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Vanguard - As Wall Street wobbles, the impact on diversified portfolios is muted
 
 

As Wall Street wobbles, the impact on diversified portfolios is muted

On September 15, 2008, Lehman Brothers Holdings Inc. announced that it would file for Chapter 11 bankruptcy protection. When the New York Stock Exchange opened, Lehman Brothers was trading at pennies per share. Long before the bankruptcy filing, however, the company had lost much of its value. A year ago, the stock was trading at about $60 a share. On Friday, the stock closed at $3.65.

Lehman Brothers' demise is the latest illustration of the ongoing turmoil in the financial sector, much of it related to mortgage-backed securities that have lost value as the housing market has deteriorated. During the 12 months ended August 31, 2008, the banks, brokerages, and insurance companies that make up the financial sector returned about –30% (see table). The broad U.S. market has fared better comparatively, returning about –10% during the same period.

Lehman is one piece of the puzzle

Gus Sauter on the market turmoil

In this video interview, Gus Sauter, Vanguard's chief investment officer, offers his thoughts on the resiliency of our financial system. Watch now »

A number of Vanguard stock funds have some exposure to Lehman Brothers, though no fund held more than 0.70% of net assets in Lehman stock as of Friday. Vanguard Total Stock Market Fund and Vanguard 500 Index Fund, Vanguard's two most widely held funds, each had 0.02% of net assets in Lehman Brothers stock.

Among Vanguard's fixed income funds, exposure was similarly modest, with no fund holding more than 0.78% of net assets in Lehman Brothers' securities. Vanguard Total Bond Market Index Fund, Vanguard's largest bond fund, held 0.25% of its net assets in securities issued by Lehman Brothers.

More significant than the performance of any single stock or bond has been the broad-based weakness among financial companies. Even after its recent decline, the financial sector accounts for a relatively large share of the stock market's value; it comprises almost 15% of assets in Vanguard Total Stock Market Fund, for example. Most diversified funds have some exposure to these stocks.

"Over the past few years, many financial companies borrowed heavily to buy assets that turned out to be riskier than expected," said Gus Sauter, Vanguard's chief investment officer." As they try to clean up their balance sheets, some will fail. But I'm confident that we're making progress. Markets are resilient. We've worked our way through crises before."

Clients remain calm

After the Lehman bankruptcy was announced, we fielded a flurry of calls from shareholders with questions about their funds' exposure to Lehman Brothers and the other financial giants in the headlines: Merrill Lynch, which has agreed to be bought by Bank of America, and AIG, the insurance giant, which is struggling to raise capital and preserve its credit rating.

In general, however, investors seemed to be taking these developments in stride. "The news is unnerving, no doubt about it," said Mr. Sauter. "But most of our clients hold portfolios that are designed to weather these periods of turbulence. The keys are balance and diversification."

The benefits of balance
  Total return (12 months ended August 31, 2008)

MSCI US IMI Financials Index

–30.3%

MSCI US Broad Market Index

–10.0%

Balanced Index*

–3.9%


* 60% MSCI US Broad Market Index, 40% Lehman US Aggregate Bond Index.

Source: Vanguard, MSCI, Lehman Brothers.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

During the 12 months ended August 31, 2008 for example, a portfolio with 60% of its assets in the MSCI US Broad Market Index and 40% in the Lehman US Aggregate Bond Index returned about –3.9%, as the bond allocation offset some of the stock market's weakness. Not great, but not the catastrophe that the headlines might imply.

As they have in crises past—the junk-bond meltdown in the early 1990s, the collapse of the tech-stock bubble in 2000—the time-tested principles of diversification and balance, fortified by a long-term perspective, will most likely prove the most productive response to the market's recent turmoil.

Notes

  • All investments, including a portfolio's current and future holdings, are subject to risks.
  • Investments in bond funds are subject to interest rate, credit, and inflation risk.
  • Diversification does not ensure a profit or protect against a loss in a declining market.

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