Other Views: The lessons of market volatility

What a difference a year makes. Last February, the economy was strong. The market was riding high – on its way toward a sixth consecutive year of record advances. Technology was the place to be. Clicks would conquer bricks.

Speculation was rampant and appeared to be highly profitable. Individual stock picking was in; professional money management was out.

Things were going so well that Federal Reserve Board Chairman Alan Greenspan told Congress that rising prosperity, increased productivity and higher stock prices were creating a “wealth effect” that was a potential source of inflation. And, he indicated, the Fed would raise interest rates to slow the economy and stop the double-digit annual gains in stock prices.

The Fed increased rates by three-quarters of a percentage point within the three months following Mr. Greenspan’s comments. Growth in the monetary base, the part of the money supply that the Fed controls, was frozen.

The Dow Jones Industrial Average plunged below 10,000 shortly after his testimony last February and remained stuck in a trading range thereafter. In 2000, the Standard & Poor’s 500 stock index posted its first negative total return since 1990, and the Nasdaq Composite Index would have its worst year ever, falling 39% from yearend 1999 levels.

Seen through the rearview mirror, that experience served as a powerful reminder of fundamental investment truths. Record volatility and rapid rotation among market sectors amply demonstrated the importance of diversification.

The value of professional management was again confirmed as actively managed funds outperformed passive index funds. And the thousands of investors who had jettisoned caution and prudence – only to see the value of their investments melt away – now understand the importance of working with a professional financial adviser to develop a sound investment strategy and plan.

When such investors show up in your office, there are two fundamental questions that must be asked and answered before a specific financial plan is designed.

Is the prosperity over? That question is the most important because it is strategic. If current conditions are just a pause in a long-term prosperity, then both equities and fixed-income investments remain as investment cornerstones. If, on the other hand, the current economic slowdown is the beginning of a prolonged period of below-average economic performance and below-average equity market returns, then we would have to design a strategy very different from what has been appropriate for the last 20 years.

Based on our research at J. & W. Seligman & Co., I am confident that the current slowdown is temporary. The reason is that corrective actions are on the way.

The Fed’s decision to reduce the federal funds rate by a full percentage point in January was a tacit admission that rates were too tight, too long. With the yield on five-year government bonds at around 4.8%, there is no reason the overnight fed funds’ target rate should not be at 4.75% or even lower by midyear. In addition, the decline in long-term interest rates and the stability of commodity prices in general, and the decline in the price of gold in particular, indicate that consumer price inflation is headed back below a 2% annual rate. Yearly changes in the CPI within a band of plus or minus 2% are associated with well-above-average growth and above-average equity market returns.

Reductions in income tax rates will reduce the tax barriers to domestic economic activity. As those barriers come down, employment, retail sales, investment and output will increase. Periods of falling tax rates, too, are associated with above-average growth and above-average equity market returns.

What are the strategies that make sense under such a scenario for the future? The following guidelines can aid the design of specific strategies.

For “harvesters” – individuals who are close to or in retirement, or anyone who is looking to a pool of assets to generate income over time – the past year underlined the danger of an over-reliance on equities. During down markets, forced sales in order to meet spending requirements deplete capital and reduce returns. Even if the broad equity market reaches new highs, those who sold during last year’s correction will not benefit by having all of their capital invested.

Income from dividends and interest is important because it reduces harvesters’ reliance on forced sales. Reliable current income also may contribute to a degree of investment comfort enabling the individual investor to avoid panic selling. However, an over-reliance on fixed income can increase the risk of not keeping up with inflation. For harvesters, we believe that an allocation of 60% to equities, 30% to bonds and 10% to cash generally is a prudent balance among current income, growth of capital and income, and preservation of capital.

diversification not enough

But good asset allocation alone is not sufficient to manage risk. A diversified portfolio with 60% invested in equities will still be subject to the inevitable short-term ups and downs of the market. In managing risk, a withdrawal strategy is as important as asset allocation.

Reliance on fixed-dollar withdrawals should be minimized; use of fixed-percentage withdrawals of the value of the portfolio should be maximized. Fixed-dollar withdrawals accentuate the depletion of capital in down markets. Fixed-percent withdrawals reduce the dollar value of the withdrawal in a down market, thereby conserving capital. Our research shows that such modest adjustments in the short term reduce the risk of really big adjustments in the long term.

For “wealth builders,” the adage that it is time in – not timing – the market that counts remains the foundation of a successful strategy.

In spite of last year’s 9.1% decline in the S&P 500, a hypothetical $10,000 investment in the S&P 500 on Dec. 31, 1981, with the reinvestment of all dividends, would have grown to $193,671 by the end of 2000. But an investor out of the market for only the 30 best days of those 19 years would have given up more than 70% of those gains. That same $10,000 would have grown to only $56,543 – a penalty of $137,128 for missing only 30 out of 4,919 trading days during that time.

But perhaps the greatest lesson is the importance of the professional adviser. Investments must be monitored and changes made.

But without the bearings provided by an overall investment plan, the individual investor inevitably is swept this way and that way by the emotions of the market, which scream “buy high” and “sell low.”

Few if any of us are capable of executing something as complex and emotionally charged as an investment plan without the advice of a professional.

After all, it’s not just the money that’s on the line, but our most important commitments and dreams. That is likely to be as true in the years ahead as it has been in the past year of troubled markets.

Charles Kadlec is a managing director with J. & W. Seligman & Co. Inc., a New York money manager.