MONEY consumer psychology

Probability Trumps Predictions When Making Forecasts

hand throwing dice
Colin McDonald—Getty Images/Flickr Select

Most of us don't think in probabilities -- but we should.

Statistician Nate Silver correctly predicted the outcome of every state in the 2012 presidential election. It instantly shot him to fame in a field most people associate with the most boring class they ever took. He’s been on The Daily Show twice. He has more than a million Twitter followers.

But the most important part of Silver’s analysis is that he’s not really making predictions. Not in the way most people think of predictions, at least.

You will never hear Silver say, “He is going to win the election.” You might hear him say, “He has a 60% chance of winning,” or “The odds are in her favor.” Pundits make predictions. Nate Silver calculates probabilities.

All probabilities of less than 100% admit a chance of more than one outcome. Silver put a 60% chance of Obama winning Florida in the 2012 election, which, of course, implied a 40% chance that he wouldn’t win. Silver’s pre-election probability map gave Obama the edge. But, had Mitt Romney won the state, it wouldn’t necessarily have meant Silver was wrong. In his book The Signal and the Noise, Silver wrote:

Political partisans may misinterpret the role of uncertainty in a forecast; they will think of it as hedging your bets and building in an excuse for yourself in case you get the prediction wrong. That is not really the idea. If you forecast that a particular incumbent congressman will win his race 90 percent of the time, you’re also forecasting that he should lose it 10 percent of the time. The signature of a good forecast is that each of these probabilities turns out to be about right over the long run … We can perhaps never know the truth with 100 percent certainty, but making correct predictions is the way to tell if we’re getting closer.

What set Silver apart is that he thinks of the world in probabilities, while the punditry crowd of coin-flipping charlatans thinks in black-and-white certainties. His mind is open to a range of potential outcomes before, during, and — most important — after he’s made his forecast. Things might go this way, or they might go that way. He adjusts the odds of certain outcomes when new information arrives. It’s the most effective way to think about the future.

Why don’t more people think like Nate Silver?

Twenty years ago, Berkshire Hathaway vice chairman Charlie Munger gave a talk called The Psychology of Human Misjudgment. He listed 25 biases that lead to bad decisions. One is the “Doubt-Avoidance Tendency,” which he described:

The brain of man is programmed with a tendency to quickly remove doubt by reaching some decision.

It is easy to see how evolution would make animals, over the eons, drift toward such quick elimination of doubt. After all, the one thing that is surely counterproductive for a prey animal that is threatened by a predator is to take a long time in deciding what to do.

In other words, most of us don’t think in probabilities. It’s natural to quickly seek one answer and commit to it.

If you watch financial TV, or read investing news, you will almost never hear someone say there’s a 55% chance of a recession this year. They say there is going to be a recession this year. Rarely does an analyst say there’s a 60% chance of a bear market this year. They say there is going to be a bear market this year. There’s no room for error. There are no probabilities. People want exact answers, and pundits are happy to oblige.

Consumers of financial news are part of the problem. Not knowing what the future holds is scary. But you don’t gain much confidence hearing someone say there’s a 60% chance of one outcome and a 40% chance of another. We are more likely to listen to a forecaster who uses unwavering confidence to insist they know the future. It’s like warm milk for our fears.

But thinking in certainties is usually a reflection of how you want the world to work, rather than how it actually works. Silver writes:

Acknowledging the real-world uncertainty in [pundits’] forecasts would require them to acknowledge to the imperfections in their theories about how the world was supposed to behave — the last thing that an ideologue wants to do.

If you have a view of the world that says raising taxes will slow the economy, no amount of information will change your mind. You won’t tolerate a claim of an 80% chance a tax cut could slow the economy, because it leaves open the possibility that your entire world view about tax cuts could be wrong.

One of the top reasons investors make mistakes is that the world works in probabilities, but people want to think in certainties. It’s why bear markets surprise people, banks use too much leverage, budget forecasts are always wrong, and most pundits make themselves look like idiots.

As soon as you start thinking probabilities, all kinds of things change. You’ll prepare for risks you disregarded before. You’ll listen to people you disagreed with before. You won’t be surprised when a recession or a bear market that no one predicted occurs. All of this makes you better at handling and navigating the future — which is the point of forecasting in the first place.

Here’s Silver again:

The more eagerly we commit to scrutinizing and testing our theories, the more readily we accept that our knowledge of the world is uncertain, the more willingly we acknowledge that perfect prediction is impossible, the less we will live in fear of our failures, and the more liberty we will have to let our minds flow freely. By knowing more about what we don’t know, we may get a few more predictions right.

Morgan Housel owns shares of Berkshire Hathaway.

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MONEY stocks

How to Tame the (Inevitable) Bear Market

baby bear in front of scary bear shadow
Claire Benoist

Stocks will eventually suffer a downturn, but don't assume it has to be a grisly one. Here's what you need to do now to get your portfolio ready.

The current bull market is looking almost old enough to qualify for Social Security. Now in its seventh year, this rally is nearly twice the length of the typical bull and is the fourth-oldest since 1900. Meanwhile stocks are getting expensive, profits are slowing, and equities will soon face another headwind in the form of Federal Reserve interest-rate hikes, possibly starting as soon as summer.

Yet this is not a call to hightail it out of the market. Few suggest a bear attack is around the very next corner. And even if a selloff is coming soon, two-thirds of bull markets over the past 60 years have added gains of at least 20% in their final stage, according to InvesTech Research. So there’s a risk to overreacting.


That said, “how you invest in the seventh year of a bull market is not the same as at the start of a bull market,” says InvesTech president James Stack. And the next bear market is probably going to look a lot different from the ones you’ve grown used to.

So here’s a playbook for getting your portfolio ready:

Expect a less grisly bear

The last two downturns you recall happen to be among the worst in history, so it’s understandable if you’re concerned about getting mauled. But this time “we don’t see any bubbles or concerns that would suggest we’re heading for a repeat of 2000 or 2007,” says Doug Ramsey, chief investment officer at the Leuthold Group.

Ramsey expects a “garden variety” downdraft of around 27.5% (see chart). After a six-year rally in which the market has soared more than 200%, that’s not catastrophic. Also, it’s psychologically difficult to buy on the dips in a megabear that might drag on for years. But a run-of-the-mill bear market can be viewed as “an opportunity,” says Kate Warne, investment strategist at Edward Jones.

Warne’s advice: Plan to rebalance your portfolio to your target stock allocation in the next bear. Get ready to do so once your mix changes by around five percentage points. A 70% stock/30% bond portfolio will hit that point as equity losses approach 20%. Selling bonds to replenish your equities will set you up for the next bull.

Stay committed abroad

In the last bear, global economies tumbled in sync. Not so this time. In the U.S., the Fed is on the verge of lifting rates on the strength of our economy. Yet the eurozone and Japan are stuck in neutral, and their central banks are trying to stimulate growth. “Their stocks reflect that weakness, making them more attractive right now compared to the U.S.,” says Warne.

The broad U.S. market trades at a price/earnings ratio of 17.7 based on profit forecasts. Yet stocks held by Fidelity Spartan International IndexFIDELITY SPARTAN INTL INDEX INV FSIIX 0.7% and Dodge & Cox International DODGE & COX INTERNATIONAL STOCK DODFX 0.7% —both in the MONEY 50—trade at about 15 times earnings. Warne suggests keeping up to a third of your stocks in developed foreign markets.

Don’t overlook late-stage bull leaders

While the S&P 500 is trading modestly above its long-term average, the median P/E of all U.S. stocks is at an all-time high. “That tells you that small- and midcap stocks have higher P/Es, and they will be the ones to fall the furthest in a bear market,” says Stack.

That makes blue chips more compelling. InvesTech also studied the final stage of bull markets and found that the energy, technology, health care, and industrial sectors tend to outperform. Energy is obviously a tricky case given the recent volatility in oil prices, but Stack says it should not be shunned. MONEY 50 pick Primecap Odyssey Growth PRIMECAP ODYSSEY GROWTH FUND POGRX 0.25% has nearly 80% of its assets in those sectors.

Dial back on alternatives

If you’ve been using high-yielding utility stocks as bond stand-ins, now is the time to take some profits. Along with financial and consumer discretionary stocks, utilities are late-stage laggards.

And if you’ve reduced your fixed-income allocation in favor of higher-yielding alternatives such as REITs or master limited partnerships, it’s time to shift back to core bonds. Such income alternatives are more highly correlated with stocks than are basic bonds. Fixed-income returns may be muted once rates start rising. But that doesn’t change the role of high-quality bonds: shock absorbers when stocks are falling.

MONEY holiday shopping

13 Halloween Costumes for Finance Geeks

Actress Katie Seeley as a bear (left) and Sacha Baron Cohen as a bull (right)
Paul Archuleta/FilmMagic (left);Fotonoticias/WireImage (right) Combine a bear costume (as worn by actress Katie Seeley, left,) and a bull suit (see Sacha Baron Cohen, right) for a punny stock market couples costume.

Look like a million bucks—literally—with these creative costumes.

Still not sure what you’re dressing as for Halloween? Don’t despair. We’ve got a bunch of costume ideas that are right on the money. These finance-themed getups are accessible for a general audience (so you don’t have to spend your evening explaining, “No, the other kind of black swan…”), cheap, and quick to pull together.

For some tried-and-true ideas, you could go as Zombie Lehman Brothers, the London Whale, or characters from Dave Chappelle’s classic “Wu Tang Financial” sketch. Or you can try one of the more timeless 13 suggestions below. Then again, you could just dress up as prerecession government regulations and stay in for the night.

1. Money. Let’s be honest: Dressing as a giant bill or stack of bills is kind of boring. The concept is improved if your homemade costume is a reference to the “made-of-money man” in those Geico ads—or if you are an adorable baby swaddled in a sack of money. (Mom and Dad, throw on a mask and a badge, and voila! A cop-and-robber duo.)

2. A market crash. If Halloween season sneaked up on you like the October stock swoon did on traders, you can craft a “market crash” costume in five minutes by taping a fever line on a t-shirt with some masking or electrical tape. Use light-up accessories, and you’ve got a flash crash. This costume can be modified for a couple or group—just extend the fever line across your torsos—and it pairs nicely with a “broke broker.”

3. The Federal Reserve Chair. Mimic Janet Yellen’s signature white bob with a wig and her go-to outfit with a black blazer over a black dress or pant suit. Don’t forget a gold necklace. If people ask who you’re dressed as, throw fake money at them and yell, “Loose monetary policy!” To turn this into a group costume, grab yourself a Ben Bernanke and Alan Greenspan. Wear matching “chair” shirts for solidarity.

4. Bull & Bear (couples costume). Like salty-sweet snacks and Brangelina, this costume combination is greater than the sum of its parts. Relatively inexpensive store-bought costumes are easy to find, assuming you don’t want to spend hundreds of dollars, or you can always build a DIY ensemble with homemade horns and ears. Hang little signs with upward and downward trending fever lines around your necks for extra clarity. The only hard part will be deciding who gets to be which animal.

5. “Bond” girl. Personify this pun by dressing as your favorite 007 lady-friend and adding a hat, sign, or other accessory that reads “T-Bill” or features an image of a (now-technically-obsolete paper) Treasury bond. Jill Masterson’s “Goldfinger” look might be most recognizable: You can do it with gold spandex or body paint.

6. Wolf of Wall Street. See bull and bear, above. You just need a suit and tie, a wolf mask, and pockets brimming with fake money. And maybe some fake Quaaludes.

7. Cash cow. Unless your name is actually Cash (like this little guy), channel the Daily Show’s Samantha Bee and decorate a cow suit with dollar symbols.

8. A mortgage-backed security. This one might seem a little 2007, but there’s evidence these investment vehicles are coming back in vogue. Start with a shirt that says “security” in front. If you’re handy, you can then turn a small backpack into a “house” and wear that around. If not, just write “mortgage” on your back, and you’re done.

9. Gross domestic product. Just wear a “Made in America” t-shirt covered in dirt and fake blood.

10. Dogs of the Dow (group costume). Grab up to ten of your friends and dress as dogs. Wear tags with ticker symbols for each of the current Dogs of the Dow.

11. Distressed securities. Similar to #8, start with a shirt that reads “securities,” then layer on some dramatic makeup, to make yourself look, well, distressed.

12. Naked position & hedge (couples costume). This idea is pretty inside-baseball, but will be a fun challenge for your finance-savvy friends to guess at. The person dressed as the “naked position” can wear flesh-toned spandex, while his or her partner dresses like a hedge, as in shrubbery. Here are DIY instructions.

13. Spider / SPDR fund family (group costume). This one is pretty easy, since instructions for homemade spider costumes abound. You could go as a solo arachnid, with “ETF” painted across your chest, but dressing up is always more fun with friends. In a group you can each represent different funds; for example, the gold fund spider can wear a big gold chain and the ticker symbol GLD, and the high-yield bond spider can glue candy wrappers and bits of tinfoil all over himself and wear a sign that says JNK.


What To Expect From This Crazy Market

Sharp one-day drops in the market can be unnerving, but they haven't changed the basic math of investing.

You know the advice: Ignore stock market swings. They don’t mean anything. Just buy and hold.

Of course, that’s easy counsel to live by when the swinging is mostly upwards. It’s even possible to follow such advice after a long market decline, once you’ve gotten used to the bad news. And near the bottom, when even the pessimists start to express some optimism, well, then it’s fairly easy to stay the course.

Times like now, however, are a true test of a long-term investor’s resolve. After a bull-market run so smooth that pundits were complaining about “complacency,” the Dow has delivered a string of triple-digit daily drops, confusingly interrupted by a 274-point rally last Wednesday. At such times, your head is saying no one can reliably predict the market’s next flush of fear or greed. But your gut worries that maybe something’s about to break.

The reality, though, is that if you look at the factors that really drive the long-run returns you care about, the market doesn’t look much different than it did a week ago. Which is to say: It’s priced to deliver kind of meh returns. But those returns still look better than your easiest alternative, bonds.

There’s a very simple Finance 101 way to think about what you’ll make on equities. In essence, a stock is just a claim on the flow of cash from a company. You can think of that as the company’s earnings, or—if you want to keep things tangible—as the dividend checks it pays to investors. (No, not all companies pay dividends, but in theory that’s the eventual purpose of all profits.) Right now, investors who own an S&P 500 index fund get paid a dividend yield of about 2% per year.

The nice thing about a dividend yield is that it’s not just a measure of how much income your investment is delivering to you. It can also tell you whether stocks are generally cheap or expensive. Imagine that a stock paying out $2 in dividends per share is trading at $100—that’s a 2% yield. Now say it falls in price by $35. Terrible news for current holders, but potential buyers can now get the same $2 payout for just $65 a share—a 3% yield. In that light, the stock looks like a better bargain.

So: Low dividend yields suggest pricey stocks, and higher dividend yields cheaper. Right now, even after the recent declines, dividend yields look okay but not fat, just as they have for a while:


Note that the almost 4% dividends came in 2009, when stocks were at the bottom of the post-crisis crash. Around 2000, at the peak of the tech bubble, yields were about 1%.

Wait, does all this mean I’m only getting a 2% return on stocks? No, it doesn’t, because you also buy stocks expecting their earnings or dividends to grow over time. Using a somewhat simplified, classic rule of thumb — I’m relying on Bill Bernstein‘s book The Investor’s Manifesto plus this useful paper (PDF) from the money managers Research Affiliates — the expected return on stocks right now is the 2% dividend yield plus the historic rate of growth in dividends or earnings-per-share of about 1.5%. So think 3.5%, maybe 4%.

That’s a real return above inflation, but still a disappointment compared to the 7% historic rate for equities since 1926. Then again, it’s much better than the fixed-income alternatives: The real yield on inflation-adjusted Treasury bonds, or TIPS, is 0.35%.

A 4% return is just a baseline. If investors collectively decide they want to value stocks higher in the future, and can live with lower yield payouts, you’ll get a bump on your investment today. If they lose their taste for the risk of stocks, you’ll do worse. But that’s driven by whatever goes on deep inside the wet, gray stuff under millions of investors’ skulls, not the profitability of the companies you buy today.

The past six market days have hardly nudged this math, except to move it slightly toward stocks being a better bargain. Before the start of last week, the S&P had a one-year total return of more than 18%. Now it’s one-year return has tumbled to 12%. That’s disappointing and, yes, anxiety provoking. But if you see 4% annual return as your basic expectation, reversals from years of high gains should come as no great surprise.

MONEY stocks

5 Ways To Tell If There’s More Trouble Ahead for Stocks

Is Monday's triple-digit loss the start of something worse — like a bear market? Here are five things to watch for in the coming days and weeks.

On Monday, the Dow Jones industrial average sank more than 223 points, marking the fifth straight day of triple-digit moves in the closely watched benchmark.

Technically, this is just a “pullback,” which is loosely defined as a drop of around 5%.

^SPX Chart

^SPX data by YCharts

The S&P 500 index has yet to reach a correction, or a 10% plunge. And the broad market is nowhere close to bear market territory, which is a sustained 20% decline in stock prices.

Still, as MONEY recently pointed out, this bull market is starting to show its age. So it’s hard not to wonder if a bear is lurking.

If you’re worried there are more troubled days ahead for equities, here are five things to watch for in the coming days and weeks:

1) Are companies reporting disappointing earnings results?

“I’d be listening to and watching third-quarter earnings reports,” says Liz Ann Sonders, chief investment strategist at the brokerage Charles Schwab.

Why? First, some companies face a new headwind in the form of the stronger dollar. While the strengthening U.S. currency is a sign of global confidence in the U.S. economy, it creates problems for American businesses. A mighty dollar makes it harder for U.S. exporters to sell their goods competitively overseas, which could crimp corporate earnings growth.

Robert Landry, a portfolio manager for USAA, put it this way:

We’re paying attention to whether companies beat, meet or fall short of revenue and earnings estimates. According to FactSet, average sales growth for the S&P 500 is expected to be 3.6% year-over-year and profit growth at 4.6%. The latter number is roughly half of where expectations stood back in late June.

What’s more, many investors think the stock market — at least prior to this sell off — was getting ahead of itself this year. Indeed, the price/earnings ratio (a common measure used to gauge market valuations) for the S&P 500 index had shot up higher than 18, based on the past 12 months of profits. That’s compared to an historic average of around 15. To justify those higher-than-average P/E ratios, investors want to see higher-than-expected earnings growth rates. The volatility of recent days suggests a worry that the bar’s been set too high.

2) Are commodity prices sliding?

The selloff in blue chip stocks recently has “coincided with mounting evidence of a global economic slowdown,” says Edward Yardeni, president and chief investment strategist at Yardeni Research.

Indeed, the reason why the dollar has been strengthening in the first place is that while the U.S. economy has been improving, Europe and Japan are both perilously close to slipping back into recession — for the third time since the start of the global financial panic.

Yardeni adds that global slowdown fears have grown in recent days as industrial commodity prices, including crude oil, have dropped sharply. (This isn’t a big surprise: Slower-than-expected growth in Europe, China and Japan has led to weaker demand for things like steel, copper and oil.)

David Kelly, chief global strategist for J.P. Morgan Funds, notes that Europe is set to release industrial production figures for August this week, along with data on inflation trends. If there’s even a whiff of deflation in the Eurozone — led by tumbling commodity prices — expect another bout of handwringing on Wall Street.

3) Are small stocks getting mauled?
While investors typically pay more attention to large blue-chip stocks, shares of smaller companies can be a harbinger of things to come for the broad market. Why? Because of their size, tiny stocks tend to be more volatile in general and the underlying companies are more easily rattled by changes in the economy.

The bad news is, the market’s tiniest publicly traded companies are already in a correction, as measured by the Russell Micro-cap Index. And should they slide into an official bear — which could be just days away — things could get really dicey on Wall Street.

^RTM Chart

^RTM data by Charts

Sam Stovall, U.S. equity strategist for S&P Capital IQ, noted that there have been 10 calendar years that small stocks have declined in price since 1979. “Of those 10 times,” he said, nine of the S&P 500’s 10 annual returns were 3.5% or less, and six of the 10 years were negative.” What’s more, for all 10 observations, “the S&P 500 posted an average annual price decline of 4.6%,” he said.

4) How is the Nasdaq composite index holding up?

Another canary in the coalmine for the broad market, according to market observers, is the Nasdaq composite index. Relative to S&P 500 or the Dow, the Nasdaq tends to be made up of slightly smaller, faster-growing and economically sensitive companies. In fact, technology stocks still make up around 45% of the index.

This is why in years when stocks slip, the Nasdaq tends to skid further. This happened in 1994, 2000, 2001, 2002, and 2008.

So far this year, the Nasdaq is close to entering into a correction. Should the Nasdaq’s 8% loss expand to 10% or more, look for more volatility in the S&P and Dow.

^IXIC Chart

^IXIC data by Charts

5) Is China’s economy growing less than 7%?

Continuing worries about China have contributed to the recent sell off in stocks. China’s economy, which had been growing as fast as 9% in 2012, slowed to 7.5% in the second quarter. That figure is expected to fall even further, to 7.3% in the third quarter. Some economists, in fact, are bracing for 7% growth or below.

Why is this important?

Brian Jackson, China economist for IHS Global Insight, notes that China’s leaders “signaled somewhere between 7% and 7.2% as a ‘bottom line’ for growth to meet job creation needs; IHS estimates that 7.2% is necessary to generate the roughly 13 million jobs annually to satisfy new job market entrants.”

Should GDP growth slip below 7%, policymakers in China may have start thinking outside the box. And Wall Street hates the unexpected — especially when it comes to governments and economic policy.

MONEY stock market

7 Years Later, Is the Bear Stalking Again?

Grizzly Bear
Scott Markewitz—GalleryStock

While the start of the 2007-2009 bear market now seems a lifetime away, there are a number of similarities between this market and that one that makes it hard to forget.

Exactly seven years ago today, the stock market fell into the worst bear market this side of the Great Depression.

The crash, which unfolded from Oct. 9, 2007 to March 9, 2009, obliterated more than half of the total value of the U.S. stock market and threatened the very existence of iconic companies from General Motors to Merrill Lynch.

Of course, all of this seems like ancient history now that the stock market has fully recovered — and then some.

^SPX Chart

^SPX data by YCharts

After the fourth-longest bull market in history, the Dow Jones industrial average and the S&P 500 are both near all-time highs. The housing market is slowly but surely recovering. And the U.S. economy has recently been growing at an annual rate of 4.6%.

Sounds like a totally different scene than seven years ago, when the economy was about to slip into a recession, the housing market was melting down, and the global financial panic was at full tilt.

Yet if you start digging into the details, there are a number of glaring similarities between today’s market and where Wall Street was on this fateful day seven years ago.

The bull market is aging. The stock market rally was an older-than-average five years old on Oct. 9, 2007. On Oct. 9, 2014, the bull is an even-older-than-average five and a half years old.

The market is starting to look its age. One way to tell if a bull is losing steam is to see how many stocks are actually participating in the rally. In 2007, the percent of companies in the S&P 1500 total stock market index that were outperforming the broad market fell to a lower-than-average 35%. Today, it’s even lower at 30%.

The market is pricey. The price/earnings ratio for the S&P 500, based on projected corporate profits, stood at 15.2 on Oct. 9, 2007. Today, that P/E ratio is an even-higher-than-average 16.2.

The market is pricey, part 2. There’s another way to measure the market’s P/E, using 10 years of average profits. In October 2007, the S&P 500’s so-called Shiller P/E stood at 27. That marked one of only four sustained periods in history where this P/E ratio climbed and remained above 25. Today, the market’s Shiller P/E is at 26.

Since 1926, whenever this measure has exceeded 25, the average inflation-adjusted annual return for stocks has been a mere 0.5% over the subsequent decade. By contrast, the historic annual real return for stocks is closer to 7%.

Greed is back. Seven years ago, merger & acquisition activity in the U.S. hit a record high, as risk-taking returned to Wall Street. Today, M&A activity, based on the total number of deals, is on pace to be even higher.

Confidence is back. When company executives are confident that the market isn’t fully appreciating the strength of their business, they initiate stock buybacks of their company’s shares, on the theory that their own stock represents a good value. The Wall Street Journal recently reported that stock buybacks totaled $338 billion in the first half of this year. That marked the highest level of activity in any six-month period since 2007.

Risk-taking is back. You know investors are getting aggressive when they’re willing to use borrowed money to make their bets. The last times margin loan debt as a percentage of GDP exceeded 2.5% were in 2000 and 2007. Well, today, it’s back above this threshold.

Does this mean that the bull market is about to end? Not necessarily. These are signs of an aging bull, not necessarily precise predictors of when the market is about to turn. Still, after growing accustomed to seeing stocks go up and up and up for several years, it’s time to reflect on how scary the market can be when investors grow complacent.

MONEY financial crisis

6 Years Later, 7 Lessons from Lehman’s Collapse

Lehman Brothers world headquarters is shown Monday, Sept. 15, 2008 in New York.
Mark Lennihan—Reuters Lehman Brothers world headquarters is shown Monday, Sept. 15, 2008 in New York. Lehman Brothers, burdened by $60 billion in soured real-estate holdings, filed a Chapter 11 bankruptcy petition in U.S. Bankruptcy Court after attempts to rescue the 158-year-old firm failed.

The venerable investment bank Lehman Brothers went under six years ago today. While Wall Street has recovered from the financial crisis that resulted, lessons endure for Main Street investors.

Exactly six years ago today, Wall Street came closer to imploding than at any other time since the Great Depression.

That was when the venerable investment bank Lehman Brothers filed for bankruptcy on Sept. 15, 2008, amid the global mortgage meltdown, triggering a cascade effect across Wall Street. Within days, the insurer AIG had to be bailed out by the federal government while other investment banks, including Morgan Stanley and Merrill Lynch, were pushed to the brink. Merrill, in fact, was eventually sold amid panic to Bank of America.

Six years later, the nation’s financial system seems to have largely healed. Banks are back to posting record profits. Over the past several years, financial stocks have been among the hottest areas of the market.

^DWCB Chart

^DWCB data by YCharts

And with the housing market recovering, even the dreaded mortgage-backed security — the type of bond that triggered the financial panic in the first place starting in 2007 — are back in fashion.

But even if it seems like it’s business as usual on Wall Street, for Main Street investors key lessons endure. Here are 7 of them.

Lesson #1: The price you pay for stocks matters. Really.

The media’s narrative is that the stock market plummeted into an historic bear market because of the global financial panic. That may be true, but equities may not have fallen that far — and for that long — if the circumstances weren’t ripe for a correction.

Remember that in October 2007, the price/earnings ratio for the stock market — based on 10 years of average profits — rose above 25, marking one of only a handful of times that market valuations rose so high. Not surprisingly, the stock market went on to lose 57% of its value from October 9, 2007, through March 9, 2009. (As an aside, the stock market’s so-called normalized P/E ratio is back above 25 again today.)

By March 2009, the P/E ratio for the S&P 500 had sunk to an historically low 13 (the historic average is closer to 16), which has been a signal of buying opportunities. Had you invested at that moment — listening to the Warren Buffett rule that says “be greedy when others are fearful and fearful when others are greedy” — you would have enjoyed total returns of 230% ever since.

Lesson #2: Don’t bank on any one group of stocks — even financials.

The turmoil after Lehman’s collapse was different and more frightening than the bursting of the Internet bubble in 2000. Why? This time the stocks that took the biggest hits weren’t shares of profitless startups that no one had ever heard of. In this crisis, the biggest losers were financial titans — some more than a century old — that produced a third of the market’s profits and dividends. No wonder these blue chips were fixtures in many retirement portfolios.

The love affair is clearly over … or is it? Financials have been among the market’s best performers since September 2011, having doubled in value in three short years. As a result, bank stocks, which made up less than 9% of the S&P 500 in 2009, based on total stock market value, now represent more than 16% of the broad market. That means they’re probably among the biggest holdings in your stock mutual funds and ETFs.

Lesson #3: Buy and hold works — eventually.

When the Dow fell to 6547 on March 9, 2009, stocks had already lost more than half their value. And equities wouldn’t fully recover until 2013. So it may seem that investors who pulled $25 billion out of stock funds in March and $240 billion over the next three years — plowing that money into bonds — were on the right track.

They weren’t. March 2009 marked the start of a bull market that saw stocks return 230% so far. Had you simply hung on to a basic 70% equity/30% bond strategy from Sept. 1, 2008, when things started to get scary, you’d have earned nearly the 9% historical annual return for this mix over five-year stretches since 1926. Of course, you’d have earned that only by staying the course.

Lesson #4: There is no such thing as a “conservative” or stable stock.

In past crashes, pundits always pointed out that the “safe” place to be is among giant, blue chip stocks that pay dividends and that are industry leaders. Well, Lehman Brothers, Citigroup, Merrill Lynch, and AIG all fell under those descriptions. Yet all of those stocks plunged more than the broad market.

This taught investors a huge lesson: Treat all stocks as the volatile, unpredictable creatures that they are. Even dividends, which are synonymous with financially stable, conservatively run companies, can’t be trusted, because during the crisis, the financial sector began slashing dividend payments to safeguard their finances.

Lesson #5: Reaching for yield can lead to a fall.

When stocks fall, the stability of cash can cushion the blow. Yet things don’t necessarily work out that way.

Just ask shareholders of Schwab YieldPlus. This so-called ultrashort bond fund — which was marketed as a cash alternative, though it really wasn’t one — fell 35% in 2008 when the mortgage securities that provided the “plus” in the fund’s name turned out to be riskier than thought. (In January 2011 Schwab settled the charges that it misled investors but did not admit wrongdoing.)

Before that, there was the Reserve Fund, the first money fund in 14 years to lose value in part because it tried to boost payouts by holding some Lehman debt.

It makes no sense to take risks with your rainy-day savings, a lesson that’s worth remembering today. Since early 2009, investors have poured billions of dollars into floating-rate bond funds, which buy short bank loans that offer higher payouts than basic cash, as well as ultrashort bond funds.

Lesson #6: Diversification works — but in diverse ways.

In 2008, only one type of diversification seemed to pan out: your basic mix of stocks and bonds. Among equities, everything pretty much fell in lockstep.

Fast-forward more than three years, when the financial crisis unfolded in a different guise — this time with the debt crisis in Europe. Fear of government defaults peaked in early 2012, with rates on Greek debt reaching 29%. Diversification worked here, too, but also in a different guise.

While conventional wisdom said investors should flee the continent, European shares wound up beating the world in 2012, returning 20.3%. The year before that, it was U.S. stocks that performed the best (despite Uncle Sam’s fiscal woes). And in 2013, Japan led the way, despite having experienced another recession.

Spreading your bets globally eventually pays off, especially given how mercurial equities can be. For investors who are hearing that the U.S. looks like the only promising market these days, this is a clear lesson to heed.

Lesson #7: Stocks always recover; people don’t.

The Dow closes at an all-time high, but that’s cold comfort to those who retired in the past five years. Big upfront losses can crack a nest egg, even if the market later improves. That’s because your portfolio has the most potential earning power in the first few years after you get the gold watch.

Historically, investors have been able to tap anywhere from 4% all the way up to 10% of their savings annually based on how markets fared in this all-important first decade of retirement.

Over the next 10 years, return expectations are extremely modest, so even a 4% withdrawal rate may seem optimistic. For boomers nearing retirement, the trick is not to make matters worse, as two out of five older workers did in 2008 by keeping 70% or more of their 401(k)s in equities.

It’s time to dial down the risks in your portfolio — before the next downturn.

MONEY stock market

These 3 Simple Steps Will Protect You If There’s a Market Meltdown

melting chocolate coins
Lara Jo Regan—GalleryStock

Every time the stock market hits a new high, we hear rumblings of a potential crash. But you can stop worrying about a meltdown if you prepare yourself -- and your portfolio -- ahead of time.

It seems that every time the stock market hits a new high these days—or retreats from one—we hear rumblings of a potential crash. In an interview last week after the Standard & Poor’s 500 hit yet another peak, Yale professor Robert Shiller noted that stock valuations were near levels that preceded meltdowns in the past and thus were “a cause for concern.”

But if you’re investing for retirement, should the prospect of a bear market give you a serious case of the jitters?

I don’t want to downplay the effects that a market meltdown can trigger. It can wreak havoc with the economy. And if you’re on the verge of retirement and have a big portion of your savings in stocks, a setback on the order of the 2007-2009 50%+ drop in stock prices could force you to sharply scale back your post-career lifestyle or stay on the job longer than you want.

But if retirement is many years away, even a severe downturn isn’t necessarily a big deal. It could even work to your advantage, as the stocks you scoop up at at a market bottom can earn the highest long-term return.

Regardless of what stage of retirement planning you’re in—just starting out, mid-career, ready to retire, or already retired—there are two important things you need to know about market crashes. One is that there’s no avoiding them. Bear markets have been around as long as we’ve had stock markets. Since World War II alone, we’ve had eight major downturns averaging nearly 39% and lasting an average of 19 months. Big, scary dives in stock prices are a normal part of the investing landscape that will always be with us. Rather than trembling in fear of their onset, smart investors learn how to live with the certainty that sooner or later stock prices will collapse.

The second thing you need to know is that, far more important than the meltdown itself, is how you handle it. And that largely depends on how well you prepare ahead of the crash. Once a major correction is really under way, there’s not a whole lot you can do to stave off damage to your portfolio; indeed, scrambling to mitigate the damage may make matters worse. Nor can you depend on some gut instinct or trusty technical indicator to get you out of the market just before things fall apart. In retrospect, it’s always easy to see when the meltdown started. But in real time, it’s impossible to tell in the early stages of a bear market whether it’s The Big One or is just another false alarm.

So what should you do to prepare in advance for an inevitable market setback, while also staying positioned to share in the gains if the market continues to rise rather than drop (which ends up being the case most of the time)?

1) Know thyself. Start by getting a handle on your true appetite for risk, specifically how much of a drop in the value of your savings you can stand before you start unloading stocks in a panic. The Investor Questionnaire in RDR’s Retirement Toolbox can help you make this assessment. As you do this risk evaluation, keep in mind that investors have a tendency to underestimate how much risk they’re taking when stock prices are rising and overestimate the risks they’re taking after prices have plummeted. Be careful not to get swept up in irrational exuberance when the market’s on a tear, and avoid becoming overly pessimistic in the wake of a crash.

2) Adjust your investments accordingly. Next, make sure your portfolio jibes both with the level of risk you’re willing to accept, and that your mix of stocks and bonds makes sense given your investment goals. Reconciling these two aims can be tricky. If you’re risk-averse by nature, you may feel much better emotionally by hunkering down almost exclusively in bonds or cash. But such a low-risk portfolio may not give you the returns you’ll need to build an adequate nest egg or allow you to draw sufficient income from your savings once you’ve retired.

So you need to balance your emotional needs with your financial needs. Your aim is to end up with a portfolio that has enough exposure to stocks so that you have a decent shot at earning a reasonable rate of return, but not so stock-heavy that you’ll be reaching for the Maalox every time some pundit prophesies doom. The Retirement Income Calculator in RDR’s Retirement Toolbox can help you gauge whether the mix of stocks and bonds you’re contemplating can give you a reasonable shot at achieving your retirement goals.

3) Sit tight. Once you’ve done that, you should largely stick to your mix of stocks and bonds regardless of what’s going on in the market or how your portfolio is doing at any particular moment. That can be tough. You can always come up with reasons to justify straying from your investing principles or strategy “just this once.”

Resist that temptation. Often, what seems like a good move in the moment isn’t wise for the long run. In the spirit of full disclosure, I recently wrote a column explaining how I abandoned my investing principles years ago by selling shares of Warren Buffett’s Berkshire Hathaway company only seven months after buying them. As a result of that lapse, I missed out on a near $400,000 gain on that stock. Ouch.

Hanging on every twist and turn of the market is no way to live, especially in retirement. So instead, learn to live with the fact that the market is flighty and the knowledge that every now and then it’s going to tumble. Just prepare ahead of time, so you can handle that volatility, financially and emotionally.

Walter Updegrave is the editor of He previously wrote the Ask the Expert column for MONEY and CNNMoney. You can reach him at


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Are Stocks Overpriced?

Photos: joe pugliese James Montier (L) says stock returns won't keep up with inflation over the next seven years. Richard Bernstein (R) thinks the five-year-old bull market has several more years to run.

Facing a stock market that has doubled in price over the past five years—and with memories of the last market collapse still vivid—you can’t help but wonder: Is another disaster lurking around the corner?

Holding vastly different opinions are two strategists with decades of insight and experience. Richard Bernstein, former chief investment strategist at Merrill Lynch, now an adviser to funds for Eaton Vance, is bullish. James Montier, who helps manage $117 billion at GMO — itself an adviser to two Wells Fargo funds — is bearish.

Both make strong arguments — ones that may challenge your view of today’s investing climate.


Are stocks overpriced?

The market is priced roughly at fair value. You have to look at valuations in light of inflation. Our firm uses sophisticated models for that, but a rule of thumb is that the price/earnings multiple and the inflation rate should add up to less than 20.

Inflation is now at about 1.5%. The P/E for stocks in the Standard & Poor’s 500, as we speak, is about 17, based on trailing earnings. So a little below 20, or roughly fair value.

Related: American Airline employees locked out of 401(k) funds — here’s why

Stocks are not cheap, but that doesn’t mean the bull market is over. Pension funds in the U.S. have their lowest equity allocations in 40 years. Wall Street strategists recommend an underweight of equities. I’ve found, over three decades, that the consensus asset allocation is a very reliable contrary indicator of where the market is headed.

A version of the P/E that carries a lot of weight now is the one championed by Yale’s Robert Shiller. By that measure, based on 10 years of earnings, P/Es are very high.

In the past, when these high Shiller P/Es signaled an overpriced market, we’ve had much higher rates of inflation than we do now.

Related: Tools to make your money grow

When interest rates and inflation decrease, P/Es tend to expand. When rates or inflation rise, P/Es contract. The theory is that inflation eats away at a company’s future value, for several reasons. Earnings might rise, but inflation-adjusted earnings might not. Earnings quality tends to decline, in part because you’re simply paying off debt with cheaper dollars. And overall investor confidence tends to deteriorate. So you have to adjust for inflation, but professor Shiller doesn’t.

If you do adjust for lower inflation, it predicts normal returns — about 8% to 9% a year. We look at more than valuation, though. For example, sentiment is still attractive. We actually think you’re going to get above-average returns — say, 10% to 15% a year over the next several years.

Two years? Five years?

I think we’re halfway through one of the biggest bull markets of our careers. The stock market has been up for the same reason it always goes up in an early-cycle environment. Expectations are extremely low, monetary and fiscal policies kick in, and the economy begins to grow. That’s what happens every cycle, and it happened this cycle too.

Now we are entering a mid-cycle phase in which you get the tug of war between rising rates — a bearish sign — and unanticipated improvement in the economy — a bullish sign. Sentiment isn’t exactly ebullient, and the economy keeps improving.

Related: How to get in trouble in your 401(k)

But when your readership believes there’s no risk in equities, the bull market is almost over. And in the kiss of death, the yield curve inverts, meaning that long-term interest rates drop below short-term rates. In other words, people are so desperate to lock in long-term rates that they pay more for them than for short-term rates.

Watching for an inverted yield curve will keep you out of trouble. That simple little indicator suggests the bond markets are beginning to expect significantly weaker growth. Generally this occurs before the stock market begins to anticipate slower growth. And we haven’t seen it yet.

You’ve noted that a classic sign of a bubble is increased use of borrowed money to invest. Margin buying of stocks is at a record high.

Nobody knows how much of that is long — betting that stocks will rise — and how much of it is short — betting stocks will fall. In the past, when individuals played a greater role in the market, you assumed that margin was used to be levered long. Today hedge funds are a much bigger force, and my research suggests they’re relatively neutral. Some of that margin is being used for shorting. So I don’t think increased leverage is driving up prices.

What other bubble indicators do you look for?

When sentiment becomes overwhelmingly bullish to the point where people jettison diversification, that is very, very worrisome.

Related: How we feel about our finances

You see that now in highflying tech, social media, some biotech. Valuations are so out of whack with reality. You’d think that people would have learned from the hot stove.

What do you say to analysts who worry that equities are inflated by the artificial suppression of interest rates by central banks?

I get that question all the time. The point of stimulative monetary policy has always been to artificially inflate asset prices. Interest rates are lowered so that people take more risks and multiples expand. Companies get a cheaper cost of capital, which they can then use to invest.

The notion that the Fed is the only reason the stock market is up is what people claim during the early stages of every bull market. The time to worry is when the Fed inflates asset prices too much and the characteristics of a bubble emerge.

What happens if earnings — the “E” in P/E — drop to historical norms?

Profit margins are at an all-time high. There’s no doubt about that. But profit levels are also a function of sales. When margins compress, companies generally start to fight for market share. We think earnings forecasts for large-cap multinationals may be way too optimistic; we are concerned about emerging markets and the impact they could have on multinationals’ earnings. But domestic U.S. manufacturing is gaining market share. I’m not talking about 3D printing. I’m talking about ball bearings and grease. Small- and mid-caps.

Examples, please?

I’m not a stock picker. But we believe investors should probably focus on more domestically oriented stocks and avoid emerging-market stocks as much as possible. In addition, since profit margins around the world seem likely to contract, investors should aim at market-share gainers. We like U.S. small-cap industrials. If you know the name of the company, the odds are that they have too much international exposure.

Also, I think that high-yield municipal bonds are a tremendous value play right now.


They yield more than high-yield corporates for the first time in history.

So when will you know your portfolio is overpriced — that it’s time to get out of small-cap industrials or high-yield munis?

We look at gaps between perception and reality. Over the past several years, the sentiment toward small-cap stocks, despite their superior performance, has been quite poor. But ultimately that gap between perception and reality will begin to change.

There will be more negative-earnings surprises because expectations get too high. Flows into small-cap funds will pick up. We’ll hear people talking about how cheap they are, as opposed to how expensive they are. [Laughs.] Then we’ll find other investments that look more attractive.



Are stocks overpriced?

There is no doubt that the U.S. stock market is exceedingly overvalued.

What makes you so sure?

The simplest sensible benchmark is the Shiller P/E. Right now we’re looking at a broad index like the Standard & Poor’s 500 trading at something like 26, 27 times the Shiller P/E. Fair value would be 16 or 17 times historical earnings.

But bulls say the Shiller P/E doesn’t look so bad if you adjust it for interest rates or inflation.

It doesn’t make any sense to do that. The history of stock prices shows that they are good long-run inflation hedges. That’s because companies can generally raise their prices when their input costs rise, which protects their profits and dividends from inflation. And since equities are valued based on profits per share, equities are largely immune from inflation too.

Adjusting for interest rates is even more bizarre. Empirical horseraces show that valuation ratios — say, P/Es — unadjusted by current interest rates have predicted long-run returns far better than valuations adjusted by interest rates.

What if you look at P/Es based on expected earnings for the next year?

I spent nearly 23 years working at investment banks surrounded by analysts, and I have to say I think analysts probably were put on this planet to make astrologers look like they know what they’re doing.

The idea of basing a valuation on a forward earnings number is laughable. Most analysts spend all of their time being spoon-fed by company management and thinking about the next quarter’s earnings release — a horizon that is just not meaningful.

But maybe rising profits will justify higher stock prices. Maybe corporate profit margins will be higher than they used to be.

It is possible. We spend a lot of time worrying about that: What could prevent margins from falling?

[GMO co-founder] Jeremy Grantham puts it very well. For most investors, he says, “This time is different” are the four most dangerous words. But for value investors [who buy stocks they think the market has undervalued], “This time it’s never different” are the five most dangerous words. They lead to simple-minded extrapolation — an unchecked belief that the future will be like the past.

For a really good example of that, think of value managers who bought financials in 2008 because they were “cheap.” They failed to understand the dangers posed by the bursting of the credit bubble and the way in which earnings had been inflated during the housing bubble.

But profits as a percentage of gross domestic product have indeed been elevated for a sustained period. Now the data show profit ratios are not increasing anymore, and that may be the first sign that they’re beginning to peak. Looking forward, more federal budget cuts are coming, which should reduce profits.

Are we in a bubble now?

The technology bubble of ’99 was a good old-fashioned mania. People really did believe this time was different — that the dotcoms would change the way the world worked forever. I think what we are seeing today is more of a near-rational bubble.

When you have central banks around the world setting interest rates below the rates of inflation, effectively telling you that cash will earn nothing, then you tend to seek out other vehicles for investing. That distorts pricing across a wide range of assets.

I’d call it a foie gras market, in which investors are the geese being force-fed risk assets by central banks. It isn’t pleasant, but it may be the best that you can do given the alternatives that are available to you.

So what should investors do?

Personal investment advice is not our business. But when you look at the S&P 500 at today’s valuations, our return forecast is negative 1.5% annually after inflation. Cash will earn something like minus half a percent over the next seven years.

It’s hard to find bits of the market that are actually attractive. So we look for high-quality stocks, which have three features: high profitability, stable profitability, and low leverage: the Johnson & Johnsons JOHNSON & JOHNSON JNJ 0.37% , Procter & Gambles PROCTER & GAMBLE COMPANY PG -0.89% , and Microsofts MICROSOFT CORP. MSFT -0.38% of the world. They’re certainly not cheap. But they are the best of the bad bunch.

And outside the U.S.?

Globally, European value stocks also probably deserve a place in a portfolio. So do some emerging markets, which is probably a brave call given the events that are unfolding around the world. In our unconstrained portfolios, we have just under 50% in equities spread among those groups, and then the rest in a combination of things like Treasury Inflation-Protected Securities and cash.

Related: How much will I need to retire?

You don’t want to be fully invested or else you give up the ability to take advantage of shifts in the opportunities you face. Also, we have found that if you shift assets depending on your opportunities, you’ve greatly reduced the risk of lifetime ruin — running out of money before you die.

Does that mean timing the market? Or simply having a global portfolio and rebalancing once a year? That is, selling the asset that’s performed the best and buying the one that’s done the worst?

Rebalancing is the simplest of all valuation-based strategies and a really good start. But I think one absolutely should try to market-time based on valuation.

Ben Graham actually said that in Security Analysis [a classic investing book co-written by David Dodd and first published in 1934]. He said, “It is our view that stock-market timing cannot be done…” and that’s the bit everybody quotes. But he goes on to say “unless the time to buy is related to an attractive price level,” which I think is exactly right.

Any tips on how to market-time?

My colleague Ben Inker says you should smoothly and slowly enter and exit markets. Rather than trying to pick the top or bottom, which you’ll never do, move maybe 5% or 10% of your portfolio in or out each quarter. That’s what we’re doing.

We are slowly drawing down our equity exposure in recognition of the fact that the markets have been expensive. If they get more expensive, we may sell a little faster, and if they get less expensive, we may stop selling.

Being patient is a massively underestimated virtue when it comes to investing because there is nothing worse than sitting there watching your neighbor get rich because he’s been invested and you haven’t because you think the market’s expensive. But if you can be patient, a valuation-based framework is exactly the right way to do things.

MONEY stocks

What to Do in a Market Where Anything Can Happen

Are we headed for bear or bull? Growth or recession? Today it seems harder than ever to say. You can still be prepared.

Four-plus years after the financial crisis, and you can’t tell whether or when the economy and the markets will return to normal, whatever that is.

Instead, we seem suspended between debt crises and central bank interventions at one pole and signs, however uneven, of a real U.S. rebound on the other. Here’s the rub with uncertainty, though: It’s always with us.

“Things are no more uncertain today than they were in the past, but we feel that way because we’re still recovering” from the trauma of 2008, says Meir Statman, a behavioral finance expert at Santa Clara University. “We have to accept that things can go wrong. All we can do is manage the uncertainty, not prevent it.”

Smart managing of uncertainty — and its attendant risks and opportunities — is what MONEY’s investor’s guide is all about. The stories focus on specific moves to make in today’s environment.

First, a look at the big picture: the three most dramatic scenarios for the markets and economy in 2013 and beyond (spoiler alert: They’re not all bad!); then, who will have the most at stake in each; and how you should prepare for the possibilities and manage the realities.

POSSIBILITY NO. 1: The long-term returns for U.S. stocks and bonds turn out to be dismal

A galaxy of investing stars, including Pimco’s Bill Gross and GMO’s Jeremy Grantham, have warned of below-average returns over the next few years — or even decades, in Gross’s view. The culprits: slow U.S. economic growth, weak consumer spending, and rising health care costs for an aging population.

Add it all up, and stock returns are likely to average 4% to 6%, compared with their historical average of 9.8%, says another star pessimist, Research Affiliates chairman Rob Arnott.

Fixed-income returns are also under pressure. Over the past 30 years, bond prices soared as interest rates fell from double digits to just 1.6% for the 10-year Treasury. Game over: Bonds are likely to deliver, at best, their yield to maturity, rather than their historical average of 5.4% a year for intermediate issues. And when interest rates rise, as they will eventually, prices will fall and fixed-income investors will suffer losses.

Who is most at risk: Lower investing returns would be bad news for all of us, of course, but the prospect is especially daunting for those aiming to retire in the next 10 or 15 years. A couple of percentage points less in average return over two or three decades means your retirement portfolio will likely be 25% to 35% smaller than it would have been.


Go on savings overdrive. The only sure way to make up, at least in part, for lower returns is to save more. So put away at least 15% of your income. Max out your 401(k) contribution, of course: “A no-brainer,” as Boca Raton, Fla., adviser Mari Adam puts it.

If getting the rest of the way there seems daunting, remember that “power saving” for bursts of a few years can make a big difference. Research firm Hearts & Wallets found that about 40% of successful savers — those who built nest eggs equal to 10 times their pay — did so by saving 15% of their incomes or more for up to 10 years.

Keep more of your return. You can’t afford to give your earnings away to the tax man or the money manager. Put investments that throw off a lot of capital gains or dividends, such as real estate investment trusts and taxable bond portfolios, into a tax-sheltered account.

Tax-exempt municipal bond funds and stock index funds, which generate few capital gains, are best kept in taxable accounts. And know this: Assuming a 7% return, switching $25,000 from the average stock mutual fund that charges 1.4% of assets to an exchange-traded equity index fund that charges 0.2% nets you an extra $20,000 over 20 years.

POSSIBILITY NO. 2: A 2008-style financial crisis and bear market come roaring in

Whatever moves Washington makes in the next few months, there are no quick solutions to the $16 trillion of federal debt. Across the Atlantic, deep divides in the eurozone between creditor and debtor nations stymie solutions, and more of the continent is drifting into recession. “The U.S. and European debt problems present significant risks to the economy through at least 2013,” says Thomas Forester, manager of Forester Value.

Related: Why market timing is so hard

Of course, there are plenty of other events, some you can think of, others that would be a complete surprise, that could trigger a financial panic and tumbling world markets.

Who is most at risk: A severe bear market, if you’re just starting out in your career, is a good thing. It is especially damaging, on the other hand, when you’re about to retire or have hung up the briefcase recently. Since you have little opportunity to rebuild your savings, you can end up facing a menu of unappetizing options: postponing your retirement, retiring anyway and taking the chance that you’ll run out of money in your old age, or cutting your withdrawals materially.


Lean toward low-risk assets. Dividend-paying stocks and alternative assets such as commodities and real estate have delivered returns similar to the broad market over the long term, yet with less risk.

In fact, an analysis of the lowest volatility stocks, published in The Journal of Portfolio Management, found that between 1968 and 2005 these equities delivered returns one percentage point higher on average than the overall market with 25% less risk.

Of course, since 2008 safety-seeking investors have been rushing into these investments, which is likely to limit the potential for future outsize gains. If you are near or in retirement, though, goal No. 1 is to inflict no harm, so it makes sense to tilt toward safety.

A moderate-risk investor might hold a 50% stock/50% bond portfolio well into retirement, says Portfolio Solutions adviser Rick Ferri. Your asset mix might include 30% in U.S. equities, including high-quality dividend-paying stocks, 15% in foreign equities, and 5% in REITs.

In fixed income, you would avoid long-term bonds, which are most affected by interest rate moves, and spread your holdings among intermediate issues (30%), high-yield securities (10%), and TIPS, Treasury bonds that offer inflation protection (10%).

Adjust to the times. When you were working and got a bonus, you spent more. When times were lean, you spent less. Keep doing that once you stop working.

“It’s important to revisit your retirement plan and make adjustments when necessary,” says T. Rowe Price financial planner Christine Fahlund. Her company found that retirees who cut their nest egg withdrawals by 25% for three years after the two bear markets of the past decade significantly improved the chances of making their money last 30 years or more.

POSSIBILITY NO. 3: Surprise! Everything turns out fine

All those dire forecasts? They could be way off. Even a top-performing money manager like Gross is, at best, a so-so prognosticator of market returns. Studies have repeatedly shown that economic and market predictions usually miss the mark. Between April and November 2008, the Federal Reserve Bank of New York’s research staff estimated that the chance of a severe recession was less than 15%.

Even if an economist makes a big call correctly, he or she isn’t very likely to get the next one right. A 2010 study by researchers at Oxford and New York University found that the forecasters who correctly predicted an extreme event were often the ones who had the worst overall track records.

Outside the ivory towers, there are plenty of signs that the economic recovery — and long-term investment returns — will end up better than you might expect.

Housing foreclosures have fallen to a five-year low. Consumer confidence has rebounded to its highest level in four years, in large part because of an improved job market. And companies continue to innovate in everything from energy to genomics to nanotechnology. All that innovation may even spur a new economic boom, says Vanguard chief economist Joe Davis. “We have a lot of headwinds to get through, but over the next five to 10 years, the economy is likely to rebound stronger than expected,” says Davis.

Of course, to benefit from this renaissance, you would need to be invested in stocks.

And there’s the rub: Over the past year, as the S&P 500 returned 15%, nervous investors have continued to pull money out of U.S. equity funds. The numbers since stocks bottomed in March 2009 are eye-popping: U.S. equity fund net outflows total $179 billion. Much of that cash has ended up moving into bonds, which has helped Pimco Total Return, with $285 billion in assets, balloon into the nation’s largest mutual fund.

Who is most at risk: For those in their twenties and thirties, an aversion to stocks would be particularly costly, since they would miss out on decades of compounded returns.

Unfortunately, young investors are also among the most risk-averse today — nearly 40% say they’ll never be comfortable buying stocks, compared with 29% of all investors, according to surveys by MFS Investments. Alas, the alternative — building the nest egg you need with only cash and bonds — requires extreme levels of saving over the long term: 20% of income or more.

You could also save less but work longer before retiring. Both strategies are plausible, but they carry their own risks. Will you be able to sock away so much your entire career? And what if you’re no longer healthy enough to keep working until, say, age 70, a too common occurrence among retirees?


Walk before you run. The young and fearful should take a gradual approach to the market, says Rob Oliver, a financial adviser in Ann Arbor. This isn’t what standard investing theory would tell you is optimal, but it beats sitting in low-yielding cash.

Invest regular amounts each month into a balanced or target-date retirement fund, which holds a mix of stocks and bonds. A 50% stock/50% bond portfolio has returned 5.6% a year after inflation during economic booms, according to Vanguard, while during recessions, it returned only slightly less, at 5.3%.

Yes, a 50% stock allocation is low for someone in the early stages of a 40-year work life. So once you find that you can handle that modest level of risk, gradually boost your stock allocation to 70%. And when the inevitable bear market comes along, buy when the goods are on sale.

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