Surviving the June Swoon

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Sometimes the direction of the market can change with just a few words.

That was certainly the case on June 19th, when the Federal Reserve Chairman Ben Bernanke mentioned the possible end of QE3 in 2014 and the prospect of reducing the central bank’s monthly bond purchases later this year.

Almost immediately, nearly all global asset classes started to sell off. Including the ones that are supposed to be uncorrelated.

Choosing uncorrelated asset classes is the cornerstone for a well-diversified portfolio. History shows that over the long term, this helps smoothen investment returns, which are usually quite volatile.

But once in a while, everything correlates to the downside.

The week after June 19th was one of those times. Stocks, bonds, commodities – everything got hit pretty hard.

Investors often get caught up in the fluctuations of the market. They panic and sell when prices drop, then fall victim to “irrational exuberance” and buy when prices soar.

This is a sure way to lose money.

And research from Dalbar shows us how much this behavior costs.

During the 20 year period ending in 2012, the S&P 500 index returned an average annual 8.21%. But the average person who invested in stock mutual funds earned only 4.25% – trailing the stock market by almost 4% a year.

While part of this loss can be attributed to high mutual fund fees, most of it is due to investors jumping in out of the market at “bad” times. For investors in bond funds, the returns are even worse.

The best course of action for investors is to accept that markets cannot be timed, and build the expectation of unexpected events (also called black swans) occurring from time to time.

Investors don’t earn returns smoothly over time. Instead, they earn them largely as a result of unpredictably bursts and crashes. Given that much of the action happens on such a small number of days, the odds of successfully predicting the days to be in and out of the markets is close to zero. The real danger is not being there when the big moves occur.

Predicting market tops to sell and bottoms to buy back in is an impossible feat. It’s entertaining, but not a good way to make money.

The only way to “beat the market” is by keeping calm and using these pullbacks as an opportunity to rebalance your portfolio to your predetermined asset allocation.

In theory this can be tough to accomplish.

Especially when so-called “safe” investments like bonds and bond funds declined more than 5% in just a few weeks.

Bonds are one of the beneficiaries of the Fed’s Quantitative Easing or bond buying program. The Fed’s consistent buying keeps the demand strong, the prices high and the yields low. Withdrawal of this support would cause demand to decline and interest rates to spike.

And if interest rates (and yields) go up, bond prices will fall in proportion to the duration.

Duration is the amount a bond (or bond fund) would decline, if interest rates rose 1%. For a bond fund with a duration of 5 years, a 1% increase should correspond to a 5% decline in the price.

Last month, the yield on the 10 year treasury rose about 1%.

However, a lot of bond funds lost more than the anticipated amount you would expect. In the case of certain closed-end funds, the decline was significantly more. In some cases, it was closer to 8 or 9%.

This is like selling a dollar for 92 cents! And it leads me to believe that the selling is probably over-done in the short term.

In the long term, you don’t have much to worry about either. As your interest from bonds gets reinvested, it will buy bonds with a higher interest rate, generating a higher future income.

So, as hard as it sounds, stick to your investment allocation.

Hopefully your bond exposure is limited to funds to short durations, limiting your risk to rising interest-rate.

Otherwise, there’s not too much to be worried about. As I mentioned in May, the summer stock swoon was expected. Just keep calm and carrying investing.

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