A New Year, a Three-Step Portfolio Review

An Investor Action Plan for 2009 from Legg Mason

The past year has seen some of the most dramatic developments in the history of the U.S. economy and financial markets. An unprecedented credit crunch reshaped the financial landscape. Lehman Brothers went bankrupt, while AIG, the world's largest insurance company, nearly collapsed under the weight of credit default swaps gone bad. The government, in an attempt to restore the health of the global credit market, has undertaken its largest intervention in the financial system since the New Deal.

Investors responded to the crisis by rapidly selling securities that had any hint of risk. By the end of the year, the S&P 500 had tumbled nearly 38%—19% in October alone—amid epic levels of volatility.¹ Foreign stocks, as measured by the MSCI EAFE Index, lost nearly 45% during the same period.²

Although the events of the past year have been dramatic, they shouldn't deter you from your long-term investing strategy. As the New Year begins, take the opportunity to refocus on your overall financial plan. The following three steps can help you put last year in perspective and prepare for a brighter future.

1. Assess your progress toward financial goals
2. Evaluate your asset allocation strategy
3. Rebalance your portfolio

1. Assess your progress toward financial goals

Begin by taking stock of where you stand relative to your objectives. List each goal, the amount of money you expect to need to pay for it, and the savings you currently have devoted to it.

The market downturn might not have had a dramatic impact on savings you held in cash or bond investments. But the S&P 500's plunge may have significantly impeded your progress toward long-term goals such as retirement. You may need to consider ways to increase your savings efforts in order to meet that long-term goal.

Start by reassessing your priorities. You may decide that increasing contributions to retirement accounts is more important than saving for a family vacation, a new car or even a child's college education. Stocks' recent losses make it all the more imperative to take advantage of your retirement plans' benefits, which include the potential for tax-deferred compound growth, and in many cases, employer-matching contributions (certain limitations may apply).

You may also want to consider boosting your retirement savings in 2009. Stock market recoveries can be sudden and powerful. If you already made the maximum 2008 contributions to an IRA, consider making your contributions for 2009 early in the year. Doing so maximizes your opportunity to capture any potential rebound.

Also review your household budget, if you keep one—and if you don't budget, now is the time to start. Financial experts recommend looking for places to cut back, such as gifts, travel and meals out, so you can devote more income to savings.

2. Evaluate your asset allocation strategy

The market's 2008 downturn was severe, even by historical standards. In fact, according to preliminary data, 2008 was the first calendar year in 70 years in which the S&P 500 produced a negative 10-year return, of -0.05%.³ But experts agree last year's losses do not change the fundamental tenets of asset allocation. In particular, stocks historically have continued to offer long-term investors much greater potential returns than bonds or cash.

The lesson is clear: Although past performance is no guarantee of future results, stocks have historically produced the investment world's strongest long-term returns in spite of occasional, severe market drops like last year's. So if you're investing for a goal that is more than 10 years in the future, it makes sense to hold an appropriate allocation to stocks that is in line with your investment objectives, risk tolerance and time horizon.

The stock market's recent losses also reinforce another axiom of asset allocation: Hold investments for short- and intermediate-term goals in cash and fixed-income investments, to help protect money you will need in the next one to two years.

3. Rebalance your portfolio

Another cruel reality of 2008 is that the stock losses probably have reduced your overall equity allocation considerably. For example, imagine you began 2008 with an allocation of 65% stocks, 30% bonds and 5% cash. Say your stock holdings lost 35%, while your bond investments gained 4% and your cash stake gained 2%. You'd have ended the year with an asset allocation of 54% stocks, 40% bonds and 6% cash. With a smaller equity allocation, your portfolio would offer much less potential for long-term growth.

A potential solution may be to rebalance your portfolio by selling bonds and cash and purchasing stocks until your asset allocation is in line with your targets. In addition to boosting your long-term return potential, it may help you recover from last year's losses. What's more, shifting assets to stocks following a major market decline provides an opportunity to purchase shares at inexpensive prices—allowing you to potentially reap greater benefits if stocks recover. Of course, keep in mind that rebalancing your portfolio will entail transaction costs and may have tax implications. Talk to your financial and tax advisors for guidance.

The extraordinary events of 2008 have rattled even the most seasoned investors, but now more than ever, it's important to maintain your focus on the long term. As the New Year begins, try not to dwell on the past year. Instead, take the opportunity to look ahead and plan for your future.