When the stock market comes off a very strong year, investors naturally worry that the gravy train is about to be sidetracked. It was no surprise when The Wall Street Journal year-end review of mutual funds cautioned that “This year, many fund managers say, the pessimists could be right and the markets could take a dive.”
That article was published last year, on January 5, 1996. The U.S. stock market went on to a second consecutive banner year, with the Standard & Poor’s 500 index up more than 20% on top of 1995’s 34% advance.
So much for taking a dive. This goes to show not the ignorance of the pundits, which remains debatable, but the futility of trying to time the markets. Yet investors from the swashbuckling fund manager to the toe-in-the-water novice persist in this most counterproductive behavior.
I can tell you with 100% certainty that the market will crash, but I can’t tell you when. Nobody else knows, either. What we know is that while the market has advanced at a healthy clip for the past century, it has been an advance punctuated by shocks, stalls and slowdowns, some of which last for years. Meanwhile, the market’s upward moves have often come in brief, sharp rallies that leave behind investors who are prone to be “defensive” when things look bad. The successful investor must accept the bad times with the good.
Remember Jeff Vinik, former manager of Fidelity’s Magellan Fund? Many people believe he was pushed out of that job for betting on bonds in the first months of 1996, which turned out to be a bad time for bonds and a good time for stocks. To my mind, however, Vinik’s sin — if any — was not that he picked a bad time to invest in bonds, but that he invested in bonds at all, given that his fund’s owners thought they were paying him to invest in stocks. Maybe he owed it to his shareholders to deliver stock performance even if stocks performed like a dog.
Back in 1985 another money manager decided that stocks just could not keep climbing as they had since the bull market began in 1982. A couple of my clients stuck with this manager as he missed the rise of 1986-87, the October 1987 crash that briefly made him look good, and the recovery from that crash which segued into the recent record market highs. The Dow has about tripled since this manager turned bearish, and as far as I know he is still waiting for Armageddon. Someday he may be right, but at what cost?
A More Rational Approach
The route to success for small investors is neither difficult to understand nor hard to travel. First, you have to know your financial goals and your personal willingness to withstand market downturns without selling. Next, you have to allocate your investment portfolio among stocks, bonds, cash and perhaps other investments in a way that is consistent with your goals and risk tolerance. Most important, you should be diversified across companies, industries, countries and investment-selection philosophies.
Then all you have to do is wait. If markets perform the way they have performed for many years, you will do quite well.
A few caveats are in order. Before you treat any money as part of your investment portfolio, you probably will want to set aside a cash reserve to cover personal emergencies, an unexpected loss of a job, etc. For most people this cash cushion should equal three to six months’ spending, with a bias toward the high side if you are a one-income household.
Also, any money that is invested in equities such as stocks or real estate should not be money that you expect to spend within the next five years, at least. If you are accumulating funds for a down payment on a house, for example, you will be better off putting the money in a short-term bond fund or money market fund, rather than risk having to postpone your house purchase if the stock market chooses that particular time to tank.
If your portfolio is less than $1 million I believe that as a rule you should own only mutual funds, not individual stocks and bonds. Mutual funds allow lower costs (though some are quite pricey), professional management and better diversification. I have heard all the arguments about “laddered” bond portfolios, razor-sharp research staffs and customized stock selection, but basically I think this is hooey. The exceptions are in odd situations such as if you own very high-value, low-basis stock, and even in these situations diversification is important, though some specialized planning may be needed. I have some clients who run multi-million-dollar portfolios strictly through mutual funds quite successfully.
Developing an Asset Allocation Plan
Modern portfolio theory teaches that for every level of risk tolerance, there is one combination of stocks, bonds and other investment products that offers the maximum expected investment return. When we consider a broad range of risk levels, the various combinations of optimum portfolios produce a spectrum of expected returns that is called “the efficient frontier.” Your goal in developing your portfolio should be to come as close as possible to the efficient frontier for your preferred level of risk.
While I have no quarrel with the theory, the reality is that most of us do not adjust our portfolios every day to keep our asset mix at the optimum combination. Moreover, the selection of an optimal portfolio mix — which is almost always done by computer — depends on the amount, quality and time period of the data you consider. Does the computer look only at stocks, bonds and cash? Does it consider only the stocks in the S&P 500, or smaller stocks as well? What about non-U.S. stocks? What about other investment opportunities — real estate, gold, baseball cards?
Modern portfolio theory is fine for those who understand its scope and limitations, and whose advisers have the software to use it effectively. Other folks can approximate the results with a simplified approach, which is a lot better than nothing.
First, decide what is the largest sudden drop in value you could withstand without feeling the need to bail out of the stock market. Let’s suppose your personal loss limit is 30%. Next, assume that the stock market could get clobbered with a 50% loss overnight. Since you want the total drop in your portfolio not to exceed 30%, this sets a limit on stocks in your portfolio at 60% of your total investments.
The remaining 40% goes to bond or money market funds. Use a money market fund for any amount that is part of your three- to six-month cash cushion, and use a money market fund or a bond fund with an average maturity of two years or less for any amount above that which you might need to spend within the next two years. The remaining bond money should go into a bond fund with an average maturity no longer than seven years. Consider tax-free funds if your combined federal and state tax rate is over 30%, and give tax-frees a very close look if your combined rate is 40% or more.
While there is sometimes a case to be made for bond funds that use longer maturities, these are much more volatile investments because they are sensitive to interest rates. As a result, they require almost as much attention as stocks, and they are not a good choice for dampening the volatility of a stock portfolio.
Where To Put It
Now for the hard part: Deciding where to put the 60% that is going into stocks.
A good general guideline would be to have 20% to 40% of the stock portfolio, which in this example would be 12% to 24% of the total portfolio, in non-U.S. companies. Most of this should be in companies based in developed countries and trading on developed markets: In Europe along and west of a Finland-Germany-Austria-Italy axis; in Japan and arguably South Korea; and in Canada, Australia and New Zealand. Everywhere else is the developing world. There are loads of exciting companies and opportunities in places like Latin America, Asia, central and eastern Europe and elsewhere, but all of these places lack the physical, legal, political or financial infrastructure to support stable democratic governments, free economies and efficient stock markets. They should constitute no more than 5% to 10% of a stock portfolio.
The U.S. portfolio should be built around a core of large, established companies, with one attractive vehicle being a low-cost index fund like the Vanguard Index 500. Smaller U.S. companies should represent 10% to 20% of the portfolio. Try to maintain a balance between growth-oriented stock selection, which tends to crowd into high-flying sectors that take dramatic plunges, and value-based selection whose stocks often have relatively little downside risk.
Most important, treat your portfolio as a long-term vehicle and ignore the noise of daily, weekly or even quarterly market moves. They don’t matter, except when they cause you to abandon your well-thought-out program.