How to deal with big, scary declines

Q: How should anyone with their retirement tied to the market handle days like the two big drops in August and the more recent declines in September? - F.D., by email

A: Bear markets are scary - and they happen with regularity. So start by remembering that they are a fact of life. They have beginnings, middles, and they all end. How you respond to big market declines depends very much on how your money is invested and the sources of your income. It's a personal matter.

Let's start with an extreme example. Suppose you were a college professor who retired from a university with income from a pension and Social Security. In fact, those two guaranteed incomes, combined, are enough to pay all of your bills.

This means you have no direct dependence on markets. Your personal savings are unaffected as long as you only draw dividend and interest income. If you start drawing principal in a bear market, you will damage your personal savings.

At the other extreme, you could have no pension (that's lots of people). Your only guaranteed income could be from Social Security, and that covers only, say, one-third of your spending. The greater your dependence on withdrawals from your investments, the more vulnerable you are to the ups and downs of the stock market.

The solution is to arrange your finances so you are less vulnerable to market ups and downs.

There are two ways you can do this. The first is to include fixed-income funds and cash in your portfolio. If you do that, you will be years away from selling stocks in a depressed market. If, for instance, you have a traditional 60/40 mix of stocks and bonds, you would be able to withdraw 5 percent of the portfolio every year for more than eight years before exhausting fixed-income and having to sell equities.

The second thing you can do is use some of your savings to buy a personal pension. You can do this by purchasing a single-premium life annuity. It will provide you with a guaranteed income for as long as you live.

One, or both, of these steps can insulate you from harsh ups and downs. Basically, you will be able to watch the markets with interest, but without fear.

Q: I have about $50,000 to invest and wonder if it is best to invest in a few index funds or put it all in one fund. I am looking at some funds you recommend such as Vanguard Balanced Index, Fidelity Spartan 500 Index and Vanguard Index 500. - L.J., by email

A: Simplicity and inattention work best for most people. There is a reason for this. Most people would prefer not to be involved. That's why you've probably seen more references to Vanguard Balanced Index Fund in this column than any other, whether Investor ($3,000 minimum investment) or Admiral shares ($10,000 minimum investment, lower expense ratio). Owning a fund that invests in both stocks and bonds reduces your risk. Lower risk, in turn, increases the odds that you won't panic and sell in a bear market.

Let's make this real. Vanguard Balanced lost 22.21 percent of its value during 2008. And that wasn't the end of it - the market continued to decline in the early months of 2009.

Sound terrible? During the same period, SPY, the ETF index fund that tracks the S&P 500, lost 36.81 percent. Lots of people bailed in early 2009 and many are still sitting in cash. Other funds lost more.

The lesson here is that unless you have an iron stomach, either invest in a fund that combines asset classes for you, or buy two or more funds in different categories. That, by the way, is why I created the Couch Potato portfolios. They allow you to start with a two-fund portfolio and expand to a portfolio of 10 different asset categories, with nominal expense and great simplicity. You can read more about it on my website: assetbuilder.com/couch_potato/couch_potato_cookbook.

It is now very easy to build this kind of portfolio at a variety of different firms, such as Vanguard, Fidelity and Schwab. All three allow you to put together exchange-traded index fund portfolios without any commission expense.

• Scott Burns is a principal of the Plano, Texas-based investment firm AssetBuilder Inc., a registered investment adviser.