Common sense and investing

by Stephen Butler

Ford family members who still own 40 percent of their family's company have gathered once again to discuss what to do about their once $2 billion that has shrunk to $150 million. The dent in my retirement plan began to feel more like a door ding by comparison, but stories about such huge reversals of fortune prompt me to question conventional wisdom.

Playing to my paranoia, Newsweek magazine begged a provocative question with last week's article entitled, "Are stocks still good for the long run?" Since timing can be everything, my question would be, "Why does anyone choose to do these comparisons on the heels of one of the greatest market downdrafts in history?"

Newsweek's article amounts to little more than tossing some red meat to individual investors who have lost confidence in the stock market. It makes a case for the fact that the financial services industry has duped us all. We probably should have been in bonds all these years, or better yet, in Treasury Inflation Protected bonds otherwise known as "TIP's."

I don't think so. Whenever I want a straight answer to questions like this, I turn to my dog-eared copy of Burton Malkiel's "A Random Walk Down Wall Street." This book constitutes the high water mark when it comes to an honest assessment of what can be accomplished in today's financial markets. Princeton professor Malkiel's jaundiced view is refreshingly disrespectful of an industry that takes itself too seriously, and he points out how to generate higher yields while reducing risk.

Malkiel's advice is to diversify into other asset classes so that, in addition to U.S. stocks, there are foreign stocks, emerging market investments and real estate through REITs. On paper, this diversification reduces stock-oriented risk by as much as 70 percent. To some extent, we have seen this reflected in just the past few months as real estate and emerging markets have been surpassing overall market results.

If you throw in bonds of roughly 40 percent of a portfolio, you reduce that remaining stock-based risk by 38 percent. Comparisons of stocks to bonds generally assume that all stock portfolios are nothing more than S&P 500 index funds. The comparisons don't know that we're already diversified well beyond the broad market averages and that we can expect higher returns as a result.

So much money management involves not so much arithmetic and analysis, but just practical common sense. If you're someone who has just watched your retirement account drop by half (and then subsequently rise to what is now "only" a 20 percent loss,) it is tempting to ask whether or not there might be a less volatile alternative.

Here's where the common sense comes in: We all tend to base our "loss" on the account balance we enjoyed on Sept. 30th of 2007 - an arguably artificial high point that generated a long-term 10 percent return over the previous 20 years. A year and a half later, thanks to a collapse of the financial markets and a $200 billion "tax" created by higher gasoline prices, we have a market that is responding to those "Black Swan" or otherwise unlikely events. This is not the time to be comparing bond returns to those of stocks. Of course bonds would look better - right now.

The next tidbit of common sense has to do with the nature of most investing done by Americans today. By far, most people investing in mutual funds are doing so with regular contributions to retirement savings accounts. This means dollar cost averaging where a steady infusion of new money at a fixed dollar amount benefits from temporary market downdrafts.

Funds are purchased during these downturns at cheaper share prices. None of these comparisons take that mechanism into consideration. They assume we're all like the Ford family with a single infusion of old money. Malkiel's book points out that dollar cost averaging into a typical growth stock fund from the mid 70s to the end of the 1990s generated about $250,000 from $100 monthly contributions totaling about $30,000. No bond fund during the same period would have accumulated anything even close.

For those staying the course into the future, something comparable can be expected with a little patience. Unlike the Ford family squabbling over their wasting trust, most of us are still building for the future. Time-tested fundamentals will see us through the bumps along the way.

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