market correction madness!

With all of the major indices – the Dow, the S&P 500, NASDAQ – off 10 percent from their 2007 highs, we are by definition in the midst of a market correction. Individual companies continue to announce frightening news stories:

  • Countrywide: Tapping their line of credit for more than $11 billion to meet their cash demands rattled the markets badly yesterday, causing another 250 point drop before a late-session rally (probably as investors “bought bargains”).
  • Bear Stearns: Two of their hedge funds filed for bankruptcy and now the almost-inevitable lawsuits are underway. The firm will survive but the damage to their reputation and the market will be fierce.
  • American Home Mortgage: This excellent article highlights the fall of AHM from real-estate boom darling to real-estate bust collapse even as analysts proclaimed it a buy.
  • BNP Paribas: the French bank froze the accounts of investors in three of their funds with exposure to the US subprime market. If there’s one thing that terrifies me on a regular basis about the market, it’s the idea that my brokerage firm could suddenly freeze my account. Your stock market investments are not FDIC insured, after all. They have a lot more latitude to forestall withdrawals than banks do.

There are many more disturbing stories out there, but the overall indication is clear: rational or not, the massive run-up in the market is over at least in the short term. What does this mean for the average investor, which includes most of us? Nothing.

Readers of this blog probably hold a conservative investment portfolio. My own portfolio is based around my key philosophy of being relaxed about my finances: I try not to tinker with my investments, other than rebalancing my overall holdings once or twice a year. I go by a 30/30/30/10 formula not unlike many other personal finance bloggers’ advice. I have two big pools: my IRA and brokerage accounts, and my 401(k). My wife has a similar setup but no 401(k) since she is not employed. Her portfolio is slightly more aggressive but follows the same general pattern. My IRA and brokerage accounts are comprised of 30% each of:

  • US domestic stock index funds (primarily VFINX and VGTSX).
  • Overseas index funds: VPACX, VEURX.
  • Bond funds such as VBLTX and VBMFX.

The remaining 10% is in “other” types of investments, primarily Real Estate Investment Trusts or REITs, a way of investing in real estate without buying it outright yourself. In the future, I would like to expand the “other” portion to include actual physical real estate I buy myself, or even foreign currencies (through Everbank – thanks Digerati Life).

My 401(k) is similarly split between domestic and international stock funds so that my overall portfolio, including my 401(k), IRAs and brokerage accounts are split 30/30/30/10. My 401(k) grows each month as I contribute. These contributions are the major reason for rebalancing, as well as my annual January IRA contributions. I am no longer adding to my brokerage account, since my wife and I made a strategic decision to put our spare cash into an HSBC high-yield savings account rather than investing it. We will not put any money further into the market other than our tax-advantaged retirement savings accounts.

The result of this strategy is that, broadly speaking, only 30% of my investment portfolio is exposed to the current downturn. While the market was flying, my bond holdings were doing poorly. Now that the market is tanking, the bond funds are on the upswing. The international funds are more difficult to predict, since sometimes they are affected by the US market and sometimes they act independently. In general, though, US-specific problems like the subprime meltdown simply will not deeply affect overseas markets, unless worldwide panic takes hold.

The other important thing to do in a downturn, I believe, is to turn your “investing brain” off. If you believe it is a great time to buy, go ahead, but don’t panic and sell. If you are broadly invested in index funds, you should be in it for the long haul and disregard short-term drops (or short-term peaks, for that matter). If you have individual stocks, you should have bought them after long and careful study that brought you to a strong conviction about the company’s future, not after listening to your buddy Al’s stock tips. Either way, if you are properly relaxed about your investments, you should disregard the bears and bulls. Buy at regular intervals – this is what a monthly investment in a 401(k) is great for – and over time dollar cost averaging will work in your favor.

So keep tuned to the latest news, but try not to react in a panic. Trust your allocations and look for opportunities. Understand that irrational exuberance caused most of these problems, just like the dot-com boom. And remember the next time you think about investing in a specific firm that even “smart guys” at places like Bear Stearns are never the smartest guys in the room.