SMU experts answered questions and gave their views on investing and saving for retirement during difficult times in “Market Volatility and Its Impact on You: Reassessing vs. Reacting in Response to Your Finances.” The Department of Human Resources presented the discussion Nov. 11, 2008 in the Collins Executive Education Center.

“Given the nature of market volatility, we thought it would be a marvelous idea to have this forum for our faculty, staff, retirees, and everyone else who has given their hearts, their souls, and their lives in dedication to this great university,” said moderator David Lei, associate professor of strategy and entrepreneurship in SMU’s Cox School of Business. “This is an opportunity to get to know the current market environment and to bounce around a few ideas.”

The panel stressed the importance of individuals knowing their own risk tolerance and managing their investments accordingly. Participants included Distinguished Professor of Finance Andrew Chen and Caruth Chair in Finance Darius Miller of the Cox School, as well as Director of Total Compensation Sheri Starkey of Human Resources.

Lei left attendees with 5 financial questions to consider:

  • If you hold stocks, what will you do if the market takes another 30 percent dive?
  • What will you do if your bank or credit card company declares your existing credit balance as your limit?
  • If you hold a large amount of cash, what will you do if inflation rapidly escalates?
  • In a depressed real estate market, what will you do in the wake of a home insurance disaster in which you can recoup only replacement costs, rather than what you paid?
  • In terms of your savings, are you looking to grow rich or to avoid being poor?

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As empirical researchers, what do you think is the source of today’s market volatility, and what do you think is the appropriate way to look at it?

Darius Miller: I always come back to what we teach our students – over the past 80 to 100 years, if you look at the returns on equities, they are indeed higher than the returns on bonds. But there has also been a lot more volatility in those investments, and that’s typically one of the risks of investing in stocks. This is one of those periods in which you’re bearing more risk by investing in equities to get that long-run return. So it’s important that when you think about your investments, now and going forward, you think about having a good mix in stocks versus bonds. If you have a much longer-term perspective and you can weather some ups and downs, the historical average does seem to play out that stocks are a better long-term investment than bonds.

If you’re getting to a point in your retirement cycle that you can’t stand as much volatility – say, there’s a two-year period in which stocks go down and you really need the money – then perhaps you need to adjust what we call your asset allocation mix. That’s basically how much of the pie you have in stocks versus bonds. Markets go up and down; that’s kind of what they do. But at the same time it’s very important to reassure yourself that you’ve put your eggs in the right baskets for the time when you think you will retire.

Andrew Chen: There’s a simple rule for asset allocation, which is that 100 minus your age should be in stock, and the remainder should be in bonds. In early 2000, I put about 90 percent in stock and 10 percent in bonds because I felt young at heart. So when the market dropped, it took me about five years to recover. But this time, early this year, I saw the signs of the markets going bad and I quickly changed to about 15 percent and 85 percent bonds, and I slipped through rather nicely.

A life-cycle mutual fund, also called a Freedom Fund, will let you set a retirement target. If you want to retire 30 years from now, 15 years from now, the fund manages your stock and bond mix. As you get closer to your target, it will shift more from stocks to bonds. I strongly encourage you to look into these funds.

Sheri Starkey: My perspective is from plan administration, and what we are finding with all three of our vendors is that people are riding it out. They’re not panicking, which I think is what we feared. I think people are really just waiting to see what happens for now. We are seeing more people enrolling in the life-cycle funds, whether new employees or current employees who are reallocating. The rebalancing is very important, and that’s the value those funds offer.

David Lei: If you look historically at how all asset classes have performed, a couple of things persist regardless of time and location. Number one, all asset classes – stocks, bonds, real estate, commodities – have their own cycles. The long-term health of any type of economy will determine the long-term returns of any asset class.

For example, when corporate profits are growing on a year-to-year basis, that typically augurs very well for a bull market in stocks, where stock prices continue to rise. For bonds, it’s the same way when you’re looking at interest rates. Typically speaking, when interest rates decline, prices of bonds go up. Cycles are inevitable with any of these asset classes. The question is, to what extent should you feel comfortable in your own mind with that? Each person’s tolerance for risk is really a function not only of your age and your comfort level with different types of investements, but more importantly with what you want to do with the money you’ve built up within your retirement timeframe. Even if you’re relatively young, if you move through many different careers and jobs, it may be that you have a preference for bonds just because you may need ready access to that cash and a little more stability.

If you look at the Dallas economy itself, you’ll see cycles that are almost rhythmic in the way they flow. Housing markets, stock markets typically have a 5-year bull/bear scenario. Bond markets also do with interest rates. So these are not unusual in terms of having the kind of downturns we do over the long haul. What magnifies the message we’re seeing is the degree to which the global markets have connected among themselves, and how quickly contagion can spread. This is one of the rare instances in which the source of the contagion is actually U.S.-based. Subprime mortgages have spread elsewhere. It shows you the degree to which these markets are interconnected.

What do you see over the long term as areas in the U.S. market where we can look for future growth?

DM: I have an almost simplistic view of the future of long-term growth. Most of the information we have to quote-unquote “predict” the stock market is based on historical information. If you want to know how well we’ll do in the future, typically you look to see how well we’ve done in the past. And history has shown us that the United States, over the past 100 years, has about a 10-12 percent rate of return on average for stocks, and about 4-5 percent rate of return on bonds. You may want to get to a mix of investments such that you don’t feel you have to check them every single day, to pull things out of one asset class and put them into something else. All the research has shown that that’s where people make mistakes. If you look at the day traders who came up during the Internet bubble, nine times out of 10 they lost money by thinking they could beat the market. Trading like that is generally not going to behoove you in the long run, so I would suggest you figure out your strategy in terms of how long an investment horizon you have and what your tolerance is for market volatility, and stick with that.

Another question that may come up is if you’ve seen a dramatic decrease in your portfolio. Stocks are killing you, so should you sell and go back into cash? The first rule of finance is to buy low and sell high. The one thing you will do if you sell now is lock in your losses. So I would think about that very carefully before you do any drastic selling of your equities just because they’re low now. Markets do tend to go up on average. Small-cap stocks between 1925 and 2001 averaged about 12-1/2 percent per year, large-cap stocks in the U.S. during the same period averaged about 10.7 percent, government bonds about 5.3 percent, T-bills 3.8 percent, and inflation averaged about 3 percent.

DL: Sometimes, to use a line from Warren Buffett, you’ll do better sleeping than you’ll do acting. In other words, once you settle on a mix of assets, you’re far better off leaving it alone rather than following the market and searching for the next hot tip. It is very easy to get caught up in momentums. Markets do have a way of moving from panic-to-buy to panic-to-sell. A good rule of thumb is to invest only as much as you feel comfortable so that you don’t have feel like you have to take Prozac to look at The Wall Street Journal.

Every stock in your portfolio can potentially become a torpedo. Who would have thought in January 2008 that Bear Stearns would go from 98 to 2? Investing over the long haul is more a game of persistence and discipline that’s consistent with your own risk tolerance, rather than trying to outsmart anybody.

Can you comment on rebalancing – when to do it and how to do it?

SS: This is one of the reasons I like life-cycle funds. SMU has those types of funds available from Fidelity, Vanguard and TIAA-CREF, and they are targeted toward the year you will retire. It sets up your allocation based on risk tolerance as appropriate to your age, and as you age it rebalances. Your stocks go down, your bonds go up, and your assets reallocate. All three of our vendors have investment counselors that will talk with you one on one about rebalancing and when it’s appropriate, as well as about your personal risk tolerance. All three of our vendors have done a really good job of responding to inquiries.

DL: The beauty of rebalancing is that by definition it compels you, essentially, to sell high and buy low. We may have the inverse situation now – many people who were heavy on stocks earlier in the summer are probably light on stocks according to where they need to be by their own benchmarks. This is why the fear factor often trumps effective investing. Short-term fear can trump long-term discipline and persistence.

This assumes that you’re rebalancing funds in retirement accounts. If you’re rebalancing in regular brokerage accounts or after-tax accounts, you also want to factor in the capital gains taxes that are likely to be assessed at that point. You want to take a look at the total portfolio, not only of what you have in your accounts, but of what the tax implications may be.

DM: You also want to check the transaction fees to perform the rebalancing. Make sure they are not excessive. If you belong to a particular type of fund that charges you to get in or get out, take that into account.

What about money markets? Are they the safest investments?

DL: They clearly have the least volatility, because they essentially don’t move. At the same time, there are different kinds of risks you can control and feel comfortable with. The rate of return on cash is probably close to .5 percent right now and trails inflation by 2 or 3 percent. Will you be able to buy as much with it at the end of the year as you could at the beginning?

No one has ever been in a position to comfortably say that any one asset class is uniformly the safest or the most versatile. That’s why the idea of asset allocation is so critical. You can’t control return, but you can control risk.