Turn losses into a valuable lesson

Did you lose money in stocks over the last 28 months? Don’t just fret over what’s happened; instead, learn some valuable lessons that will improve your future investment experience and returns. Bear markets like the one we’ve experienced are great teachers of basic investment lessons. Among them are:

  • Diversification works.
  • Investments return to the mean.
  • You cannot outsmart the market.

Safety in diversification

Owning one stock exposes you to tremendous risk specific to the company that issues it. Think Enron, Lucent, Cisco Systems, and AT&T. Each has experienced tremendous declines in value over the last two years and all have dropped far more than the U.S. stock market.

Owning one group of assets also exposes you to major risk relative to that category of investments. Big growth stocks, which soared in the latter half of the 1990s, lost 40% of their value from January 2000 through March of this year, as measured by the Russell 1000 Growth Index.

Throwing in your lot with one mutual fund manager also exposes you to extreme risk. Many large and well-known growth stock funds suffered severe losses in the bear market when managers made bad bets on individual stocks.

John Bogle, the former chairman of the Vanguard Group and a long-time advocate of indexed investing, notes that by owning a diversified portfolio of index funds, “there is neither individual stock risk, nor style risk, nor manager risk. Only market risk remains.”

That magnetic mean

The mean is the middle—that point on the spectrum where half of all data points are above it and half below it. If you want a good estimate of your future long-term investment returns, start with the mean. Investors weren’t thinking like that in the late 1990s—they were betting that big American stocks would continue to grow at a 20%-plus rate far into the future. Yet the market’s mean over the longer term is much lower.

The market’s results of the last two years are a case of returns going back to the mean. The Standard & Poor’s 500 Index has returned 10% per year during the five years through March. That is a combination of returns as high as 33% in 1997 and a loss of 12% last year. “Reversion to the mean is a manifestation of the immutable law of averages that prevails, sooner or later, in the financial jungle,” Bogle says.

The market is smarter than you are

At any time you may be worried about the bear continuing or excited about a potential upturn. These are tempting times to act and make a change in your investment strategy. Don’t do it! The investment market already reflects the forecasts, fears, and hopes of millions of investors like you. “Times of market duress are almost always terrible times to change investment strategies,” Bogle says. “The market, however fickle, has usually taken into account almost every eventuality.”

Rather than trying to make a forecast and trying to outsmart everyone else, you should set a portfolio allocation that takes into account your investment time frame, ability to take risk, and needs for income. That allocation should be your guide for a long time to come. Don’t change it simply because conditions have changed and you want to adjust to a market forecast.