Tired of worrying helplessly about what might happen to your mutual-fund investments if a bear market hits Wall Street? Here's something you can do right now about the problem.
Suspend immediately all efforts to guess when stock or bond prices might top out. You can't predict market declines, and once they have started you have no better shot at figuring out how long they will last or how far down they will go.Instead, subject your fund holdings now to a simple shock test, which can be conducted with nothing more elaborate than an electronic calculator.
Use the percent key to reduce the present value of your stock-fund investments by 20 percent, then 30, 40, maybe even 50 percent. Pay particular attention to the bottom-line number for the total value of your portfolio after you have deflated your stock funds by each amount.
Ask yourself how well you could stand this sort of jolt - not only financially, but also emotionally and psychologically.
Then project the reduced value of your nest egg one year, two years, even three or four years into the future. Does this ruin your plans to educate your children, to retire from your job or to reach other primary goals in your life?
If so, give serious thought to rearranging your portfolio now so that a turn for the worse in the markets wouldn't hurt you so badly.
The realignment might not require wholesale shifts of money out of stocks. Moving a relatively modest sum into a flexible bond fund, money-market fund or other means of diversifying your holdings may be all that is required.
Chances are you don't want to stop riding the bull altogether. Rather, your purpose might be to assure yourself of a softer landing should you get thrown off its back.
Robert Sanborn, portfolio manager of the $8.9 billion Oakmark Fund and an investor widely respected for his patient philosophy, puts it this way: "As value investors, we always focus on the downside.
"Your task is to review your entire portfolio and to assess whether it meets your risk-return parameters," Sanborn writes in the Oakmark fund family's just-published semiannual report.
"Also, remind yourself that the money you have invested in equity investments should not be needed for at least five years, and can decline by, say, 30 percent at any given time without its affecting your lifestyle. It is far better to do this now than to do it when a decline does occur."
Lab-testing your portfolio this way also can answer the question of how to keep your expectations from getting out of hand. When someone asks what you expect to earn from your stock funds, you will be able to respond with the truth: You don't know.
After all, the only numerical guideline you have to what any market investment might earn in the future is its past performance. And history can never be counted on to repeat itself exactly.
Says Jeremy Siegel, finance professor at the Wharton School, in the second edition of his book "Stocks For The Long Run": "The returns derived from the past are not hard constants, like the speed of light or gravitation force, waiting to be discovered in the natural world.
"Historical values must be tempered with an appreciation of how investors, attempting to take advantage of the returns from the past, may alter those very returns in the future."
The past does provide evidence - compelling evidence, many people feel - that stocks stand a good chance to earn a better return over time than something "safer," such as Treasury bills.
How sure is this pattern to hold in the future? How much more might stocks earn? Over what period of time? Investors in stocks and stock funds must operate without knowing the answers to these questions.
In fact, that element of uncertainty is what makes higher returns from stocks possible in the first place. If stocks could be bought with the same kind of certainty as Treasury bills, the market would price them to pay the same kind of return as Treasury bills.