The S&P is Hitting Some New Highs. Now What?

U.S.News & World Report

As I write this, the S&P 500 index stands near its four-year high. For those with short memories, four years ago was just days before the start of the 2008-09 market crash, which "officially" began on September 15 of that year with a 500 point drop in the Dow Jones average. I remember this day well as I was attending a financial conference with a number of fellow advisors.

A little history and perspective:

--The S&P 500 index peaked at 1,569 on October 9, 2007.

--The index bottomed out at 677 on March 9, 2009.

--The index closed at 1,410 on August 29, 2012.

What does this mean to me as an investor? Unless you are a professional trader, probably not too much. The long-term S&P 500 chart looks like a series of hills with peaks and valleys going back to the late 90s. As most investors remember all too well, the index peaked at 1,527 in March of 2000 before dropping to a low of 777 in October of 2002. This was followed by the run up through October of 2007 described above, and so forth.

The press refers to the decade of 2000-2009 as the "Lost Decade." If your portfolio consisted totally of an investment in an S&P 500 fund this is pretty accurate. However investors with a properly diversified portfolio still did reasonably well.

Lessons learned and relearned. Nothing here should be a surprise, but here are some timely (and, I think, timeless) rules for investors to consider:

--Controlling downside risk is at least as, if not more, important than squeezing out every bit of possible upside. Investors should look at their returns over five and 10-year periods or longer. Being a winner over these longer time periods means that you will need to limit downside risk during periods of extreme market upheaval like 2008-09 and 2000-2002.

--Discipline is critical in an up market. Invariably many investors feel overly confident that their investments will continue to rise. As we have seen twice in the past 12 years the market has a way of punishing those investors severely. If your desired equity allocation is 60 percent and a market rally pushes that up to 75 percent, you should bring the allocation back in line as a way of keeping risk in line with your original strategy. Investors who lost staggering amounts of money during 2008-09 were in many cases over-allocated to stocks.

--True diversification is vital. Owning several different types of stock funds or ETFs did little for investors during the worst months of the market decline. Unlike in 2000-2002 when value-oriented funds held up fairly well, the 2008-09 market downturn took its toll uniformly on all equity categories as well as real estate and natural resources. Correlations tended toward 100 percent across many asset classes previously thought to be somewhat uncorrelated.

--If you want diversification, you will need to own investments that are not highly correlated to one another. This means in addition to equities, you should consider asset classes such as bonds and alternative investments. For example, let's look at three index mutual funds.

--The Vanguard Total Stock Market Index tracks the broad US stock market. Vanguard Total International Stock Index tracks the broad non-US market. The Vanguard Total Bond Index tracks the broad domestic bond market.

--The Vanguard Total Stock and Total International Stock funds show a 91 percent correlation to each other over the past ten years. The Vanguard Total Bond Index, however, shows a correlation of 0.05 percent to the Vanguard Total International Stock and a negative 0.05% correlation to Vanguard Total Stock. A correlation of 1 signifies a perfect correlation in the movement of two securities. A correlation of 0 signifies no relationship in their price movement, a correlation of -1 means that their prices move in harmony, but in opposite directions.

--Applying this to the "Lost Decade" the value of $10,000 invested on January 1, 2000 and held for the next ten years for each of these funds was:

------Vanguard Total Bond Index, $17,997

------Vanguard Total International Stock, $12,532

------Vanguard Total Stock Market, $9,735.

While this is admittedly a rather simplistic analysis, it does show the potential value of diversifying your portfolio. You might consider broadening the asset classes and types of investment vehicles that you utilize in your portfolio. You should also take into account that the next bear market will likely look a bit different than the last two. As always, you need to look at your own unique situation and should consider consulting with a professional financial advisor before undertaking any adjustments to your portfolio.

Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. Read more about Roger here.

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