Calm for the Storm: Asset Allocation

This article was first published on Sept. 17, 2001. It has been updated.

What gives with this stock market? It keeps bouncing around, but the one thing it seems not to do is to go up with any consistency. According to Yahoo! (NASDAQ:YHOO) Quotes, the Standard & Poor's 500 is still down 24% from the high of 1527 it reached on March 23, 2000. When this market will finally recover is anyone's guess. Let's see what history has to say.

Over the last 50 years there have been 10 bear markets counting the one we just had. Indeed, some might argue we're still in it. Regardless, in all those market declines, the longest time from peak to trough to peak was 90 months (from 1973 to 1980). That bear market took 21 months to reach its low, but from that bottom it took another 69 months to regain the previous market high. The chart below shows that the average bear market loss was more than 30% and the average time from peak to peak was 31 months. And, perhaps even more importantly, from the start of a bear market (i.e., at the former peak), five years later the average gain was nearly 12%, but on three occasions there was actually a loss.

Recovery from a bear market

These bear market statistics are why we say repeatedly in various places throughout Fooldom that no money you know you will need to take from investments within the next three to seven years should ever be invested in stocks. If you're an aggressive investor, then a three-year reserve should remain out of the stock market. Conversely, if you're a conservative investor, then a seven-year cushion should suffice. I'm partial to a five-year period myself. Once I have set aside a five-year cushion of any cash I must take from savings, my remaining assets are invested in the stock market.

Where does the five-year stash go? Into things such as money market funds, Treasury bills, certificates of deposit, and short- to mid-term bonds, or bond funds where it can still earn interest but avoid most of the volatility found in the stock market. By doing that, I don't need to sell stocks at a low point, which would deplete my lifetime savings far quicker than I desire.

The concept I'm talking about is known as asset allocation. Asset allocation entails investing part of a portfolio into each of the three primary investment markets: stocks, bonds, and cash. In theory, these markets do not move together. As one is at a high, another is at a low, and the third is in between the other two. Having money in all three market areas minimizes downside risk while achieving portfolio growth.

So does this mean you should immediately do the asset shuffle -- sell investments here to buy investments there? Not necessarily. The market remains unsettled, and even the big boys aren't really sure what to do. Unless your analysis reveals that the long-term prospects and fundamentals of your investments have changed, it's probably prudent to simply hold what you have. I suppose you could consider delaying any purchases until the market settles down -- unless, of course, your analysis reveals some true bargains based on your long-term projections and the business' fundamentals.

Some folks may take more risk, and others less. That's an individual choice. The only thing I know for sure is that keeping three to seven years' worth of needed investment withdrawals out of the stock market does much to preclude a nervous stomach when the market inevitably falls, and fall it will. In my opinion, it's an approach that will work reasonably well for any investor, retired or not.

Longtime Fool contributor David Braze is all about retirement. He is thrice retired, but still finds time to answer questions for subscribers to the Rule Your Retirement newsletter service. The Motley Fool may be all about investors writing for investors.