GuidePost - Vol. 4, Issue 6 2008

The GRABot BAG
by Sherrie E. Grabot, CEO

October 2008
Guest Author: A Higher Authority

In these historic and troubling days, nothing seems to be going according to expectation or precedent. So this edition of GuidePost will break with tradition as well. Instead of offering my own observations and thoughts, I defer to a higher authority: Dr. Harry M. Markowitz, renowned Nobel Laureate in Economics, and co-founder and Chief Architect of GuidedChoice.

What follows is an article written by Dr. Markowitz primarily for GuidedChoice participants, and refers to the seven levels of risk tolerance used by our advice system. However, it applies just as well to any retirement plan investors – or to any investors at all with a long time horizon.

“The Sky is Falling!” What should I do?
As this is written the Dow Jones Industrial Index is down thirty-five percent for the year; the broader S&P 500 Index is down thirty-eight percent year-to-date. Many GuidedChoice participants naturally ask, “What should I do now?” This note presents some background and reviews some options.

How extreme is this market move?
If the year were to end at current levels, the 38% loss in the S&P 500 would be a rare but not an extremely rare event. We think of market returns as being drawn from a probability distribution with an average return and a standard deviation (volatility) of return. Most of any probability distribution is between the average minus two standard deviations, on the low side, and the average plus two standard deviations on the high side. With a normal (bell shaped) distribution there is roughly a 2.5 percent chance that a loss greater than two standard deviations will be experienced in any one year. The 38% loss in the S&P 500 is a two and one-half standard deviation move: as we said, a rare but not extremely rare move.

For a broad view of the ups and downs and long-term growth of the market, Figure 1 shows the level of the S&P 500 since January 1950. At the start of the period the S&P 500 had a value just over 17; at the end (on October 9, 2008, as this is written) it had a value of 909, well under its recent high, or its high at the top of the tech bubble, but well above 17.

Depending on your risk level
The GuidedChoice procedure emphasizes that markets are uncertain, and that you have a choice of risk-level as well as savings rate and retirement age. Your proper action now depends on many factors, such as the risk-level you chose, how close you are to your originally targeted retirement date, your wealth, and so on. We discuss some options under the general headings of your choice of risk level.

If you chose risk level 6 or 7
The highest levels we offer. At level 7 your portfolio is one hundred percent in stocks. This, historically, has had the greatest growth over the long run, but has had greater year-to-year volatility than portfolios with lower risk classes.

Your actual year-to-date performance may differ from the S&P 500’s thirty-eight percent decline, for two reasons: First, the stocks in the risk-level 7 portfolio are not all large cap(italization) stocks. The portfolio typically includes small cap, developed country foreign stocks, and emerging market stocks. Second, GuidedChoice first finds combinations of asset classes (such as large cap, small cap, etc.) that minimize risk for given return on the average. Then we find combinations of securities (usually investment companies) that your company permits in your 401(k) plan and which best mimic the asset class portfolio (taking into account the costs and past performances of these securities as well as the ability of the “real” portfolio to track the asset class portfolio). In other words, you don’t buy asset class portfolio 7, you buy a portfolio of securities permitted in your 401(k) plan. This may not give exactly the same performance as the asset class portfolio.

What to do?
But what to do? (The risk-level 6 portfolio is mostly in stocks; our comments for level 7 also apply, but with a little less force.) If you now move to a less volatile portfolio, perhaps with risk-levels four or five, then you will be selling stocks and buying more stable assets, like bonds and money-market funds. The advisability of this depends on whether you think of this as a temporary or permanent move.

If you plan to move back and forth between higher and lower risk-levels, more than one research report has shown that investors are very poor at market timing; that they tend to buy when the market is high and is assumed to be headed higher, then sell when the market is low and it is feared that it will move lower. In short, they buy high, sell low, and do much worse than buy-and-hold. On the other hand, if the experience of a two and one-half standard deviation move in the market, in real time, makes you decide that you would rather be “permanently” in a lower risk class, then by all means move. The previous discussion implies that there is little or no point in trying to “time” the move to the lower risk level. There is no time like the present.

“Permanently” appears in quotes in the previous paragraph because the right risk class for you may change with your wealth level, time to originally planned retirement, willingness and opportunity to retire later, and perhaps other circumstances. The best way for you to determine the best risk-level for you is to use the GuidedChoice simulator to estimate the probabilities of retiring with different levels of consumption--depending on your choice of savings rate, retirement age and risk level.

If you chose risk levels 4 or 5
Your exposure to the stock market is much less than at level 7. In particular, at risk level 4 your portfolio is only about half in stocks and half in more stable investments. The advisability of moving down maybe one risk level is somewhat like that like that given to the level 6 and 7 participants, but milder.

If you chose risk levels 1 through 3
Try not to gloat in the presence of investors in risk levels 6 and 7.

~~ Sherrie