Is the market scaring you? Thoughts on when to bail


Should you bail out of your stocks and mutual funds?

You may be torn, given the spooky market and the indoctrination you've received to be a long-term buy-and-hold investor. The refrain goes something like this: "Don't try to time the market. Invest in a solid, well-diversified portfolio and hold on in good times and bad."

But after taking a beating in the early 2000s, you may be a little suspicious of the buy-and-hold advice, especially when you see small-cap mutual funds and international funds down close to 8 percent since the beginning of May.

During the bear market of 2000-02, investors were stung by the buy-and-hold concept. Many misapplied it: They bought hot technology funds at crazy prices and assumed they were supposed to hold on forever. Then some lost 70 percent or 80 percent before pulling the plug. They naively made the same mistake with popular large-cap funds, such as the Janus Fund, which were overdosing on overpriced tech stocks.

The idea behind buy and hold was never to buy and hold anything. Hot investments, whether technology then or perhaps emerging markets and gold recently, are just that: hot one day and disasters the next because of speculation.

But what about the typical well-diversified stock portfolio, maybe with 60 percent of your stocks in a mutual fund that invests in large-company stocks, 20 percent in small-company stocks, 15 percent in a fund that invests in stocks all over the world and, maybe, 5 percent in a volatile emerging-market fund? Balanced with a sizable portion in bonds, that's the type of broad portfolio you are supposed to assemble in a 401(k) or individual retirement account and hold through thick and thin.

Once bruised, you may wonder if you can trust even a diversified 401(k).

I decided to test the idea.

With the help of T. Rowe Price's database, I looked at what would have happened to investors who tried to flee to safety when investments turned scary. I assumed that investors would notice a mutual fund dropping after it had lost 10 percent in a month and then would get out of that one type of investment.

They would keep other investments intact. And they would park the money from the menacing investment in a money-market fund. In other words, they would keep a well-diversified portfolio, except for the one investment that frightened them.

The money from that investment would be kept in cash as the investor watched for dark clouds to pass. When conditions seemed safer, with the investment up 10 percent in a month or a quarter, the investor would jump back in.

For example, if international markets fell 10 percent in a month, the investor would leave his international funds and put the proceeds in a money-market fund. He would make no other changes. He would continue to keep the same exposure to large-company stock funds or small-company funds unless, of course, those categories also dropped 10 percent.

I assumed the person had been investing from July 1990 through March 2006, using the basic stock portfolio: 60 percent in large caps (the Standard & Poor's 500 index), 20 percent in small caps (the Russell 2000 index), 15 percent in international stocks (the MSCI EAFE index) and 5 percent in emerging markets (the MSCI Emerging Markets index).

The results support the indoctrination investors are given: Investors who made the moves they thought would make them safer after a 10 percent drop in one or more of the pieces of the portfolio ended up with an average annual return of 8.2 percent.

Messages for Gail MarksJarvis also can be left at 312-222-4264.

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