Finance Roll

Periodically, investors are given a sharp reminder that stock prices can go down as well as up-and can do both very quickly and with relatively little warning. These sudden market movements can raise doubts about the wisdom of a long-term commitment to equity investing.

Investors are often tempted to overreact in such situations. Their first instinct may be to sell holdings particularly stocks that are highly susceptible to market moves. Or, they may try to "time" the market-liquidating positions in hopes of buying them back at cheaper prices when the worst is over. This is usually a mistake: Even professional money managers can't often guess the market's next move.

When markets turn volatile, it's more important than ever for investors to keep a clear head and a cool hand. The middle of a sudden correction-or an upswing-isn't the right time for an investor to be making impulsive emotional decisions about their portfolio. As the saying goes: Act in haste, repent at leisure.

RISK AND REWARD

Short-term volatility is a fact of life in the stock market, a risk equity investors have to be prepared to accept. While diversification and prudent portfolio management may reduce this risk, it cannot be eliminated entirely. However, a review of more than eight decades of market history suggests long-term investors in U.S. stocks typically have been well rewarded for the risks they have taken-particularly when compared to supposedly "safe" investments such as government bonds and money market instruments. How well? Consider this:

- A dollar invested in large-cap U.S. stocks at the beginning of 1926 could have grown to almost $3,250 by the end of 2007, according to Ibbotson Associates.

- By comparison, that same dollar invested in long-term Treasury bonds would have grown to only $77, while $1 invested in short-term Treasury bills would have been worth just $20, according to Morningstar, a financial research firm.

- The annualized return on large-cap stocks over the past 82 years has been just under 10.4%-almost twice the average return on long-term U.S. government bonds, according to Ibbotson. T-bills, meanwhile, have barely kept ahead of inflation over that same period.

Equities have not only outperformed over the long run, they've done better over most shorter-run periods as well. Largecap U.S. stocks (as represented by the S&P 500 Index) have delivered higher returns than either T-bills or Treasury bonds in 36 of the past 62 years-or about 58% of the time, according to data from Ibbotson and Smith Barney. The same data shows that since 1945, stocks have outperformed bills and bonds in 43 out of 58 rolling five-year periods (or more than 74% of the time) in 44 out of 53 rolling ten-year periods (more than 83% of the time) and in every 20-year rolling period.

THE ODDS FAVOR THE LONG-TERM INVESTOR

On a monthly or quarterly basis, stocks historically have been more volatile than bonds, T-bills and most other fixed income assets. The market has also experienced deep and prolonged downturns, such as the 49% decline seen during the 2000 - 2002 bear market. However, these events have been less common than many investors might think:

- Returns on the S&P 500 have been positive in 59 of the past 82 years-or almost 72% of the time.

- During that same period, there have been only ten years in which the market lost more than 10%, and only five years in which it lost more than 20%.

- On the other hand, returns have been greater than 10% in 47 of the past 82 years, and greater than 20% in 31 of those years-or almost two years in every five.

Many studies have suggested equity returns are actually higher than what the market's historical volatility otherwise would suggest. In other words, investors are demanding-and, on average, getting- unusually high returns to accept the risks associated with owning stocks. This extra return (sometimes known as the equity risk premium) is one of the reasons the stock market has proven so attractive for long-term capital accumulation.

THE RISKS OF MARKET TIMING

In theory, investors could boost returns even more by avoiding-or successfully timing-market volatility. However, as mentioned earlier, this is extraordinarily difficult. And the costs of being out of the market at the wrong time can be enormous.

From 1980 through December 2007-a period containing more than 7,000 trading days-an investor who missed the 50 biggest up days would also have sacrificed more than 75% of the increase in stock prices during that period-converting a 14.4% annualized rise into a gain of only 3.6%.

Of course, if an investor could figure out how to catch the biggest up days in the market, while missing the biggest down days, he or she could add, not subtract, from long-term performance. The problem is that the biggest up days often come immediately after the big down days. Jump out of the market after a big decline, and there's a good chance the investor will miss at least part of the rebound.

On the other hand, the costs to long-term investors of putting money to work in the market at the wrong time-i.e., right before a market top-have been relatively small, at least over the long run. An investor who put $10,000 in large U.S. stocks at the tops of the last eight major bull markets could have had a portfolio worth more than $2.7 million by the end of 2007. By comparison, the same amounts invested in T-bills at the same times could have grown to roughly $503,000 over that same period.

CONCLUSIONS

Taking a long-term perspective on market volatility isn't always easy. However, overreacting to the latest market events can easily compound the damage, by forcing investors to sell at the bottom or miss all or part of a subsequent recovery. It can also lead them to forget the powerful long-term case for equity investing.

Investors can best protect themselves from short-term volatility by developing prudent, diversified investment strategies- ones that reflect their long-term goals and tolerance for risk. They can and should review these strategies periodically to see if they still match their financial needs. However, changes shouldn't be based on the latest dip or surge in the market-or fear of where the next one might lead. Because the most critical danger most investors face isn't the risk of short-term volatility, it's the risk of making decisions they will regret later.

INDEX DEFINITION: The S&P 500 Index covers 400 industrial, 40 utility, 20 transportation and 40 financial companies of the U.S. markets (mostly NYSE issues). The index represents about 75% of NYSE market cap and 30% of NYSE issues. It is a capitalization-weighted index calculated on a total return basis with dividends reinvested.

There is no guarantee that any strategy will success as past performance is no guarantee of future results and investment results may vary. This information is intended for illustrative purposes only and does not necessarily represent the experience of other clients. The investment strategies presented are not appropriate for every investor. Each investor should review with their Financial Advisor the terms, conditions and risks involved with specific strategies.

Diversification does not guarantee a profit or protect against a loss.

Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer's credit rating, or creditworthiness, causes a bond's price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.