How Bulls and Bears Affect Your Investment Plan

(MoneyWatch)  It's important to understand that just as life events -- such as a birth or death, marriage or divorce, or a new job -- can alter the assumptions you made regarding your need to take risk, so can bull or bear markets. Let's see why this is the case.

Consider a couple in their early 50s as we entered the 1990s. They had accumulated a significant amount of wealth and were well on the way to achieving their financial goals. Their plan called for an equity/fixed income allocation of 70/30. This allocation was based on the assumption that stocks would provide returns of 10 percent a year and five-year Treasury bonds would return 8 percent. (As hard as it may be to believe, that was the current yield at the time.) Thus, the expected return of the portfolio was 9.4 percent.

At the end of the decade, they found that their portfolio* had actually returned 14.9 percent, and they were now much closer to their goals than expected. Thus, they could lower their equity allocation. (Note that a bear market would have produced the reverse outcome. They would have been further from their goal, and it's likely they would have needed to increase their equity allocation accordingly.) On the other hand, the bull market of the 1990s was (from an investment standpoint) the worst thing that could have happened to younger people as it lowered future expected returns for both stocks and bonds.

Those who appropriately lowered their equity allocations (due to their lower need to take risk) after the strong markets of the 1990s or after the good run from 2003-06 were much better positioned when the bear markets of 2000-02 and 2008 occurred. Their losses were much lower than they would have been had they simply bought and held (and even rebalanced).

Investment plans are based on certain assumptions. Thus, it's only logical that if any of the assumptions on which the plan was based have changed, that the plan should also be changed to adapt to the new circumstances. As we have seen, it's not only life events that can cause the plan to change, but significant bull and bear markets can also cause the assumptions upon which the plan was based to change. Thus, it's clear that a passive investment approach should only be adopted in terms of avoiding active management strategies. And it's important to recognize that you should be active in terms of:

• Managing the plan, making sure you don't allow market movements to cause your portfolio to drift away from its desired allocations.
• Tax managing the portfolio throughout the year.
• Adapting the plan to account for changes in expected returns if they impact your need to take risk.

* Stocks are represented by the CRSP Deciles 1-10 Index.