How to Repair Your Damaged Portfolio
In the financial turmoil of the past decade, mutual fund investing became decidedly more complicated. After all, over the course of just 10 years, investors looked on as two bear markets ravaged the economy, as a pair of bull markets jolted stocks back to life, and as the Internet and housing bubbles inflated to their breaking points and then burst. The
Looking back at the rubble strewn across the market, some commentators have labeled this period the "lost decade." But it's what lies ahead that has them even more concerned. In the aftermath of a crushing recession that tested the faith of most long-term investors, Americans are now facing the daunting task of rebuilding their retirement savings.
As they do so, they will have plenty to worry about. With the unemployment rate hovering around 10 percent and a sustained period of slow growth on the horizon, annualized stock returns for the next couple of years will probably be in the single digits, says
Where we are right now. As the market began to rally last year, something curious happened: Investors kept pulling money out of stock mutual funds. And even as these funds exploded in value, many mutual fund investors largely missed out. "Unfortunately, a lot of investors sold in early '09 and missed a tremendous rebound," says
In fact, over the 52-week period immediately after the stock market bottomed out on
Because of these uneven flows, many investors now own portfolios that are far out of synch with their long-term goals. This will obviously have to be a temporary phenomenon if they hope to rebuild their nest eggs. But as long-term investors regain their nerve, many will be faced with the question of how best to re-enter the stock market.
The first step is to come to terms with the fact that the bulk of the rally has passed. Now that stocks are experiencing a bumpy ride, experts say that the most prudent strategy is for investors to ease back into the market. By spreading out their stock-fund buys--perhaps over the course of a full year if they pulled completely out of stocks--investors can avoid the possibility of going all in right before the market peaks and turns. "If you do it all at once and you're right, then you look brilliant. But of course if you're wrong, then you've taken another conk on the head," says Tjornehoj.
Taking the gradual approach, of course, requires a commitment to long-term planning. When the market is healthy, investors can sometimes get away with not differentiating between their short- and long-term goals. But when the economy inevitably takes a turn for the worse, they often find that they don't have enough cash to meet immediate needs. Part of what made the recession so devastating was that in the banner years before the bust, investors were gambling heavily on stocks--as opposed to stashing enough away in bond and money market funds--even when they needed instant liquidity for things like college tuition or mortgage payments.
Meanwhile, investors who develop time horizons and take inventory of their needs well in advance are much better able to weather recessions, says
That often means that they will absorb temporary losses in order to eventually capitalize on a rebound. "[They're] far more likely to stay the course," Finke says.
But even investors who plan ahead can fall victim to traps. And going forward, one such danger is on the minds of many experts. Some call it investing through the rearview mirror. Others refer to it as fighting the last war. Finke prefers a harsher term: "the dumb money effect." Regardless of what it's called, investors' strong urge to chase performance is perhaps the biggest thorn in the side of advocates of long-term approaches. Backward-facing investors "tend to pull money out of funds when valuations are relatively low, and they tend to put money into funds when valuations are relatively high. They tend to focus on recent returns, and that's why they fall into this trap," says Finke.
This is particularly dangerous in the wake of the market's breathtaking rally. "The 2009 returns are not typical. What we've seen in the last year is staggering in terms of total returns," says Tjornehoj. Notably, the funds that saw astronomical gains last year were often the ones that got clobbered the hardest during the downturn. This means that their returns--which often eclipsed 100 percent--aren't a convincing indicator of long-term potential.
Take, for instance, real estate funds, which felt extreme pain from the collapse of the housing market. As the economy recovered, the funds sprinted to the front of the pack, with
In other words, investors who charge into hot performers will often find themselves buying into risky and overpriced sectors at the wrong time.
The alternative, of course, is to pick funds that have the best potential for long-term growth. With that in mind,
The search for the best. So what do the best mutual funds for the long haul look like? Unsurprisingly, they have a lot in common. Actively managed funds have a clear mandate: to beat the market over sustained periods. And in their quest to clobber their benchmarks, top-performing managers have developed some similar repertoires.
One common approach, for example, is to run a concentrated portfolio. Take
FMI Common Stock, a top-performing mid-cap fund. At the end of 2009, the fund owned stocks in fewer than 50 companies. "We're not big believers in sheer numbers of names," says
Broadly speaking, running a very compact portfolio is a risky proposition. More concentrated portfolios, for better or worse, have stronger odds of experiencing large swings. If even one bet goes sour, the fund is certain to feel the blow. At the same time, concentrated portfolios allow managers to invest only in companies they know intimately.
Another potential advantage of a concentrated portfolio is that the more companies a fund owns, the more likely it is to hug rather than significantly outperform its index. "Beyond a certain point," says
A final factor is costs. Kinnel says that particularly for long-term investors, expenses should be a primary consideration. "Costs play a big role in fund returns. You tend not to see it if you look too close up. In other words, if you look at a single year, that advantage of, say, 50 basis points or whatever isn't that big, especially in years like '08 or '09 when you've got huge negative or positive returns," he says. "But over time, it adds up."
Still, costs are a contentious issue in the industry. "There are some things in life that are worth paying more for. There's a reason that a Mercedes-Benz costs more than a Kia," says
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