Fundamentally: The ?R? Word Doesn?t Have To Be So Scary

AS fears over the credit crisis and housing correction have mounted, a growing chorus of economists has been talking up the probability of a recession next year.

For investors, there are few things as scary as the “R” word. That’s because, historically, recessions have often wreaked havoc on stock portfolios. Since 1945, the Standard & Poor’s 500-stock index has tumbled nearly 26 percent, on average, in the periods leading up to and during recessions. Worse, equity investors have had few places to hide during these downturns, as virtually every sector of the market has lost ground, on average, during the last 11 recessions, according to S.& P.

But if you’re a buy-and-hold investor with a balanced portfolio consisting of stocks for growth and fixed-income securities for ballast, “you don’t need a place to hide,” said Mike Scarborough, president of the Scarborough Group, an investment advisory firm based in Annapolis, Md., that works with 401(k) plan participants.

Indeed, investors are encouraged to establish a long-term mix of stocks and bonds and cash in the first place — and to maintain it over time — largely to keep their portfolios on an even keel no matter which way the market winds are blowing.

And history shows that a balanced asset-allocation strategy can provide that stability. Consider the last recession, which lasted from March to November of 2001, according to the National Bureau of Economic Research.

During that period, a portfolio mirroring the S.& P. 500 index would have lost 7.2 percent of its value. But had you invested in a balanced way, with 60 percent of your money in S.& P. 500 stocks, 30 percent in domestic bonds and 10 percent in cash, you would have lost 2 percentage points less. That’s according to an analysis run by the investment management firm T. Rowe Price.

This balanced portfolio would have benefited from its stable fixed-income investments, which rose in value as interest rates fell during that time.

Bonds won’t always bolster your portfolio, though. During the 16-month-long recession from November 1973 to March 1975, it was cash that really shone. During that recession, which coincided with the 1973-74 bear market, equities lost nearly 18 percent of their value. But as 30-day Treasury bills, a proxy for cash, generated double-digit gains, a 60-30-10 portfolio would have fallen only 8.4 percent during this stretch.

Of course, this raises a question: If you really fear recession, why not go entirely to bonds and cash? The simple answer is that there are major risks associated with trying to time the market. Mr. Scarborough says it’s impossible to know whether a recession is on the way. But, he added: “Let’s say a recession is coming and you go to cash. Great. Even assuming you got that call right, now tell me when you think is the right time to get back in?”

Even if a recession is imminent, there’s no guarantee how any asset class will perform during the downturn. For instance, during the recession from July 1990 to March 1991, the S.& P. 500 actually gained 7.6 percent. But because of the stellar performance of bonds, a balanced 60-30-10 portfolio actually gained slightly more, 7.7 percent.

To be sure, the reason to maintain a diversified portfolio is not to outperform the market, but to prevent you from panicking during a short-term crisis in equities, said James A. Shambo, a financial planner in Colorado Springs. And that’s what recessions have been in recent decades: extremely brief episodes.

Since 1945, the average recession has lasted only 10 months, according to the National Bureau of Economic Research. You have to go back to the Great Depression to find an economic downturn that lasted longer than 16 months. So if a recession is at hand, “there’s a good chance that this is really only a temporary concern,” Mr. Shambo said.

Unfortunately, many investors are likely to panic in the event of a recession because they haven’t taken the time to establish an asset allocation plan, financial planners say. Even worse, those who have settled on an appropriate mix of stocks, bonds and cash aren’t safeguarding their strategy by periodically rebalancing their assets.

How do we know this? Every year, Hewitt Associates, the employee benefit research firm, studies the behavior of the nation’s 401(k) participants. In 2006, only 17 percent of 401(k) investors made even a single trade. Yet to rebalance your portfolio, you have to sell some winning assets or buy some losing ones (or at least some that have been relatively unsuccessful).

If you don’t rebalance every year, assets that have been outperforming will become a bigger and bigger part of your portfolio, said Pamela M. Hess, Hewitt’s director of retirement research. And that means you may be overexposed to equities — in particular, specific types of shares like emerging-market stocks — just as the economy is slowing.

Ms. Hess says the simplest way to establish and maintain an asset allocation strategy is to invest in a so-called target date retirement fund. These all-in-one portfolios invest in a mix of stocks, bonds and cash that are considered appropriate for someone your age or with your time horizon.

Better still, these professionally managed mutual funds also reset your mix periodically, which means you don’t have to worry about rebalancing.

IF you don’t want to cede control of your portfolio to a single manager, there may be another choice. Today, 42 percent of 401(k) plans offer an automatic rebalancing, resetting your mix of stocks, bonds and cash once a year.

Relatively few investors are using this tool, and last year, about 15 percent of those who were using it dropped it.

“The truth is, the bulk of people aren’t really doing anything when it comes to asset allocation and rebalancing,” Ms. Hess said. That’s unfortunate, she said, because at the end of the day, a diversified asset allocation strategy will ensure that your portfolio isn’t entirely exposed to stocks just when they’re most vulnerable.

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

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