? Won’t it take these funds years and years to recover from losing half of their value? I’m not going to sell anything–that would be locking in the losses–but I’d sleep a lot better at night if a much bigger chunk of my future retirement savings was going into bonds or a money-market. What do you say? Thanks for all your help in this crisis. Erin New York, NY

Answer: Uncertainty is the overarching concept that rules our lives. We may have hunches and even mathematical probabilities, but we never know for sure what the future holds. Peter Bernstein.

Your portfolio is down even more after today’s carnage, with the Dow Jones Industrial average plummeting by 445 points, or 5.6%. Citigroup shares lost 26% and J.P. Morgan Chase fell by 19%. Month after month, week after week, day after day it seems that the stock market falls ever lower. We keep hearing that this is the worst financial crisis since the Great Depression. Does that mean an 89% decline is in our future, which is what happened to the blue chip index in the early 1930s? Or, even though the timing is uncertain, is this a once-in-a-lifetime buying opportunity?

Like soothsayers of old, working people of all ages are struggling to peer into the future. That’s because, over the past three decades, the 401(k) has become the mainstay retirement savings plan for private sector workers. Their nonprofit peers save in 403(b)s and government workers in 457 plans. Whatever the label, workers throughout the economy are confronting difficult investment choices. And the answers matter since investment decisions made today will influence whether a worker enjoys caviar or roe two-to-three decades from now.

This is no way to run a retirement system. But it’s the one we got and it’s the one you’re invested in. My judgment is that you have time on your side so I would stay the course. I essentially agree with what Zvi Bodie, finance professor at Boston University, recently told me: “I would characterize my approach to investing as cautious optimism with the emphasis on cautious and the optimism faith in the progress of the U.S. economy,” he said. “Another way of saying this, we have to be careful of wishful thinking, the belief that we can get high returns without higher risks, and on the other hand catastrophyzing, if that’s a word.”

In a recent article for the Wall Street Journal, University of Chicago finance professor John Cochrane made a compelling case for taking a more positive slant on the stock market’s future, without going overboard. It’s a cautious, well-grounded argument. (You can read it at his website. It’s a good website for learning and researching finance, too.) Here’s the kernel of Cochrane’s position:

In a recession, or following losses, many investors become more averse to holding risks. They want to sell. But we can’t all sell — a fact routinely ignored in much financial advice and commentary. Instead, prices must fall and prospective returns rise until some investors are willing to buy. Unsurprisingly, upward spikes in the dividend yield came in bad economic times.

History is not a guarantee — this time could be different. Rather than a higher return going forward, this price decline could reflect a consensus opinion that a massive depression is coming — a 34% permanent decline in earnings and dividends and a massive wave of bankruptcies.

But as I read the news, the “risk aversion” story seems more plausible. We are in, or headed for, a recession. Anyone whose job or business will be impacted can’t take stock-market risks, and should be selling despite low prices. We are seeing lots of “deleveraging,” “disintermediation” and “forced selling.” As losses mount, investors or institutions that have borrowed money must sell to avoid bankruptcy. Others, such as some university endowments or defined-benefit pension funds, have backstop commitments that must be honored, and they too must “capitulate” at some point. Still others may just be less willing to take risks after suffering a huge loss, a sensible “once burned, twice shy” mentality.

All of these actors become more averse to holding risks as the market declines, so they sell. This increasing risk aversion amplifies an initial price decline — coming from bad earnings news or the huge rise in credit spreads — into a rout.

If this is indeed what’s going on, it also means that unleveraged, long-term investors should be buying, since prospective returns are better. They must be able to suffer through further mark-to-market losses, and not have recession-sensitive jobs or businesses. They must still have some money left to invest, so they can exchange some of their valuable Treasurys for assets that the suddenly risk-averse are trying to unload. The more these investors can understand and digest slightly exotic securities being dumped by leveraged intermediaries, the better. Warren Buffett is in the news, and he should be.

That said, you are putting a lot of money into the fund. If it were me, I’d be okay with it. (But I haven’t changed my retirement asset allocation at all during this time; all the shifts have come outside the tax-sheltered retirement accounts.) You clearly want to take full advantage of your company’s match. But you also said you aren’t at the sleeping point. Why not direct future contributions into the high quality bonds and money market fund? This way you don’t lock in any losses in the Target fund, but you build up a more conservative overall portfolio. Rather than selling down to the sleeping point, its more like redirecting your savings to the sleeping point.

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