As the stock market falls for the third straight year — something that hasn’t happened since 1941 — I get asked three questions: 1. When will it end? 2. Why is it happening? 3. What should I do?
The third question is by far the most important, and the answer is fairly simple. But let me first dispose of the other two.
When will the slide stop? No one knows. Already, the decline is the second-worst since World War II, according to the scorekeepers at Bridgewater Associates in Wilton, Conn. The benchmark Standard & Poor’s 500-stock index has dropped 44 percent from its peak on March 24, 2000. But picking a bottom is a fool’s errand. What we know about bear markets is that they always end. Since 1931, a basket of S&P-style stocks has never lost money in any overlapping 10-year period (e.g., 1931-41, 1932-42, etc.), and since 1938 the market has lost money only three times in five-year periods.
The second question is a good subject for chitchat among politicians and economists but largely irrelevant to investors. Repeat after me: Despite all the verbiage on CNBC, one rarely knows why stocks decline in the short term. The financial markets are unbelievably complex places, and it’s irresistible to opine that this or that event or trend is influencing prices. (Hey, I do it all the time!) When the pundits can’t pinpoint a reason, they say that stocks fell on “profit-taking” or that they rose on “bargain-hunting.” Nonsense.
Ultimately, the price of a stock today reflects the long-term expected profits that a company will make over its lifetime, and accounting scandals, terrorist threats and currency fluctuations (not to mention the most important thing: what’s happening within the business itself) can affect those expectations.
The main factor, of course, is the economy, and, try as they might, economists can’t forecast it very well in the short term. Right now, the economy looks healthy, though not robust, for the rest of this year. That’s what Alan Greenspan told Congress, and it’s what most experts believe.
The Economist magazine’s survey, for instance, finds professionals on average estimating that gross domestic product (GDP, or the total output of goods and services) in the United States will grow 2.8 percent this year and 3.5 percent the next. Those figures are higher than for any developed country in Europe or Asia. By historic standards, they are low for a recovery after a recession, but the 2001 recession was mild.
Could the economy slow again soon, or go into a “double dip”? Economy.com, an excellent subscription Web site, has concocted a risk-of-recession index to predict downturns in the next six months. Currently, the index stands at 11 percent, compared with 14 percent in February and 43 percent after the terrorist attacks last September.
Because the economy seems decent and the stock market is falling, many commentators are stumped by the disconnect between the two. But market prices and real-world performance don’t march in lockstep. Day to day, the emotions of investors affect prices, but over the long term a good economy always means a good stock market. That’s really all you need to know. If you think the U.S. economy is sound in the long term, then you can expect stocks to continue to produce the same annual returns, on average, that they have throughout history — about 11 percent a year including inflation and 7 percent to 8 percent in purchasing power.
Finally, what to do?
The answer lies in two boring words: “asset allocation.”
Of all the decisions you will make in your investing life, your choice of how to divide up your money among financial categories is the most important. By far. All the academic research says so, and it’s obvious. What matters is not so much which individual stocks and bonds you pick, but the proportion you assign to each asset.
It is encouraging that, during an hour-long Internet discussion with readers on washingtonpost.com last week and in many recent e-mail messages, most of the reader questions I received were not about fleeing the market but about allocating assets within it. “How much money should I put into stocks if I am retiring in 10 years?” asked a 52-year-old. “My portfolio is 50 percent bonds. Is that the right amount in times like this?” asked a 35-year-old woman.
Asset allocation, or AA, begins with self-analysis. What are your needs, desires and fears? Most people figure they will need money in retirement, and most investing is geared to building a nest egg. If you are in your twenties, thirties or forties and expect to retire in your mid-sixties, then it makes sense to put the vast majority of your retirement money into stocks. But be sure you allocate within the allocation, that you balance your holdings of large-caps with small-caps, finance with technology, consumer stocks with real estate. As you approach retirement, money should come out of stocks and into bonds and cash.
Make your asset-allocation plan now and don’t change it because of market conditions. Stock and bond prices will rise and fall, but your plan should endure. In fact, the most responsible action you can take today, in the face of a frightening market, is to sit down — either on your own or, as I prefer, with a good financial adviser — and set a serious, simple AA strategy.
The three asset categories are stocks, which represent ownership in a business; bonds, which are IOUs for loans you make to companies or government agencies; and cash, which is very short-term debt, in the form of Treasury bills, certificates of deposit, money-market funds or bank deposits. In the short term, there is a clear continuum: Stocks produce the highest returns, but they are the most risky; cash produces the lowest returns, and it is the least risky; bonds fall in between.
The nature of stocks is that they return far more than the other assets, but they are also more risky in the short term; that is, they bounce wildly up and down. For example, Ibbotson Associates, the Chicago research firm, found that from 1926 to 2001, large-cap stocks (like those in the S&P 500) returned an average of 10.7 percent a year while U.S. Treasury bonds returned 5.3 percent and cash (T-bills) returned 3.8 percent. But the standard deviation (a fair measure of risk) for stocks was 20 percent annually; bonds, 9 percent; cash, 3 percent.
Over longer periods, however, the riskiness of stocks declines so that, according to economist Jeremy Siegel of the Wharton School of the University of Pennsylvania, “the safest long-term investment has clearly been stocks and not bonds.” The standard deviation over 20-year holding periods is about the same for the three assets.
That’s the case for stocks in the long run. And it is always the case. Through thick and thin. Through bear markets and bull markets. Yes, it would be wonderful if you could pull your money out of stocks just before the market tanks and put it back just before the market booms. But such exploits in market timing rarely prove successful.
The reason AA is so important is that, over long periods, differences in the returns widen among different asset groups. In a single year, the gap between a stock that returns an average of 11 percent and a bond that returns an average of 5 percent is minor.
But over an investing lifetime, consider this: You put $600 a month into a portfolio that’s allocated 70 percent to stocks and 30 percent to bonds. The average return of such a portfolio, based on three-quarters of a century of history, is about 9 percent annually. At the end of 30 years, your nest egg will exceed $1 million, according to a handy calculator from TIAA-CREF, the large pension-management firm.
Now imagine you put the same $600 a month into a portfolio that’s allocated 20 percent to stocks and 80 percent to bonds. At the end of 30 years, you will have $588,000. With the 70-30 allocation, you will end up, incredibly, with two-thirds more retirement income than with the 20-80 allocation.
In a fascinating letter to clients recently, Todd E. Grady of David L. Babson & Co., a Cambridge, Mass., investment management firm, explored “the miracle of compound interest.” Compound interest, writes Grady, “is when the interest paid to you is on both the original principal and the accumulated reinvested interest.” It’s the interest on the interest — or, in the case of stocks, earnings (that is, dividends and rising stock prices) on top of earnings.
Grady cites the classic example of Peter Minuit’s purchase of Manhattan from Indians in 1626 for $24 worth of trinkets. Compounded at 6 percent annually (an aggressive bond rate), that $24 would be worth $78 billion. Compounded at 10 percent annually (slightly below the average stock return), $24 would become $87 trillion — or about nine times as much as last year’s GDP.
In 1791, Benjamin Franklin, the American hero I admire most, gave the cities of Boston and Philadelphia each $5,000 with the stipulation that after 100 years each could withdraw $500,000 for worthy projects. By 1991, the remaining funds had grown to $20 million per city.
Ibbotson calculates that, if you had invested $1,000 in a basket of large-company stocks in 1926, you would have $2,279,000 by the end of 2001. The same amount invested in bonds would have grown to just $51,000; in Treasury bills, to $17,000.
But what about inflation and taxes? Taxes hurt bonds (whose interest is taxed at the higher ordinary-income, rather than capital-gains, rate) more than they hurt stocks. Still, let’s give bonds a break and assume that, in real, after-tax terms, bonds return 3 percent and stocks 6 percent. If you invested $400 a month in bonds, you would have $232,000 in today’s purchasing power at the end of 30 years; in stocks, $392,000. Stocks accumulate a nest egg that’s 69 percent larger.
AA is a personal endeavor. If you can’t sleep at night because you are worried about your stocks, then get out of them entirely. If you are saving not for retirement but for tuition bills that are five years off or a house down payment that’s three years off, then stick to bonds. The most miserable stories I have heard lately involve people on the verge of retiring who have lost half their money because they had it all in the stock market. That’s a shame. In the short term, anything can happen, so lock in your gains and switch to bonds as the date when you’ll need to use your money nears.
Let’s assume you will need your investments only for retirement, starting at age 65. A simple asset-allocation formula would work like this. Keep an emergency stash of cash that might represent a few months’ expenses. All of the rest, if you are in your twenties, should go into a diversified portfolio of stocks. In your thirties, the allocation should be 90 percent stocks, 10 percent bonds. In your forties, move to 80 percent stocks, 20 percent bonds. In your early fifties, 70 percent stocks, 30 percent bonds; in your late fifties, 60 percent stocks, 40 percent bonds. By age 65, a good mix for most people who can also count on Social Security and some pension money from another source is 50 percent stocks, 50 percent bonds. And remember to diversify within those categories as well.
But these are only guidelines. Nearly everyone has different needs, desires and fears. What’s important is to keep your eye on the ball: on how to allocate your assets for the future, not on what the stock market is doing this minute.
— A version of this article first appeared in the Washington Post. Made available through techcentralstation.com
