It Was the Best and Worst of Times

(MoneyWatch)  It was the worst of times -- the S&P 500 Index lost 37 percent in 2008. It was the age of panic -- it had fallen another 25 percent by March 9, 2009. It was the epoch of despair -- unemployment rose from 4.9 percent to 7.2 percent in 2008. It was the season of darkness -- unemployment had risen to 10.2 percent by October 2009.

It was the age of hope -- the S&P 500 closed at 676.53 on March 9 and ended the year at 1115.10, a gain of 65 percent (not including dividends). It was the season of light -- equity markets around the world rallied in response to the fiscal and monetary stimuli provided by central banks.

The following are the returns for some of the major equity asset classes for last year.

• S&P 500 Index -- 25.1%
• Russell 1000 Value -- 19.7%
• Russell 2000 -- 27.1%
• Russell 2000 Value -- 20.6%
• MSCI EAFE -- 31.8%
• MSCI Emerging Markets -- 78.6%

For those investors who had the discipline to stay the course, it was the age of reason. For those who had the courage to rebalance, it was the age of wisdom. For those who sold in a panic, it was the age of foolishness.

Those who panicked learned bear markets can turn 30-year horizons into 30-day horizons. Good investment plans incorporate the virtual certainty of bear markets, and that there's no one who can tell us when they will arrive, how deep they will be or how long they'll last. That's why it's so important to focus on developing plans that don't exceed your ability, willingness or need to take risk and to take the time to educate yourself on the history of bear markets.

We also know that since we can't control returns, we should focus on what we can control:

• Risk
• Costs
• Tax efficiency

Having a well-developed plan is only the sufficient condition for success. The necessary condition is to have the discipline to stay the course. To help keep discipline, it's important to remember that things are never quite as dark as they seem during bear markets, nor as great as they seem during bull markets. For example, a 2008 study found when unemployment has been high (over 6 percent), stock returns have been more than seven times as high as when the rate is low (less than 4 percent) -- 15 percent a year versus about 2 percent.

There's an old saying that the greatest returns are made during bear markets, it's just that you don't know it at the time. Investors that stayed the course and rebalanced relearned that lesson. Investors that sold in a panic (or in reaction to some guru's forecast of doom) learned an entirely different and far more costly lesson.