Special Report on Investments and Personal Finance : Return to Simplicity : First Quarter Special Report on Investments and Personal Finance
A simple approach to making money served investors just fine in the first quarter. And the lessons learned from that turnabout may be good for a lifetime.
After two years in which exotic investments and strategies boomed, then busted--from Third World stocks to high-risk bond bets to derivative securities--Americans have gone back to the basics this year.
Blue chip U.S. stocks roared back to popularity in the first quarter, surging to record highs while most foreign stock markets were tumbling. Banks and S&Ls; drew about $60 billion in cash into federally insured small savings certificates in the quarter, the biggest inflow of this decade.
And when they shopped for bond investments, many people opted not for open-ended mutual funds, but for individual U.S. Treasury issues or insured municipal bonds--securities with principal repayment guaranteed.
“That’s where the money flowed in the quarter: It was definitely toward the simple,” said Neal Litvack, executive vice president at mutual fund giant Fidelity Investments in Boston.
Cynics might call investors’ Forrest Gump-like attitude nothing more than a knee-jerk reaction to rising bank CD yields, the bond market’s 1994 crash and the harrowing collapse of some formerly hot Third World stock markets, led by Mexico.
After all, it’s human nature to chase what’s in vogue and ignore what’s not. Securities are the only universally desired product that consumers often avoid when prices decline--even though that’s illogical and usually wrong.
But something else may be motivating small investors who are thinking in back-to-basics terms--a realization that their portfolios have become too complicated in recent years, perhaps too diversified. And maybe, overall, too risky.
Consider the hypothetical case of two investors who each had $20,000 cash on Dec. 31, 1984, about 10 years and three months ago. Both chose to invest all their money in stock and bond mutual funds.
Investor No. 1 wanted a well-diversified portfolio, so he picked funds from eight investment categories and divided the money among them: growth stocks, small stocks, bonds, utility stocks, natural resources stocks, gold stocks and two types of foreign-stock funds.
Investor No. 2 also wanted diversification, but without a lot of complexity. So she divided the money evenly among four fund categories: growth stocks, small stocks, international stocks and bonds.
After 10 years, who came out ahead--not accounting for taxes?
If each investor’s funds performed in line with category averages, investor No. 1 had $61,586 at the end of the period, but investor No. 2 ended up with $68,850--a bigger return, and arguably for less work and less risk.
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Admittedly, the time frame and fund categories used in the example are arbitrary. Depending on the funds selected, an investor’s real-world experience could have been vastly different--either much better or much worse than the category averages.
But if you’re trying to look 10 or 20 years ahead, to retirement or your child entering college, all you can rely upon in building an investment portfolio is logic and hope. And often, what is logical is pretty simple.
How to tell if your portfolio contains logical choices for you? It’s not whether you made or lost money last quarter. The questions to ask are whether you can easily explain why each element is there and how its proportion--relative to the portfolio overall--fits your long-term goals.
Investing too cleverly for one’s own good is a common trap, financial consultants say. Gib Kerr, a Culver City-based financial planner, says his first task with most new clients is to sort out what they own and offer a plan for simplifying the portfolio.
“People usually have investments scattered all over the place,” Kerr says. New clients may own six different bond mutual funds, he says--and may long have forgotten why they bought (or rather, were sold ) any of them.
The first step in portfolio simplification is to decide on what’s called strategic asset allocation: how to split your investment portfolio, including all retirement accounts, among stocks, bonds and “cash” accounts (such as CDs or money funds).
Every investor will have a different comfort level in strategic allocation, of course. But the basic advice put forth by the legendary Benjamin Graham in his 1949 book “The Intelligent Investor” is as valid today as ever, experts say.
That advice begins with stocks, which--however volatile--are the only proven ticket to long-term asset growth other than well-chosen real estate. Wrote Graham: “As a fundamental guiding rule the investor should never have less than 25% or more than 75% of his funds in common stocks.”
Young investors and those willing to accept short-term risk for better long-term return should skew to the upper end of Graham’s range; older investors and the more risk-wary ones would skew toward the lower end. All should then take the same basic vow of patience.
After deciding on your stock allocation, the balance of your portfolio would be kept in bonds and cash. How much in each sector? Again, that depends on your age, your needs and your risk tolerance.
Their 1994 performance notwithstanding, the allure of bonds is that they offer greater long-term stability of principal than stocks, along with a reliable income stream. Cash accounts do the same, but because they generally provide total stability of principal (that is, extremely low risk), you would expect returns on cash also to be lower in the long run, as indeed they are.
Viewed in the context of strategic asset allocation, some aspects of the back-to-simplicity investing theme over the last few months do appear logical. Imagine quite a few investors who loaded up on stocks and bonds in the great bull market of 1990-93 suddenly realizing in 1994 that the one asset they didn’t build up was cash--that cushion which, while small, lets you sleep better at night.
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For most investors, strategic asset allocation is the easy part. Tactical asset allocation-- which stock, bond and cash investments to own and how much of each--is far more difficult.
The natural tendency is to think that more variety is better. That may be true with individual stocks, but in the case of mutual funds, financial consultants say, less may ultimately be more.
John C. Bogle, chairman of the Vanguard Group of mutual funds in Valley Forge, Pa., says that, depending on your goals, time horizon and risk tolerance, you might own as many as eight different funds or you might be happy with a single “balanced” fund that typically keeps 60% of its assets in stocks and 40% in bonds.
Why not spread your money over dozens of funds? In his book “Bogle on Mutual Funds,” the Vanguard chief notes that “while many investors own 10 funds or more, superior returns in one fund are often offset by inferior returns in another.”
The result: You may be paying each fund high management fees to produce what in the end is only an average market return.
“Over-diversification is very easy to do when you have the number of mutual funds we have today,” says Heidi Steiger, managing director of individual asset management at the New York financial advisory firm Neuberger & Berman.
Because it’s an easy decision to buy a fund but emotionally difficult to sell, Steiger notes that many people wind up after 10 years or longer investing in a jumble of funds rather than a sensible, well-directed portfolio.
“They might all be top-rated funds, but that doesn’t necessarily mean you’re accomplishing your objectives,” she said.
Here’s her idea of an intelligent tactical makeup of a $50,000 stock portfolio:
* $30,000 split between two funds that own large, quality U.S. stocks--perhaps one fund with a “growth” approach (consumer stocks) and the other with a “value” approach (industrial, financial, utility stocks). Such blue-chip companies are the backbone of the economy, Steiger notes, so it makes sense for them to be the backbone of a portfolio.
* $10,000 split among three U.S. small-stock funds. Because the risk is higher with smaller companies--and the potential returns greater--using three small-stock funds provides better odds that one of the three will score big.
* $10,000 split between two broadly diversified international stock funds, to tap into economic growth overseas not fully exploited by U.S.-based companies.
How long do you keep your funds, and keep adding to them? For as long as they meet your objectives, which doesn’t necessarily mean beating the market every year. Assuming a fund’s long-term performance keeps up with the market, “if it ain’t broke, don’t fix it,” says Steiger. Long-term compounding of returns is a powerful vehicle.
For the bond portion of your portfolio, if any, things get simpler still. Bonds are in many ways generic securities, unlike stocks, and so the variance of returns in the bond market is much narrower than in the stock market.
What affects bond returns most are changes in market interest rates. Thus, apart from basic issues of safety--do you want U.S. government bonds, or higher-yielding but less safe corporate or municipal bonds?--your choice of bonds or bond funds should be based largely on the term of securities you want to hold.
The longer a bond’s term, the higher its yield--but the greater the susceptibility of its principal value to market interest rate changes.
Bogle says simply: “You should hold the smallest number of bond funds needed” to shape the desired term of your bond portfolio. Period.
In 1993, as interest rates hit 20-year and 30-year lows, many investors snapped up the longest-term--and thus highest-yielding--bonds they could find, forgetting about the risk to their principal if market rates were to rise. Which they did.
Since last year’s rate surge and the damage done to long-term bond values, Steiger sees many investors reshaping their bond investments by focusing exclusively on shorter-term (one- to five-year) and intermediate-term (five- to 10-year) bonds and bond funds. That’s simpler and much more logical, she says.
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What about all those exotic mutual fund categories--”emerging market” stock funds, for example, and industry-specific funds?
Most financial consultants consider them to be purely speculative bets because of their tremendous volatility. If you have the wherewithal to dedicate a small portion of your portfolio to speculative securities, go for it, some experts say. Just don’t regard exotics as core portfolio holdings, no matter how good their recent performance. Booms, after all, are made to go bust.
Michael Lipper, head of fund tracker Lipper Analytical Services in New York, advises thinking of most exotic fund categories as spice for your portfolio. “If you want more spice, you have to realize that it will occasionally give you heartburn,” he says.
If all of this sounds elementary, maybe that’s the point. And maybe that’s what is motivating many individual investors to buy U.S. blue-chip stocks this year, fortify their cash reserves and avoid long-term bonds, despite the recent rally there.
Master investor Warren Buffett once said: “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
Bogle puts it another way. Of his “12 Pillars of Wisdom” for individual investors, the first is: “Investing is not nearly as difficult as it looks.” No. 2 is: “When all else fails, fall back on simplicity.”
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Plain and Fancy
The investment world is a complex place, but the instinct to mirror that complexity in your portfolio won’t necessarily pay off. An investor who sank $20,000 at the end of 1984 into an elaborate portfolio betting on a full gamut of mutual fund categories would have had less 10 years later than one whose investments were restricted to four basic fund groups.
* Fancy Portfolio
Gowth: 16.7%
Small Cap: 16.7%
Fixed Income: 16.7%
Utilities: 16.7%
Natural Resources: 8.3%
Gold: 8.3%
International: 8.3%
Global: 8.3%
Investment 12/31/84 Sector Value 12/31/94 $3,333 Growth $11,299 $3,333 Small Cap $12,365 $3,333 Fixed Income $7,966 $3,333 Utilities $9,132 $1,666 Natural Resources $3,965 $1,666 Gold $3,282 $1,666 International $7,130 $1,666 Global $6,447 $20,000 Total $61,586
* Plain Portfolio
Growth: 25%
Small Cap: 25%
Fixed: 25%
International: 25%
Investment 12/31/84 Sector Value 12/31/94 $5,000 Growth $16,950 $5,000 Small Cap $18,550 $5,000 Fixed Income $11,950 $5,000 International $68,850 $20,000 Total $68,850
