January 18, 2008

Most mutual fund investors understand that a fund that shot up 50% last year is not guaranteed to repeat the performance this year. As some of us have learned the hard way, making an investment decision based on short-term, recent performance can be hazardous.

Chief Investment Officer Gus Sauter applies the same logic to today's volatile markets. Recent performance has been unnerving, as markets react to weakness in the economy and continued write-downs at financial institutions. Through January 18, the S&P 500 Index had fallen almost 10% so far this month and is down almost 15% from the record high it set in October 2007. But to project recent performance forward and make an investment decision based on that assumption is usually a mistake, Mr. Sauter said.

"The reason trying to time the market is such a dangerous risk is that people are reacting to what they have seen currently or in the recent past, whereas they should be looking at what's in the future. However, investors aren't very good at predicting the future," he said.

You might expect the stock market to go down when a recession begins and rally as the economy is starting to improve. But that's not always the case, as Vanguard research shows. And even when the market's turns have coincided with the start or end of a recession, these inflection points become clear only well after they've occurred. In the moment, you don't know when you're at the bottom or the top of an economic or market cycle.

"By the time you know the recession has started, it's too late to try to respond by adjusting your portfolio," Mr. Sauter said. "The market is already anticipating economic weakness in the future and it might fully discount that in the current level."

The strong performance of the stock market over the long term, as well as the unreliability of market-timing, argue for maintaining your investment strategy even through the tough times. Ideally, that strategy is balanced across asset classes—stocks, bonds, and money market or cash investments—so that whichever direction the markets turn next, you're able to stick with the plan.

The unwinding of the subprime debt market in late 2007 has reinforced a second timeless lesson, Mr. Sauter said. "When you see two bonds with the same ratings and one offers a meaningfully higher yield than the other, then it isn't really the same quality. There's no free lunch," he said. "Whenever investors throw caution to the wind, the market will teach them that lesson all over again."