About a hundred years ago, J. Pierpont Morgan, the legendary financier, was asked what the stock market's next move would be. He answered "It will fluctuate."
Although most people can see the logic in this answer, they tend to develop unreasonable expectations based on recent market performance. When stocks rise for a prolonged period of time, the possibility of a significant market decline seems like an archaic notion relevant only to a previous era. This mindset is prevalent in today's real estate market, for example. On the other hand, in the midst of a bear market, investors become so demoralized that they can hardly conceive of better times ahead.

The best way to keep your expectations in check is to take a long-term view of the market. From 1926 to 2004, stocks returned an average of 11% per year. Although there are no guarantees, it is reasonable to expect attractive returns in the future as well. However, in order to realize these gains, it is often necessary to endure short-term volatility. Bear markets can be precipitous and painful. The worst market decline since World War II occurred in 1973-74 when the S&P 500 dropped 43%. More recently, the S&P 500 fell almost 37% from March 2000 to September 2001. It is a virtual certainty that similar declines will occur in the future.

Fortunately, there are strategies for reducing, although not eliminating, stock market risk. One is to diversify into asset classes that do not move in lockstep with U.S. stocks. The classic example is the use of bonds to reduce overall portfolio volatility. Broadening your equity holdings can also help dampen portfolio fluctuations. For that reason, we advocate spreading your stock holdings across a wide array of domestic and international asset classes. Finally, your greatest safeguard against market volatility is to invest for the long run. This will allow you to ride out the inevitable ups and downs on the road to reaching your financial goals. Success comes from persistence and the ability to stay the course when market volatility strikes.

April 2005

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