First, a confession.
Nearly 20 years ago, when I was in my mid-thirties, I got a chance for the first time to manage my own tax-deferred retirement portfolio. I was confronted with the same choices as the 42 million Americans who now have 401(k) plans and the millions of others with federal Thrift Savings Plans. I blew it. I put the whole thing into bonds — specifically GICs, or fixed-rate “guaranteed investment contracts.” I figured that this was my nest egg, so I shouldn’t fool around with it — better to get a certain 6 percent than to risk the money in the stock market.
I didn’t know much about investing at the time, but I learned — and I moved from bonds to stocks. What I learned was this: If you can’t touch your money until you retire, 20 or 30 years from now, then you have a spectacular opportunity. You can take advantage of the particular quirk offered by the stock market. In the short run, stocks are very, very risky. But over most long periods, history shows that stocks have been no more risky than bonds — and they produce average annual returns that are twice as high, 11 percent vs. 5.5 percent.
Americans are at last absorbing this basic truth about investing. An extensive study of the contents of 11.8 million 401(k) plans, released last week, found that three-quarters of plan balances were invested directly or indirectly in equity securities — mainly through stock mutual funds. Researchers for the nonprofit Employee Benefit Research Institute and the Investment Company Institute, the mutual fund trade association, found that for the average 401(k), the proportion of total assets invested in stocks rose by one-sixth between 1996 and 2000. At the same time, the proportion invested in GICs dropped by two-thirds, in conventional bonds by one-quarter, and in money-market funds by one-fifth.
This is very good news because throughout the 1980s and much of the 1990s, most people had far too much money in bonds and cash and not enough in stocks. The study also found that investors in their twenties and thirties had one-third more of their assets in stocks than investors in their fifties and sixties. That makes sense, too. When you are close to retirement, a sharp stock-market decline can be devastating since you don’t have the time to recoup the loss before you need to withdraw your money.
The process of dividing investments into categories — mainly, stocks, bonds and cash — is called “asset allocation.” Academic studies show that the proportion that you assign to each category is far more important than the particular stocks and bonds and mutual funds you pick within the category. But — face it — allocating assets is nowhere near as much fun as picking stocks.
The basic rule is simple: The younger you are, the more stocks you should own. Unless you can’t sleep at night, a retirement portfolio that’s composed entirely of stocks may be appropriate for investors in their twenties and thirties, but a 50-50 or 60-40 split between stocks and bonds (with a little cash on the side) is better for the average 60-year-old.
Some portfolio analysts, however, believe that even young investors should own bonds. Bernstein Investment Research and Management in New York is probably the most articulate advocate of this approach. In a recent study, Bernstein argued that all portfolios should balance risk and reward, and the best way to do it is by owning asset categories that have a “low correlation” to each other — that is, when one category goes down, the other tends to go up.
Stocks and bonds are wildly uncorrelated. “In 10 of the 11 years since 1950 in which U.S. stocks declined, the bond market made money,” says the Bernstein study. “In the eight bear stock markets of the past 30 years, bonds always made money, and sometimes lots of it.” For example, between March 2000 and June 2001, the Standard & Poor’s 500-stock index, the equity benchmark, dropped 9 percent, but five-year U.S. Treasury bonds returned 15.4 percent, counting both interest and price increases (when rates fall, bond prices rise).
Bernstein has concocted what it calls a “fully diversified portfolio,” or FDP — 55 percent conventional stocks; 10 percent REITs (real estate investment trusts, which are shares that represent ownership in diversified properties, usually within a theme, from hospitals to outlet malls to resort hotels); and 35 percent medium-term bonds (generally maturing in two to six years). The conventional stocks are divided up this way: 19 percent growth stocks (companies with fast-rising earnings but also relatively high prices), 19 percent value stocks (overlooked companies that appear to be bargains), 14 percent stocks of major foreign companies, and 3 percent stocks of companies in emerging markets. In my opinion, the particulars of diversification within that category aren’t very critical, though you should have a mix of growth and value, large and small, choosing from the best countries around the world, wherever they are.
Between 1981 and 2000, this FDP asset allocation produced average annual returns of 13.7 percent, compared with 15.7 percent for an all-stock portfolio (represented by the S&P). But the FDP cut volatility by one-third. That’s very impressive.
“For many people,” says the Bernstein report, “that smoother ride means greater peace of mind, and a greater likelihood you’ll have the money when you need it.” And the FDP made a lot of money: an investment of $10,000 grew to $130,000.
But is the trade-off — two points of annual growth for a lot less risk — worth it? Not for investors who can ignore the short-term ups and downs of their 401(k) balances and who absolutely don’t need the money for a long time. But for investors who are more anxious and have a shorter horizon — yes, absolutely. Investors who, like most of us, fall between these two poles can modify the Bernstein formula.
Still, never underestimate the fear factor. Volatility is frightening. It may force you into bad mistakes, like bailing out of stocks entirely, at just the wrong time. And the fully diversified portfolio does prevent bad things from happening to good investors. For example, Bernstein measured the FDP’s results against the S&P as a whole during several rocky periods. Between September and November 1987, the S&P dropped a scary 30 percent, but the FDP lost only about half that: 16 percent. More recently, from April to December 2000, the S&P fell 11 percent, but the FDP actually rose 4 percent.
One of the keys to the FDP’s success is that dose of REITs, which, like bonds, have very little correlation to stocks. For the 20 years ending in 2000, the REIT index returned 12.4 percent, but volatility was strikingly low. Tax law requires REITs to pay out nearly all their earnings to shareholders in dividends, and that flow of cash adds stability to a portfolio. For example, Archstone Communities Trust, a Denver-based REIT that specializes in garden apartments, recently merged with Charles E. Smith Residential Realty, a large Washington-area firm, to form Archstone-Smith Trust. Based on the expected payout this year, the REIT has a dividend yield of 6.4 percent, compared with 4.9 percent for 10-year Treasury bonds. While the dividend itself is not guaranteed, the way bond interest is, Archstone has been remarkably consistent. The lowest yield in the past 10 years was 4.4 percent, but in eight of those 10 years it has been at least 5.7 percent.
Cohen & Steers Realty Shares, the top pick of the No-Load Fund Investor newsletter, is probably the class of the REIT mutual-fund field. Top holdings include some of the largest firms, including Equity Office Properties Trust, with a 6 percent yield; Simon Property Group (shopping centers), 7.3 percent; and Health Care Property Investors, 8.4 percent. Through Wednesday, the Cohen & Steers fund was up 3 percent for the year including dividends (compared with a loss of 13 percent for the S&P). Its 10-year record is almost precisely the same as the equity benchmark: 12.7 percent average annual return.
Another fund with a superior track record is Fidelity Real Estate Investment, up 15 percent over the past 12 months. The fund’s top holdings include Apartment Investment & Management (currently yielding 7 percent); Equity Residential Properties Trust, run by legendary bargain hunter Sam Zell (6.2 percent); and Crescent Real Estate Equities, whose CEO, Richard Rainwater, won fame as manager of the Bass family fortune (8.6 percent).
But Robert Mitkowski Jr., analyst for the Value Line Investment Survey, warns of Crescent: “We’d avoid these untimely shares.” He’s worried about the collapse of the high-end Arizona housing market, and he notes that Crescent recently cut its dividend to $1.50 a year. That’s still a hefty number for a stock trading at $17.42, but dividend-cutting is a bad sign. No one ever said that REITs carry no risk.