Commentary & Insight

Special Market Update — Strategies for Declining Markets — January 18, 2008

Markets continue to decline as ongoing investor pessimism and dour economic data dominate the landscape. At times like these, a historical perspective and a closer look at some of the truisms to investing can be helpful in setting expectations as we look ahead.

This is not the first or last time that markets will be in decline and this information serves as a reminder of the importance of remaining calm, sticking to a long-term plan and removing emotions from the decision-making process — even in the face of adverse and volatile market conditions.

Market history - corrections and bear markets are a fact of investing life (source: RiverSource Institute)

Markets are not built to go up indefinitely. Long-term investors must remember that market corrections and bear markets are a natural part of the market cycle and will occur from time to time. The following are a few historical facts that shed some light on past corrections and bear markets.

• By definition, a bear market occurs when declines are in excess of 20%, while a correction occurs when declines are in excess of 10%.
• By our analysis, since 1950:
• There have been 10 bear markets, or one every 5.8 years.
• There have been 29 corrections, or one every two years (Note: The current correction makes 30).
• The market has finished higher in 42 of 57 years, or 74% of the time.
• The average annual returns of the major U.S. asset categories from Dec. 31, 1949 through Dec. 31, 2007 is as follows:
• S&P 500 Index (price only) 8.02%
• S&P 500 Index Total Return 11.88
• 30 Day T-Bill Total Return 4.88
• Long-term Corporate Bond 6.26
• Long-term Government Bond 5.99
• The long-term performance of the S&P 500 index also provides some additional historical information of interest including:
• From its peak on March 24, 2000 to its trough on Oct. 9, 2002, the index fell 49%, or 46% with dividends reinvested.
• From the index’s March 2000 peak, it took until May 2007 to get back to even on a price-only basis (or with dividends reinvested, until October 2006), so even with the severity of the index’s drop, it eventually fully recovered.
• An even more important point is that investors not properly diversified (no small cap, value, international, etc.) would have ultimately recovered their gains only to see them given up again two months later in July 2007, when the current correction began.

Recessionary markets (source: Ned Davis, Lehman Bros.)

There has been much conjecture recently that the U.S. economy is headed towards a recession, with some economists suggesting we are already in one. We thought it would make sense to share some data that discusses market behavior as it relates to a recession.

• Since World War II, there have been 10 recessions, with a median duration of 10 months.
• On average, market declines began approximately six months before the start of a recession and continued to decline for another five to six months after the start. They then began to rise in anticipation of the next recovery.
• The average market decline during these recessions was 22.6%, while the median decline was 17.4%. The highest decline was 46.3% in 2001 and the lowest was 6.6% in 1980.
• The current market decline, from its peak of Oct. 9, 2007, is 14.8% through Jan. 17, 2008
• If you look at the subsequent gains from the market lows following a recession, they have been impressive:
• After 3 months, they gained 16%.
• After 6 months, they gained 24%.
• After 12 months, they gained 32%.

Futility of market timing (source: Ned Davis, Lehman Bros.)

To correctly time the markets is nearly impossible and has been the undoing of many investors, inexperienced and experienced alike. Investing for the long-term requires discipline and an acceptance that markets will go both up and down. Here are some important things to consider when discussing the concept of market timing:

• Market timing requires an investor to make two correct decisions that are very difficult to make: exactly when to sell and when to buy back in.
• You must be invested in order to participate in the gains when markets recover; missing out for even a short period of time can have a dramatic effect.
• Between 1982 and 2001, there were 5,050 trading days. Over that time, an investor who remained fully invested would have realized an average annual return of 15.10%, while:
• Missing just the 10 best trading days would reduce the average annual return to 12.20%.
• Missing just the 20 best trading days would reduce the average annual return to 10.20%.
• Missing just the 30 best trading days would reduce the average annual return to 8.40%.
• Missing just the 40 best trading days would reduce the average annual return to 6.90%.
• Missing just the 50 best trading days would reduce the average annual return to 5.40%.

• According to Dalbar, market timing and performance chasing caused individual investor mutual fund returns to badly lag behind their mutual fund benchmarks. For equity funds, individual investors earned only 3.7% versus the benchmark of 13.2%, while fixed-income individual investors earned only 2.0% versus the benchmark of 5.7%. For asset allocation funds, individual investors earned 3.6% compared to the benchmark of 13.2%.

How investors should respond

There are steps every investor can take to deal with market declines and the volatility associated with the turbulent markets of late. Here are some tips for protecting your portfolio during times of market uncertainty and decline:

• A well structured, properly diversified portfolio is always the best defense against market volatility.
• Resist the urge to respond emotionally to market declines, instead remaining focused on your long-term investment objectives.
• The core of any investment portfolio should be a long-term, strategic construction, while a smaller portion can be dedicated to making tactical adjustments that may help you take advantage of opportunities and/or avoid risks.
• Create a portfolio with the highest likelihood of achieving your desired investment objective with the least amount of risk. The focus should not be on achieving the highest return, with the attendant risks and increased likelihood of failure.
• Embrace dollar-cost averaging as a method to take advantage of the opportunity to buy at lower prices during market declines.

Potential defensive maneuvers

For investors who feel they must take some defensive action in response to the current market unrest, here are some ideas to consider:

• Focus on high-quality assets, represented by companies or debt issuers, who are better able to withstand a recession because of their operating strength.
• In equity markets this generally means larger companies versus small because:
• They are generally more mature businesses, with long operating histories.
• Their earnings stream is generally more stable and predictable.
• They are more likely to pay dividends, which can lend some stability to returns.
• In the current market, they represent the best value.

• Equity sectors like consumer staples and utilities tend to be more defensive than economically influenced sectors like technology, energy, industrials and materials.
• In bond markets high-quality generally means higher-rated issuers whose operations will not be strained as business conditions deteriorate
• Cash and short duration debt instruments have very low historic volatility.
• Non-correlated assets can be particularly effective in diversifying a portfolio

The role of financial planning

• Ameriprise Financial believes that a client-centric financial planning model, designed to promote focus on the successful achievement of an investor’s long-term objectives, is the best protection against volatility and market declines.
• A comprehensive financial plan employs many of the recommended tactics already noted including diversification, asset allocation, dollar cost averaging and more. This helps investors remain calm during turbulent and volatile times in the markets and helps ensure rational vs. emotional decision making.
• Investors with a long-term plan will resist the urge to attempt to time the markets and will understand the buying opportunities that a declining market may provide.
• For investors with a plan, this is a great time to visit with their financial advisor to discuss their investment portfolio in relation to their long-term objectives, and whether adjustments to their allocations or other parts of their plan are needed.
• For investors who do not have a long-term financial plan, this is the perfect time to meet with their financial advisor to discuss their goals and dreams and the role a financial plan may have in helping make them happen.