STOCK MARKET HYPE ALLAN CAMPBELL
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To my daughter, Katherine Louise Margaret Campbell, in the hope that her generation will treat money without the fears of her grandparents’ generation or the greed of her parents’ generation.
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Contents
Preface ix Acknowledgments
PA R T
I
CHAPTER
Recognize When the Bell Has Rung
1
The Paradox CHAPTER
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2
Listening for the Bell
3
4 They Do Ring a Bell at the Top . . .
11
Bubbles 11 The United States: The Roaring Twenties 12 Japan: The Late Eighties 14 Emerging Markets: The Nineties 16 The United States Again: The Late Nineties 20 The Psychology of Bubbles 25 Hearing the Bell at the Top 28 CHAPTER
3
. . . And at the Bottom
29
Six Crises 29 The Psychology of Market Bottoms 40 How to Recognize a Market Bottom 42
v
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contents
CHAPTER
4
The Up-and-Down Stock Market
45
Is the Market Really Efficient? 45 What Prevents Market Efficiency? 48 CHAPTER
5
How to Tell Whether the
55 Risk and Reward 55 Pizza Parlors or Stocks? 56 A Simple Tool for Valuing the Stock Market 59 You Say You Don’t Trust Reported Earnings? 68 The Fed Model 71 Yield Curve Analysis 73
Stock Market Is Fairly Valued
PA R T
II
CHAPTER
Steps to Take After the Bell Has Rung
6
Building an Investment
Portfolio for the Long Haul
79
Investment Plans 80 If Not Stocks, Then What? 83 Choosing Your Asset Mix 88 A Good Way to Buy Stocks 96 Which Index? 98 Do-It-Yourself Index Funds: Spiders, Cubes, Diamonds, and Vipers 101 Monitoring Your Portfolio 104
CHAPTER
7
Beyond Plain Vanilla
Active Funds Versus Index Funds 107 Growth Funds and Value Funds 111 Equity Income Funds 112 Sector Funds 114 International Funds 118
107
contents
Small- and Mid-Cap Funds 124 High-Yield Bond Funds 128 Socially Responsible Funds 128 Balanced, Life Cycle, and Asset Allocation Funds Convertible Funds 135 Gold Funds 136 Real-World Choices 139 CHAPTER
8
131
Four Myths That Could
147 Myth #1: Wall Street Strategists Will Tell You When to Get Back in the Market 147 Myth #2: It’s Best to Wait Until the Investment Outlook Is Clear Before Investing in Stocks 148 Myth #3: Real Estate Is Always a Better Investment than Stocks 151 Myth #4: Bonds Are Safe 157
Keep You Out of the Market
CHAPTER
9
Eight Steps Not to Take
After the Bell Has Rung
161
Market Timing 161 Wall Street Research 162 Charting 165 Day Trading 165 IPO Opportunities 167 Overdiversification 169 Patriotic Investing 169 Buying on Margin 170 CHAPTER
10
It’s Never Too Early
173 How Much Money Will I Need to Retire? 173 How Am I Doing? 177 Will Social Security Still Be Around When I Retire?
to Save for Retirement
180
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contents
Epilogue: Bringing It Together 183 Appendix A: Summary of 2003 Tax Law Changes 185 Appendix B: Tax-Deferred Savings Plans 189 Appendix C: College Savings Plans 193 Appendix D: Largest Index Funds and ETFs 197 Glossary: What Wall Street Really Means 201 Index 221
Preface
D
o you check the value of your stock portfolio whenever you get a chance? Would you rather read a stock analyst’s buy recommendation than a John Grisham novel? Would you rather trade stocks online than chat? Have you ever calculated a P/E ratio? If you answered yes to any of these questions, this book was not written for you (though you’ll probably want to read it anyway and then add it to your collection of investment books). It was written for the rest of us. For people who have a life outside the stock market. For people who have better things to do with their time than check the value of their stock portfolios ten times a day. And more important things to think about than whether they should be buying or selling. It is true that it’s getting harder and harder to escape from making investment decisions. Once upon a time, most folks with real jobs had defined benefit pension plans. That meant the employer was responsible for managing retirement assets and then paying out a defined amount to the employee during each month of retirement. Between lifetime employment, a pension plan, and social security, most folks from our grandparents’ generation didn’t need to worry too much about the stock market. But things are different now. Defined contribution plans, such as 401(k)s, 403(b)s, and Keoghs, have replaced defined benefit plans. We define how much money we put into the plan, but the stock and bond markets determine how much we will take out during our retirement years. And it’s up to us to decide whether to put the money into some-
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p r e fa c e
thing safe (like a money market account) or something riskier (like a stock fund). And if that isn’t bad enough, we aren’t offered simple choices like a stock fund, a bond fund, or a money market fund, but— in the case of some retirement plans—we may have twenty different funds to choose from. I guess when employers decided we couldn’t choose our own doctors anymore, they figured they would make it up to us by letting us choose how to invest our life savings. But the truth is, it’s not nearly as complicated as some financial writers make it out to be—provided you don’t get greedy and you are willing to let your money grow along with the U.S. economy. Or maybe a wee bit faster. Numerous academic studies have proven what common sense should tell you—you only make money in the stock market if you buy stocks at a reasonable price. What’s more, this research has provided measuring sticks to determine when stocks are overvalued. But while these studies have circulated among professional investors, they have not reached the average investor—the person who really needs them. One of the goals of this book is to give you the findings of these studies— in plain English. If you understand what academic research has discovered about the workings of the stock market, you shouldn’t need to look at your longterm investment portfolio more than once or twice a year during normal times. Only in abnormal times—when panic or “irrational exuberance” rule—is there a reason to make changes to a sound investment portfolio. Contrary to the Wall Street aphorism “They don’t ring a bell at the top,” there are all sorts of signals when the stock market is grossly overpriced and ready to take a tumble. The Internet boom that began in October 1998 and ended in March 2000 offers a classic case in point. In early 2000 the market did ring a bell at the top. It rang loud and clear to anyone who cared to listen. The sound consisted of ever-louder “strong buy” recommendations from the big brokerage houses, financial news drowning out crime stories on the six o’clock news, and finally the sound of your auto mechanic telling you how he made a killing on his investment in autoparts.com. And then a little more than two years later, there were all sorts of bells, sirens, and other signs to let you know that the market was extremely undervalued and ripe for big gains. Is the bell signaling a mar-
p r e fa c e
ket top or bottom today? With the help of this book, you will be able to figure that out.
Why I Wrote This Book In 1999, when the bull market in stocks was approaching its peak, the majority of financial writers seemed to be projecting past performance into the future with their forecasts that stock prices would rise at a double-digit annual pace over the long run. In 2002, when the correction in stock prices was nearly complete, it seemed the majority were again projecting the recent past into the future by forecasting longterm returns close to zero. And while stock prices were falling, bond and real estate prices were soaring. So many writers were advocating an investment in bonds or real estate instead of stocks—right before bond prices peaked (and perhaps right before the peak of real estate prices as well, but it’s still too early to tell). Listening to these financial writers’ advice to avoid stocks when they are cheap and to buy real estate or bonds when they are dear is not only harmful to your financial health, it is harmful for the nation’s economy. The markets are meant to be the means by which society allocates investment capital into the parts of the economy where it will do the most good. When people make bad investment decisions, they are investing their money into projects that are unproductive—ones that will neither provide them with a financial return nor benefit society. In the 1980s this resulted in overbuilding of commercial office space. In the 1990s it resulted in laying fiber-optic cable in the ground long before it was needed, while at the same time neglecting the nation’s electric power grid infrastructure. The result has been cheaper longdistance phone calls—but only if the power stays on. Following the plunge in stock market prices from 2000 to 2002, government has belatedly taken action. New York State Attorney General Eliot Spitzer has reached a monetary settlement with the brokerage firms whose research sent stock prices to unjustifiable highs and has also required that these firms provide independent stock research in addition to their own. Congress passed the Sarbanes-Oxley Act to require more complete and honest reporting of a company’s financial results.
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This government action is all well and good, but in the final analysis it has to be the responsibility of the individual investor to avoid the hype and to put his or her money where it will do the most good. It is easy to give the advice to buy low and sell high, but how does one know whether stocks are cheap or dear? This book is my answer to that question.
How to Read This Book This book was written for two groups of investors. The first, and no doubt the most numerous, are those of you who hate math, know next to nothing about stocks and bonds, and dislike having to make your own investment decisions. My recommendation to you is to first read Chapter 1 of this book, which describes the basic paradox of investing, and then move on to Chapters 5 and 6. Chapter 5 gives the theory behind stock valuation (I’ve tried to bring it down to earth for those of you who fell asleep during Statistics 101), while Chapter 6 provides the basic rules of thumb for investing, which are also summarized in the short Epilogue. Then, at your leisure, read Chapters 2 and 3, which give a history of stock market booms and busts, along with a description of the bells that signaled market turning points, and Chapter 4, which talks about those aspects of human nature that make stock markets so irrational. Chapter 7 is for folks who want to explore investment opportunities beyond the basics. Chapters 8 and 9 warn about common investment myths and mistakes; check out the headings there and read those sections that interest you. Then read Chapter 10 if you want to focus more narrowly on planning for retirement. And whenever you come across a term you don’t fully understand, check it out in the Glossary, “What Wall Street Really Means.” Now for those of you who enjoy making investment decisions and reading about investments, no problem. Just read right through from cover to cover!
Acknowledgments
T
his book does not present the findings of any groundbreaking research, nor does it present any new investment theories. Rather, it builds on the work of past researchers and attempts to synthesize their work and put it in a form understandable by the average investor. As such, it is right that I should acknowledge the work of at least a few of those who did the original research that helps to make us better investors. I start with Benjamin Graham and David Dodd, who first transformed investing from an art into a science based on sensible valuation criteria. Next I acknowledge Arnold Bernhard, founder of The Value Line Investment Survey, who in the 1930s began to make such valuation criteria accessible to the general investing public. I am also thankful for the work of Professor Robert J. Shiller of Yale University, who has made his database of historical stock market returns available at the Yale website, and to Robert P. Arnott of First Quadrant, for his seminal journal articles regarding the equity risk premium. Furthermore, I wish to thank my employer, Daiwa Asset Management, in particular Masahiro Hotchi, president of Daiwa Asset Management (America) Ltd., both for their support and for setting a good example of fiduciary responsibility in the investment trust industry (as the mutual fund industry is known in Japan). However, the opinions expressed in this book are those of the author and are not necessarily the same as those of Daiwa Asset Management. On a more personal note, I wish to thank Henry B. (Hank) Rainville, my former fund management colleague at ABD International Manage-
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acknowledgments
ment Co. (and present fellow member of the Over the Hill Gang, in our efforts to conquer the Appalachian Trail one hill at a time). Hank contributed numerous pithy suggestions for this book, some of which were actually publishable. I also wish to thank Jane Hassler, another former colleague from ABD, for reviewing those sections of the manuscript dealing with fixedincome investments; Dr. Steven W. Ross for reviewing sections of the manuscript on retirement planning; and the Reverend Kenneth J. Ross, Presbyterian Church (USA), for explaining how John Calvin’s theology became transmuted into Max Weber’s capitalist ethic. On a still more personal note, I wish to thank my wife, Louise, for patiently putting up with my numerous weekends and evenings spent in front of the computer screen while I wrote this book; my daughter, Katherine, for warning me when parts of the book would be unintelligible to Generation Y; and my parents, childhood pastors, and church school teachers who instilled in me the values that are needed to handle investments with something that hopefully approaches good stewardship.
PA RT
I
Recognize When the Bell Has Rung
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C H A P T E R
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Listening for the Bell
I
n 1999 Michael Alexander, a forty-year-old Michigan chemist, moved all the money in his company 401(k) plan from stocks to money market funds and wrote a book titled Stock Cycles: Why Stocks Won’t Beat Money Markets Over the Next Twenty Years. He wrote the book during the longest sustained bull market the country had ever seen. From the beginning of 1982 to the end of 1999, the U.S. stock market, as measured by the Standard & Poor’s 500 Index, had produced an annual return of 18.24 percent (including dividends). Ten thousand dollars invested at the start of the period would have grown to $213,077.36. Because inflation was a tame 3.3 percent per year over this eighteenyear period, most of the gain was real. In 1999 investment counselors were telling clients that stocks are the best investment for the long run; while they occasionally have down years, stocks can be expected to outperform bonds or cash over an extended period of time. Therefore, according to the investment counselors, anyone investing for the long haul should have most of their money in the stock market. Not surprisingly, Michael Alexander could not find a publisher. Eventually he turned to a vanity press. By April 30, 2002, the book was on the shelves at Barnes & Noble and rising up the charts. And $10,000 invested in the stock market at the start of the new millennium ( January 1, 2000, for nonpurists) had grown to . . . $7,546. Not only had money market accounts beaten the stock market, but Mexican pesos (up 1.17 percent) stuffed under a mattress would have beaten the stock market.
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4
Recognize when the bell has rung
Alexander was right—but for the wrong reason. He believes in the inevitability of long-term bull and bear market cycles. I say cycles, schmycles. When stocks get ridiculously expensive—as they did at the end of 1999—it’s time to sell, whether the bull market has lasted twenty years or twenty days. And when they are dirt cheap—as they were during the summer of 1982—it’s time to buy.
The Paradox Reasonably good historical data about the U.S. stock market extends back to 1871. Since that year, stocks have handily outperformed cash, bonds, real estate, gold, and even baseball cards. In fact, over the past 130 years, stocks have produced a return of about 7 percent a year after adjusting for inflation, compared with a long-term return of less than 3 percent for long-term government bonds and under 1 percent for Treasury bills. Money market accounts, a more recent development, also tend to produce a return of less than 1 percent after adjusting for inflation. I am confident that stocks over the next 130 years or so will again outperform their main competition for your investment dollars. So if you’re planning for retirement in, say, 2135, then by all means put all your wealth in the stock market and never look back. The problem, of course, is those nasty little episodes when people lose a great deal of their wealth in the stock market. And no, they don’t come in orderly cycles. During the last seventy-five years, there were three such episodes when a stock market portfolio would have suffered huge losses: • The Great Crash: Between September 1929 and May 1932 an investor with a diversified basket of stocks would have lost 79 percent of his or her wealth. • The years of impeachment and inflation: From January 1973 to September 1974 tumbling stock prices and rising oil prices combined to cause a 52 percent cut in the buying power of a typical stock portfolio.
l i s t e n i n g f or t h e b e l l
• The end of irrational exuberance: From March 2000 to October 2002 the loss in value was 49 percent. As you can see in Figure 1.1, the value of a stock market investment was still down a decade after the first two sell-offs. Whether the value of a stock portfolio will be down ten years after March 2000 remains to be seen (but my best guess is that it will be). Sure, anyone who put all their retirement funds in the stock market in 1982 hoping for a 7 percent return and planning to buy a condo on the beach in Florida at the start of the new millennium could buy that condo—and a house on Cape Cod for the summer as well. But what about someone who put money into the stock market at the end of 1965 Figure 1.1 Value of $1 Invested in Stocks in 1871 $10,000 End of irrational exuberance
$1,000 The Great Crash Impeachment and inflation
$100
$10
0 20 02
8
19 9
6
19 7
4
19 6
2
19 5
0
19 4
8
19 3
6
Based on data from econ.yale.edu/~shiller.
19 1
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19 0
3
18 9
18 8
18 7
1
$1
5
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Recognize when the bell has rung
with plans to retire ten years later? Instead of retiring to an oceanfront condo in Florida, they spent their retirement years with their daughter and son-in-law in Buffalo. Their hundred grand would have turned into $137,946—but it would be worth only $61,783 in 1965 purchasing power because of the inflation that ravaged savings during the early 1970s. Indeed, stock investments have lost value over ten-year periods 12 percent of the time going back to 1871 (see Figure 1.2). This then is the paradox: while over the long run, stocks outperform bonds, cash, and real estate, over the shorter run—say ten years or less—they may well underperform other forms of investment. In fact, they may be worth less at the end of the period than at the start. How do we know whether the present is “not an ideal time to invest?”
Figure 1.2 Distribution of Annual Stock Market Returns Over Ten-Year Periods from 1871–2003 40% 34.3%
35% 30% 25%
23.7%
22.8%
20% 15% 12.2% 10% 7.0% 5% 0%
Negative
0–5%
Based on data from econ.yale.edu/~shiller.
5%–10%
10%–15%
15%+
l i s t e n i n g f or t h e b e l l
I GNORING I NFLATION , C OMPOUNDING , AND D IVIDENDS Have you ever seen an ad that breathlessly proclaims that $10,000 invested in an IRA, or whatever financial instrument the ad is pushing, when you are twenty-five years old will grow to a nest egg of $1 million, or some other remarkable sum, by the time you hit retirement age of sixty-five? Or even worse, one that tries to scare you by saying that the cost of a college education twenty years from now will be $400,000, or some other such unaffordable sum? Even if these ads are right, the dollar amounts are meaningless without knowing to what extent inflation will eat away the value of a dollar between now and then. For example, the cost of living rose more than threefold from 1975 to 2000. A dollar in 2000 could buy only as much as 32¢ could buy in 1975. If inflation were to rage at the same rate in the first quar ter of the twenty-first century, then the milliondollar nest egg would have the buying power of only $320,000, while the $400,000 college education would be a more reasonable (though maybe still not affordable) $128,000. Because a dollar today is not the same as a dollar tomorrow, all historical data and forecasts of the future in this book are presented in inflation-adjusted dollars, called real dollars. Not only do many financial writers ignore inflation, they also show the growth of an investment with a simple arithmetic graph, such as that seen in Figure 1.3. This makes it look like the recent stock bubble and subsequent correction were the biggest ever, when in fact the stock market crash of 1929 caused bigger losses. Strangely enough, these same writers who ignore inflation and compounding often ignore the positive effect of dividends on the growth of an investment por tfolio. They show the change in share price but not the total return including dividends. Compare Figure 1.3 with Figure 1.1, which is the same figure adjusted for compounding (by using a logarithmic graph), inflation, and dividends. This book defines investment success or failure in terms of real total return, meaning investment return that takes into consideration both dividends and inflation.
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Figure 1.3 S&P 500 Index 1600 1400 1200 1000 800 600 400 200
02 20
90 19
78 19
66 19
54 19
42 19
30 19
18 19
06 19
94 18
83 18
71
0 18
8
The best investment advice I have ever heard came from Fred Schwed Jr., a professional trader who lived through the stock market crash of 1929. In his classic book titled Where Are the Customers’ Yachts? (1940), Mr. Schwed gave us the following rule: When there is a stock-market boom, and everyone is scrambling for common stocks, take all your common stocks and sell them. Take the proceeds and buy conservative bonds. No doubt the stocks you sold will go higher. Pay no attention to this—just wait for the depression which will come sooner or later. When this depression—or panic—becomes a national catastrophe, sell out the bonds ( perhaps at a loss) and buy back the stocks. No doubt the stocks will go still lower. Again pay no attention. Wait for the next boom. Continue to repeat this operation as long as you live, and you’ll have the pleasure of dying rich.
l i s t e n i n g f or t h e b e l l
Although there has not been a depression since the 1930s, there have been many panics and recessions and, as noted earlier, severe bear markets. More to the point, nothing that has happened since 1929 contradicts the basic wisdom of Mr. Schwed’s advice. How do we know whether the bell is ringing loudly enough to be a sell signal? Or whether the panic is palpable enough to be a buy signal? Well, for starters, we can take a look at history.
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C H A P T E R
2
They Do Ring a Bell at the Top . . .
B
ooms, bubbles, bull markets—whatever you want to call them— stock markets have often experienced good times that seemed like they would never end. But despite, or perhaps because of, the giddy feelings these good times engendered in investors, they all did come to an end—with calamitous results for shareholders. This chapter uses the term bubble to describe the good times and, more importantly, tells you how to recognize the signals that indicate they are coming to an end.
Bubbles A stock market bubble refers to the run-up in stock prices until they reach so high a level that there is no one left who is foolish enough to buy. At this point there are sellers but no buyers, and the bubble bursts. Not only have there been stock market bubbles and panics since the 1930s, but there have also been bubbles and panics for as long as men and women have used symbols (shells, gold, bank notes, stock certificates) to represent real wealth (goods and services that people consume). For Homo sapiens, while sometimes rational, more often makes decisions involving money based on greed or fear. History’s first bubble and panic is unrecorded. Perhaps it occurred when Caveman A traded a brontosaurus burger to Caveman B in exchange for hunting rights represented by a brightly painted brontosaurus bone. Caveman B then trades the bone to Caveman C for two
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brontosaurus burgers after telling him about the lush hunting grounds, abundant with woolly mammoths, that the bone represents. The story of the potential of the hunting grounds spreads, and the bone is exchanged for more and more real wealth in the form of brontosaurus burgers. Finally, the bone reaches Caveman K, a greedy dreamer who offers one hundred brontosaurus burgers for this bone and the mystical hunting grounds that it represents. But Caveman K has trouble sleeping that night and begins to worry about how good the hunting grounds really are. In the morning he begins to look for someone to buy the bone but finds no one willing to pay one hundred brontosaurus burgers. To cut his losses, he sells the bone to Caveman L for fifty brontosaurus burgers. Talk of the declining value of the bone spreads far and wide. How good could the hunting grounds be if everyone wants to sell the bone, people wonder. Now the bone is passed around like a hot potato—until it is sold by Caveman Z for a single brontosaurus burger. The first recorded stock market boom and crash, however, had to await the development of the first modern stock market. This occurred in Amsterdam at the beginning of the 1600s. And by the 1630s speculation in, of all things, tulip bulbs was the cause of the boom. Ninety years later the London stock market was the scene of a boom in the price of shares in the South Sea Company, an enterprise with exclusive trading rights in the Spanish colonies of South America. No matter that the Spanish king did not recognize these rights—the value of a share in the company rose severalfold during the course of 1720 before shareholders realized that any rights Spain would grant would be narrowly limited. As reality sank in, the result was the bursting of the second great stock market bubble. Next, let’s take a closer look at four more recent bubbles.
The United States: The Roaring Twenties In the United States, short bull markets followed by panics that caused the stock market to fall by more than 10 percent were quite common in the nineteenth century and early years of the twentieth, but recoveries tended to be fairly swift. World War I produced the first extended period
T h e y d o r i n g a b e l l at t h e t o p . . .
of stock market losses, but the 36 percent wartime decline in stock values would prove mild compared with what was to occur starting in 1929. The Roaring Twenties saw the inflation of the United States’ first big stock market bubble—and the 1930s saw a more spectacular deflation. The decade got off with a bang, literally. On September 16, 1920, terrorists parked a cart containing a bomb wrapped in shrapnel just up Wall Street from the stock exchange. Forty people were killed in the ensuing explosion, and the shrapnel scars remain to this day in the wall of a J. P. Morgan office building. Unlike the act of terrorism that would take place eighty-one years later, this attack on lower Manhattan was soon forgotten and the perpetrators were never caught. In 1920 the United States had had its fill of war and longed to look inward toward a decade of peace, prosperity, and isolation. It said good-bye to Woodrow Wilson and his dream of a League of Nations and hello to Warren G. Harding and his dream of “normalcy.” With a Republican in the White House and peace in the world, it was indeed easy for investors to believe they were living in a new era. Not only had President Harding rediscovered the laissez-faire economic policies that many believed would ensure permanent prosperity, but physical evidence of the new prosperity was present everywhere. The mass production of automobiles was revolutionizing transportation, the radio was revolutionizing communications, and perhaps most important, the electrification of factories was making the U.S. worker much more productive. Most investors, however, continued to view stocks as speculative investments to be avoided. As a result, the Dow Jones Industrial Average hovered around 100 for much of the first part of the 1920s. Then in 1924 the first popular book touting the stock market was published: Common Stocks as Long-Term Investments by Edgar Lawrence Smith. In 1925 the Federal Reserve Bank cut interest rates, and in 1926 Congress cut taxes. Wall Street always seems to like it when the government is cutting something—whether it’s taxes, interest rates, or red tape—and by 1927 the Dow had doubled to 206. In November 1927, President Calvin Coolidge gave a speech in which he declared that the United States “was entering upon a new era of pros-
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perity.” Stock market historian B. Mark Smith wrote that investors quickly came to believe that: The scientific management of business and the implementation of sound economic policies by government would eliminate the troublesome boom-and-bust cycles of the past. The future would bring steady growth and rising wealth for all Americans. And, it went without saying, rising stock prices as well. Less than two years later, in September 1929, the Dow had almost doubled again, to 381. At that level it was trading at a P/E (price/earnings) ratio of 19, meaning that the combined price of the companies in the index was nineteen times the amount of money they were earning. While the Dow had traded at higher P/E ratios in the past, it had only done so during recessions, when earnings were depressed. Never before had it traded at such a high multiple of high earnings. While a few observers commented that the market was priced above any reasonable level based on earnings or dividends, their words of caution were widely ignored. As the market continued to climb, even the cautious began to question their judgment. Instead, the press and academia were full of people scrambling to come up with reasons why the market would not reverse direction. One quote, from Harvard economist Irving Fisher, captures the prevailing sentiment of the summer of 1929. “Stock prices,” Professor Fisher said, “appear to have reached what looks like a permanently high plateau.” In retrospect, Fisher’s plateau looks more like the jagged peak of the Matterhorn (see Figure 2.1). From 381 in September 1929, the Dow would fall to a low of 41 in July of 1932, with the most precipitous slide occurring on Black Tuesday (October 29, 1929), when fear thoroughly routed whatever remained of new era optimism.
Japan: The Late Eighties Boom-and-bust cycles are by no means limited to the United States. The Japanese stock market boom of the late 1980s, like the Roaring
T h e y d o r i n g a b e l l at t h e t o p . . .
Figure 2.1 Dow Jones Industrial Average (1921–1932) 400 350
Sept. 1929
300 250 200 150 100 50 July 1932 0 20 21 22 23 24 25 26 27 28 29 30 31 31 32 1/ /30/ /31/ /28/ /29/ /31/ /30/ /31/ /30/ /29/ /28/ /30/ /31/ /30/ 3 / 2 3 1 12 11 9 5 6 8 4 7 12 11 10
Twenties bubble, was started by a policy of low interest rates. In 1986 the Bank of Japan responded to an economic slowdown by aggressively lowering rates until the resultant low yields made savings accounts unattractive. As a consequence, both individual investors and corporations shifted their excess cash into the stock market in a search for short-term gains. The demand for stocks pushed prices up, and the rise in stock prices began to feed on itself as the improving performance of individual stocks and mutual funds began to attract new money. It is true that while Japanese stocks were going up in price, rational justifications were offered, such as the following: • Japan has the most dynamic economy in the world—look at all the capital investment and soaring real estate values.
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• Japan is the leading maker of the most important products (automobiles and electronics) for the world’s consumer economy. • Japanese stocks really aren’t that expensive when you adjust for accounting differences. Then the brokerage firms began to add fuel to the fire, as when Nomura Securities took out full-page ads in the world’s financial press asserting that anyone concerned about the sustainability of Tokyo stock prices was the equivalent of a sixteenth-century astronomer refusing to accept the Copernican Revolution. As a result, the retail investors of Japan financed an unprecedented capital investment spree that made Japanese factories, at least temporarily, the most efficient in the world. They made it possible for Americans and Europeans to afford high-performance Japanese automobiles and high-fidelity Japanese consumer electronics. But those who bought Japanese stocks as they approached their peak prices in the late 1980s were left holding the bag. The Bank of Japan decided that it was time to let some air out of the bubble and on Christmas Day 1989 left a lump of coal in investors’ stockings when it began raising interest rates. Figure 2.2 shows the rise and fall of the Japanese stock bubble. At the peak, on December 30, 1989, the shares in companies of this small island nation accounted for more than half the world’s stock market valuation. Thirteen years later they would be worth one-fifth as much.
Emerging Markets: The Nineties As it became apparent that Japan was no longer the world’s rising economic superpower, the smart money concluded that growth had shifted to the world’s less-developed nations. Mutual fund marketers quickly figured that less developed was not a term that would inspire investor confidence, so they replaced it with emerging. The year 1993 saw a flood of money into so-called emerging markets. It poured into Mexico, sparked by negotiations to create a North American Free Trade Agreement (NAFTA), whereby Mexican products
T h e y d o r i n g a b e l l at t h e t o p . . .
Figure 2.2 Japan’s Nikkei Index (1982–2002) 45000 40000 Dec. 1989
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would gain duty-free access into the huge U.S. market. It poured into Southeast Asia, where Japanese companies were building factories because labor costs at home were now too high. It poured into Eastern Europe following the fall of the Iron Curtain because many believed that an economic miracle would take place there as entrepreneurial capitalism encountered a low-paid, well-educated workforce. But volatility proved to be the name of the game in emerging markets. After making big gains in emerging market stocks in 1993, investors saw large losses beginning in 1994 after the U.S. Federal Reserve Bank started raising interest rates. This caused investors to pull money out of emerging markets in favor of the high and safe returns that could now be earned at home. It also caused Mexico’s peso to plunge in value as no one
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wanted to hold pesos when they could earn up to 8 percent on U.S. dollar money market funds. (The power of the Fed!) This created the socalled tequila effect as investors also pulled their holdings from other Latin American markets. The year 1995 brought another sharp reversal of sentiment as the Fed changed direction and began to push U.S. interest rates downward again. Slowly, investors reacquired a taste for emerging market stocks. Southeast Asia in particular gained allure as the smart money decided that Confucian ethics and authoritarian planned economies would lead to more rapid growth than the free-for-all of Calvinist-rooted U.S. capitalism. (Never mind that Japan’s planned economic miracle was in the process of unraveling like the Chicago Cubs in the heat of a pennantclinching game, or that a Singapore-style legal system that, until 2003, imposed a penalty of a year in jail for possession of chewing gum may not encourage a risk-taking entrepreneurial spirit.) With interest rates also low in Japan, it was easy for governments and corporations of emerging market companies to borrow abroad for growth. And the authoritarian governments of Indonesia, Malaysia, Thailand, Singapore, Hong Kong, Taiwan, and South Korea continued to promote economic growth as the greatest good. But the economic miracle in Southeast Asia was based on easy borrowing, which was based on stable currencies, which in turn was based on linking these currencies to the U.S. dollar. As the U.S. dollar began to gain value compared with European and Japanese currencies, the Southeast Asian currencies were pulled upward as well. At the same time, the economic fundamentals in Southeast Asia began to deteriorate as the region’s factories produced more goods than the rest of the world needed. In the summer of 1997 currency traders sensed that these high fixed-currency exchange rates could not be maintained. They began dumping Thai baht, Malaysian ringgit, and Indonesian rupiah in favor of U.S. dollars, Japanese yen, or German marks. The result was similar to what happened in Mexico in 1994, but this time the impact was felt worldwide as investors had to sell other emerging market stocks to compensate for losses in Southeast Asia. The latest turmoil in emerging market currency and stock markets also caused investors to demand
T h e y d o r i n g a b e l l at t h e t o p . . .
C ALVINIST-R OOTED U.S. C APITALISM ? The sixteenth-century Swiss religious reformer John Calvin often gets the credit—or blame—for the so-called work ethic of U.S. capitalism. Actually, Calvin himself, with his medieval mind-set, would probably be shocked by many of the dog-eat-dog aspects of modern capitalism. But his doctrine of predestination—that all things are preordained by God and that humans lack free will— received a new twist as interpreted by New England’s Puritans. They decided that wealth was a sign of God’s favor. This implied that pover ty was not a sign of bad luck but rather of God’s disfavor. Thus the Puritan belief system placed great pressure on people to succeed at work to prove their wor thiness, while discouraging any urge to help the poor. The result is what the sociologist Max Weber has called the “Protestant ethic.” Although the Puritan belief system is generally rejected today—even by Protestant denominations that have their roots in Calvin’s teachings—the belief that the rich are wor thy, while the poor are lazy, lives on in popular U.S. folklore about welfare Cadillacs. Hence, it is not incorrect to talk about “Calvinistrooted U.S. capitalism” even if it makes John Calvin roll over in his grave (though it probably doesn’t distress him as much as the Calvin Klein underwear ads).
higher interest rates in emerging market debt to compensate for the increased risk. What started as a currency devaluation in Thailand in July 1997 ended with Russia defaulting on its foreign debt in August 1998 when it could no longer find creditors willing to refinance the debt as it came due. What did this mean for investors in emerging market stocks? Figure 2.3 shows the trend of stocks in the late 1990s in the quintessential emerging market: Hong Kong. The Hong Kong market made a roundtrip from 8000 to 16000 and back to 8000 in the space of three years. As the emerging market roller coaster completed its stomach-churning
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Figure 2.3 Hong Kong’s Hang Seng Index (1995–1998) 18000 Aug. 1997 16000
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/95 9/1 /95 12 /29 /95 4/2 6/9 6 8/2 3/9 6 12 /20 /96 4/1 8/9 7 8/1 5/9 7 12 /12 /97 4/1 0/9 8 8/7 /98 12 /4/ 98
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ride, many investors pulled their money out in favor of the safety of the United States.
The United States Again: The Late Nineties As Figure 2.4 shows, anyone who took their money out of emerging markets in 1998 and put it in the U.S. market merely got off one roller coaster and on another. The U.S. stock market had been rising steadily prior to the fall of 1998. The reasons cited for the runup in stock prices were numerous, but three in particular are worth mentioning:
T h e y d o r i n g a b e l l at t h e t o p . . .
Figure 2.4 S&P 500 Index (1998–2002) 1600 Mar. 2000 1500 1400 1300 1200
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• The peace dividend following the end of the Cold War, meaning that some of the money formerly spent on national defense could now be used in more productive ways • An era of low inflation and low interest rates, attributed to the leadership of Alan Greenspan at the Federal Reserve and Robert Rubin as secretary of the Treasury • Technological leadership on the part of U.S. companies in the key growth areas for the twenty-first century: information technology and biotechnology And as with the bubble of the 1920s, there was a popular book that made investors comfortable with the idea of putting their nest egg in
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stocks. The book was Stocks for the Long Run, written in 1994 by University of Pennsylvania professor Jeremy Siegel. In the final analysis, however, what enabled the bubble to reach its gargantuan proportions was a false faith that somehow it would be different this time—that the laws of gravity had somehow been suspended. On December 5, 1996, when the bubble was in its early stages, Federal Reserve Chairman Alan Greenspan expressed his concern that investors were exhibiting “irrational exuberance.” But by June 1997, as stock prices continued to rise, Greenspan seemed to be secondguessing his own caution, for he began to refer to a “new era” economy. By 1999, when the bubble was inflating rapidly, he was pondering aloud whether higher productivity and low inflation had indeed created a “new paradigm” that justified permanently higher stock prices. And by the end of the year, as the Federal Reserve flooded the economy with money as a precaution against potential Y2K catastrophes, Chairman Greenspan, as well as most everyone on Wall Street and Main Street, had placed faith and savings in the “new paradigm.” The stock market bubble of the late 1990s had a bubble within a bubble—that being the Internet bubble (see Figure 2.5). The Internet bubble began to inflate when Steve Case, the founder of America Online, took his company public by selling stock. This was followed by the high-profile IPOs (initial public offerings) of stock in Netscape, Amazon.com, and Yahoo! But in the six years following AOL’s IPO in March 1992, the shares of most Internet companies moved up and down instead of straight up as investors questioned—quite reasonably, I might add—how anyone would make money from the Internet. Then in August 1998 Russia’s debt default sparked a sell-off in all speculative stocks, which sent the price of Internet stocks tumbling. In response to the global financial crisis, the Federal Reserve increased the money supply. This easy money policy at a time when the U.S. economy itself was already robust caused a reacceleration of economic growth. With money easy to come by, almost any entrepreneur with a semicoherent business plan was able to find a venture capitalist willing to fund him, and many were then able to sell shares of their companies to a trusting public on the NASDAQ stock exchange. And then there were the sell-side analysts at the big Wall Street brokerage firms who supplied the “research” to justify buying these shares.
T h e y d o r i n g a b e l l at t h e t o p . . .
Figure 2.5 Inter@ctive Week Internet Index (1998–2002) 800 700
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Their gross overestimates of the potential of most of these Internet companies have been blamed on investment banking relationships. Sure, if investment bankers expected to win the right to underwrite an IPO— and take a cut of up to 7 percent of the value of the stock sold—they would expect their firm’s stock analysts to prepare sales materials, not critical research. But I think another side of human nature played a role here, too. These analysts wanted to believe that they were playing a part in funding a technological revolution that would make life better for everyone. They came to believe the Internet would give students in developing nations access to scientific knowledge from developed nations. That it would let freedom fighters in countries with repressive regimes communicate with one another and with supporters on the outside. That it would make the manufacturing process so much more efficient that the standard of living would improve for everyone.
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And perhaps they were a little naive. They were young themselves— mostly in their twenties and thirties—and they admired the Internet entrepreneurs who, no older than themselves, were out to change the world. The entrepreneurs’ business models were exciting, and some of them actually worked. Jeff Bezos, who was thirty-two years old when he founded Amazon.com, has sold books, music CDs, and DVDs worth in excess of $7 billion without having the expense of retail outlets. The search engine developed by Stanford grad students David Filo and Jerry Yang now brings in more than $1 billion a year in revenues under the name Yahoo! But most of the models, though exciting, were destined for failure. Not enough people wanted to sit in front of a PC to order groceries to justify the more than $300 million that Webvan spent building warehouses. Nor were there enough computer-savvy cats and dogs to make Pets.com a success. And perhaps the young analysts lacked the experience to know that things change and the humility to admit that they couldn’t predict the future. Instead, they saw trends, projected that the trends would continue, and called the projections forecasts. After Internet stocks tripled in value during the first six months of the rally that began in October 1998, many wise investors took their profits. By any rational means of measurement, Internet stocks were overvalued. They had been driven to their spring of 1999 highs only by greed and by the unrealistic long-term earnings forecasts and price targets publicized by Wall Street analysts. Yet for eleven more months individual investors kept buying Internet stocks. Many bought them on margin (meaning with borrowed money), and many were buying them online (meaning they could keep secret the risks they were taking). As a result, these same stocks more than doubled again in price before peaking on March 27, 2000. For eleven more months greed triumphed over common sense, and many investors who took profits early regretted it as they watched their friends’ portfolios soar in value. But a year later the regrets should have vanished as Internet stocks plunged back to fair valuation, and then some. The late 1990s stock market bubble, and the Internet bubble within it, burst as fear gradually began to surpass greed as the dominant emotion of investors. Between March and September 2000 there was a tugof-war between these two emotions. For a while at the end of August
T h e y d o r i n g a b e l l at t h e t o p . . .
it looked like greed was again winning. On September 1, 2000, the stock market rallied further when the Federal Reserve signaled that it was becoming more concerned about recession than inflation and would not raise interest rates any higher. But the next day, the market headed downward as the significance of the word recession sank in on investors. A recession would indeed occur during the next year, and investors would quickly discover that not only were Internet stocks not immune from recession but many of these “virtual” companies would be harder hit than “bricks-and-mortar” companies. For the next two years the stock market would go steadily downward, with the S&P 500 declining by half, NASDAQ stocks losing 60 percent of their value, and Internet stocks falling by 90 percent. One could say in 2002 that: It would be quite impossible to estimate the amount of money that has been thrown away by usually sane and sensible people during the past ten years in an effort to make a substitute for the cable and the telegraph and the telephone. However, one would merely be repeating the words of Albert Shaw when he wrote in 1908 about investing in the “wireless telegraph,” now better known as the radio. But every burst bubble has a positive side to it. Just as the Japanese stock market bubble financed an unprecedented capital investment spree that benefited Japanese manufacturing prowess, so, too, the U.S. retail investor financed the build-out of the Internet and a high-speed fiberoptic telecommunications infrastructure. Granted, he or she lost a lot of money in the process. But what is money compared with the undying thanks of every U.S. teenager engaged in the high-speed download of pirated music? Hmm. Maybe the positive side to this bubble left something to be desired.
The Psychology of Bubbles Stock bubbles all tend to develop in the same manner. Stocks start to rise in value for sound fundamental reasons. In the late 1800s railroad
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W HY N O R ECESSION ? The 1929 stock market crash was followed by the Great Depression. Japan has endured thir teen years of off-and-on recession since its stock market bubble burst at the end of 1989. Why has the United States gotten off so easy after our second big bubble burst in 2000? The answer may be that we’ve actually learned from history. The Herber t Hoover administration dealt with the decline in tax revenues as economic growth slowed by trying to spend less— not exactly the best way to stimulate the economy. And Congress didn’t help with the infamous Hawley-Smoot Tariff Act of 1930, which raised tariffs on impor ts to the United States, thus inviting retaliation in the form of higher tariffs by foreign countries. This, in turn, cut off demand for the products of our expor t industries. In response to the global economic slowdown that followed the bursting of the 1990s stock market bubble, the Federal Reserve lowered interest rates and the George W. Bush administration pushed through tax cuts—both measures designed to stimulate economic activity, and the direct opposite of the response of the Hoover administration. Interestingly enough, European policy makers responded to that continent’s economic slowdown with a lot more caution. Interest rates came down less than in the United States, and the rules that helped to create the European Union forbid countries from going too far into debt to stimulate their economies. As a result, while the United States’ economy was showing clear signs of growth in the second half of 2003, Europe’s economy was still sputtering. Of course, the long-term effects of the United States’ loose monetary and budget policies in the form of higher prices and rising interest rates remain to be tallied. Only time will tell which was the better response to the economic slowdown: the United States’ bold response or Europe’s timid one.
T h e y d o r i n g a b e l l at t h e t o p . . .
stocks began to soar in both Britain and the United States as investors recognized the potential of the railroads to transform transportation. The United States’ stock market bubble in the 1920s was a response to true technological progress: mass production of the automobile, the radio, and thousands of other consumer goods. In Japan in the 1980s the central bank’s easy money policy caused the economy to grow rapidly, while low interest rates did not offer investors an attractive alternative to stocks. In the United States in the 1990s investors recognized the ability of the Internet to transform the way people would communicate and do business. But at some point people no longer buy stocks for their growth potential. They buy stocks simply because they are going up. At that point rational investing turns into irrational exuberance, and the bubble begins to inflate. Soon afterward the so-called greater fool theory kicks in. The greater fool theory says that although we know stocks are overpriced and we are foolish to buy them at this level, someone will be an even greater fool and will buy them from us at a higher price. In Japan the “greatest fool” bought shares on the Tokyo Stock Exchange on December 30, 1989. No one before or after bought shares at a higher price. In the United States the S&P 500 Index reached an all-time high of 1552.87 on March 24, 2000. It had risen by 14.4 percent—two years’ worth of normal gains—in less than eight trading days. The easy money caused fools to rush in, and one of them bought stock on March 24, just as the index peaked. By the end of the day the index had fallen 1.6 percent. On October 9, 2002, it would be exactly 50 percent lower. No one would again be as foolish as that person—at least not in this boom-and-bust cycle. Two anonymous fools (probably one Japanese and one American, but they could have been two very gullible foreigners) bought stock from two very astute—or more likely, very lucky—sellers. This book was written to help you avoid being one of the world’s greater fools. By avoiding such foolish and irrational stock market behavior, you’ll not only be protecting your own net worth, but you’ll also be helping the economy. When people start making investment decisions with their hearts instead of their heads, money is not allocated efficiently. Money
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goes toward building unwanted warehouses for Webvan or Pets.com instead of toward natural gas exploration and development, as one example.
Hearing the Bell at the Top As the stock charts in this chapter show, all bubbles follow a roughly similar trajectory. And as each of these bubbles reached their maximum height, the bells were ringing loud and clear—for those who knew what to listen for. To hear a bell at the top, first turn on your TV. If the pundits are talking about a new era for investors or a new paradigm for the economy, it’s probably a signal that it’s getting close to the time to sell. And when the Federal Reserve chairman or the president of the United States starts talking about a new era, then it’s definitely getting close to the time to sell. Next, head for a bookstore. If publishers are racing one another to publish books with titles like these: • Dow 36,000: The New Strategy for Profiting from the Coming Boom in the Stock Market • Dow 40,000: Strategies for Profiting from the Greatest Bull Market in History • Dow 100,000: Fact or Fiction? (as they were in the spring of 1999), then you know it’s close to a market top. And if reviewers write lines like the following quote from the Amazon.com website about Dow 36,000: Many will dismiss this kind of thinking as wishful, but they’re probably the same Chicken Littles who have been calling the market overpriced for years. then you’re there. It is a market top!
C H A P T E R
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. . . And at the Bottom
T
he greed and irrationality at the top of stock market bubbles are well documented. The panic and fear at market bottoms have received less attention. But what happens at a stock market bottom is just as important as what happens at the top. Money is lost by people buying at the top. Money is made by people with the courage to buy at the bottom.
Six Crises This chapter examines six crises that produced stock market bottoms and the mood at the bottoms. We’ll see that just as the four bubbles of the last chapter had much in common, so, too, do the six bottoms.
July 1932 Chapter 2 described the mood as the stock market bubble grew during the 1920s and the panic that followed the bursting of the bubble in September 1929. But what of the mood almost three years later, in July 1932, when the stock market finally hit bottom during the depths of the Great Depression? What were the signals that said it was finally safe to get back into the market? Figure 3.1 shows that the stock market staged several so-called suckers’ rallies between October 1929 and July 1932, as the U.S. economy
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sank deeper and deeper into depression. The year 1932 was the only year in history in which the companies that make up the Dow Jones Industrial Average lost money. By July 1932 everyone had given up on the stock market. The last stubborn optimists had given up their final hopes for a stock market rally and sold out at a loss. During the course of the depression that followed the Great Crash, the total national income of the United States fell from $88 billion to $40 billion. The unemployment rate rose from 3 percent to 25 percent. American cities were filled with soup kitchens and men selling apples seemingly on every corner. And for those who still had jobs, the average weekly wage in manufacturing fell from $25.03 to $16.73. Little did most Americans realize it, but the stage was now set for economic recovery. There was a huge labor force eager to work and a huge demand for the products they could make. All that was required was
Figure 3.1 Yes, Virginia, There Is a Bottom—the Dow After the Crash 400 Sept. 3, 1929 (market top: 381.17) 350 300 250 200 150 100 50 0
July 8, 1932 (market bottom: 41.22)
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confidence to begin hiring. That confidence began to build on June 16, 1932, when the Republicans nominated Herbert Hoover to run for a second term; the Democrats nominated Franklin D. Roosevelt two weeks later, on July 1. Both men promised to maintain orthodox economic policies, refraining from using inflation, budget deficits, or a weakened currency to pull the nation out of depression. Oddly enough, despite the severity of the recession, the business community reacted favorably to the promises to do nothing rash. During the summer of 1932 there was a boom in industrial production and employment. And as can be seen in Figure 3.1, those few Americans who still had money in the stock market saw the value of their investments rise by 50 percent. Although the recovery in the stock market from 1932 on was by no means steady, the worst was over. Anyone who later sold stocks that they had bought in July 1932 had a huge return on their investment regardless of when they sold.
October 3, 1974 The Doo-Wop Era—the Eisenhower ’50s and Kennedy ’60s—saw big stock market gains in a time of peace and prosperity. The gains were fairly gradual, so there was no bubble to burst as in 1929 or 2000. Instead, the gains continued under the presidencies of Lyndon B. Johnson and Richard M. Nixon. Rising stock prices together with the economic consequences of Johnson’s attempt to wage simultaneous wars against communism in Vietnam and against poverty at home—his socalled guns and butter strategy—would eventually cost investors dearly. But toward the end of 1972, the fourth year of Nixon’s presidency, there was still joy on Wall Street. The Dow had broken through the 1000 barrier for the first time ever, and Nixon was reelected over the ultraliberal George McGovern in a landslide. In January 1973, less than a week after Nixon took the oath of office for his second term in the White House, the United States signed the Paris Peace Accord, officially ending our direct role in the Vietnam War. Could things get any better for the stock market? No . . . but they could get worse. Inflation had fallen to an acceptable 3.3 percent in 1972 only because of government price controls—
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an odd technique for a Republican administration supposedly committed to a free economy. But in 1973 unemployment was on the rise and the Federal Reserve Bank, confident that inflation was under control, began to increase the money supply in the hope of stimulating the economy. Then two things went terribly wrong. First, crop failures, especially in the Soviet Union, caused food prices to rise worldwide. Then Arab nations stopped selling oil to the United States in retaliation for its support of Israel during the Arab-Israeli war that they had started on October 6. With supplies of oil and food reduced, price controls produced shortages. So the controls were lifted and prices soared. This led to a new word coined to describe the state of the U.S. economy: stag flation, meaning the combination of a stagnant economy and high inflation. Next came the impeachment of President Nixon following his coverup of his role in the break-in at Democratic headquarters in the Watergate building. This led to his resignation on August 8, 1974. On October 3, 1974, after President Gerald Ford had shocked the nation by pardoning Nixon, the stock market was down 42 percent from its high, and inflation had eaten away another 10 percent of an invested dollar. By that time company earnings were finally on the rise again, and stocks were selling at P/E ratios of only seven to eight times their earnings. But no one wanted to own stocks in an environment of high inflation and low confidence about the nation’s future. The reluctance was not limited to individual investors. The professionals who manage pension funds had cut their stock holdings to 54 percent of assets from 74 percent a couple years earlier. The one exception among the pros may have been Warren E. Buffett—now the United States’ second richest person (after Bill Gates) and arguably the most successful investor of the late twentieth century. Buffett, a cautious Nebraska-based value investor, told Forbes magazine: “I feel like an oversexed man in a harem. This is the time to start investing.” (And this was before the invention of Viagra.) Buffett proved to be right and the rest of the world wrong. Figure 3.2 shows that the market hit bottom less than two months after Ford took office. Anyone who bought on October 3, 1974, would see the value of their investment rise by 50 percent within nine months.
. . . A n d at t h e B o t t o m
October 19, 1987 This was the date of the biggest one-day stock market crash in U.S. history. The bull market that began in 1982 was five years old. Declining inflation, declining bond yields, rising corporate profits, and lower taxes had combined to send stock prices upward. But in 1987 the run-up in stock prices began to accelerate. By October the Dow Jones Industrial Average was up more than 40 percent from the previous December. A bubble had formed as only the good news about the U.S. economy was given any heed. But there was also a dark side to the economy in ’87 in the form of twin deficits: a huge budget deficit, caused by the Reagan tax cuts, and a huge trade deficit, caused by the shrinkage of the United States’ industrial base, that had turned us into a debtor nation.
Figure 3.2 The Ford Rally 100
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When Germany’s central bankers, after criticizing the United States’ spendthrift ways, raised interest rates, U.S. interest rates also began to rise as bond buyers demanded similar high rates to those they could get in Germany. As a consequence, stock prices began to fall. After falling steadily during the week of October 12, the selling intensified on Friday, October 16, a day on which the Dow fell by 4.6 percent. This gave many an investor an uneasy weekend. By the market’s opening bell on October 19 most had made up their minds. The market was immediately hit by a barrage of sell orders. By the close it was down an incredible 508 points, or 22.61 percent. The bubble had disappeared in one day. By midafternoon many traders had stopped trading, and many brokers had stopped taking sell orders. Instead, they were staring transfixed into Quotron machines that were showing a sell-off like no one had ever seen before. At the time, I was a stock analyst at Value Line, Inc., a financial publishing firm. Like most Value Line analysts, I didn’t have enough money to have a stock portfolio. So I stood with the other analysts watching this disaster happen to other folks—much like watching a plane crash in slow motion. With twenty-twenty hindsight, I should have taken out a second mortgage on the house I had just bought and put everything in the stock market. But at 4 p.m. on October 19, most investors had one number on their minds: 1929. It looked like Black Tuesday all over again—and Black Tuesday was followed by continued stock market losses and a depression. But 1987 would not be like 1929, because the rest of the world had learned the lessons of ’29. Three hours after trading ended in New York, it began in Tokyo. The Tokyo stock market quickly fell by 15 percent that morning as the panic followed the sun across the Pacific, and it would likely have been down much more were it not for so-called circuit breakers, which halt trading after a stock has fallen by 15 percent. But after the usual two-hour lunch break in Tokyo, buy orders began to appear. During the lunch break, Japan’s government and private financial leaders had met and determined that only they— with their huge hoard of dollar assets earned from exports—could prevent a worldwide stock market collapse. So beginning that afternoon, they did something that J. P. Morgan and the United States’ other financial titans were unable to do in 1929. They supported the market and
. . . A n d at t h e B o t t o m
restored confidence through their buying. As a result, October 19, 1987, proved to be a bottom. From that day forward, the Dow returned to its 12 percent growth trajectory (see Figure 3.3), its excesses having been expunged in one cathartic day. And as David Hale and R. Taggart Murphy astutely pointed out, the bureaucrats from Tokyo saved the world, or at least the world’s stock markets, from the laissez-faire ideologues of the Reagan administration.
August 2, 1990 You may not recognize this date like you recognize September 11, 2001. The United States was not attacked on this date, but Kuwait was. It was
Figure 3.3 The Crash of 1987 2800 2600 2400 2200 2000 1800 1600
Dow Jones Industrial Average
4/ 30 /8 8 8/ 31 /8 8
12 /3 1/ 85 4/ 30 /8 6 8/ 31 /8 6 12 /3 1/ 86 4/ 30 /8 7 8/ 31 /8 7 12 /3 1/ 87
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Steady 12% growth line
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the date when Iraqi troops rolled into that oil-rich emirate. The invasion triggered a worldwide sell-off of stocks as everyone feared what instability in the Middle East would do to oil prices. A little more than two months later, U.S. stocks were down more than 16 percent (see Figure 3.4). But the run-up in oil prices that followed the invasion was not to last. Stocks began to rise in November when the United Nations approved military action to oust Iraqi troops from Kuwait, and a much bigger rally occurred when Operation Desert Storm began in January 1991. By February investors who did not panic but had kept their money in the stock market were again ahead of those who held cash. And those who bought stocks in the uncertain months after August 2 were the biggest gainers.
Figure 3.4 Stocks Versus Cash During the Gulf War $11,000 Aug. 2, 1990 (Iraq invades Kuwait) $10,000
$9,000 Oct. 11, 1990 (market bottom: $8,406) $8,000
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. . . A n d at t h e B o t t o m
September 11, 2001 The stock market never opened on September 11, 2001, because of the attacks on New York and Washington that had taken place just moments before. When it reopened on September 17 the investing public was sufficiently frightened by the saturation media coverage of the “Attack on America” that they didn’t know what to expect. After all, this was the first time in most people’s memory that the United States had come under attack and the first time since the start of World War I that the stock market had been forced to close. Stocks closed down only about 5 percent on September 17, but frightened investors who were slow to react on that first day of trading continued to sell over the next four days, until by Friday, September 21, the S&P 500 had fallen 13.5 percent. Were the United States’ five hundred largest companies worth that much less simply because nineteen fanatics armed with box cutters were largely successful in their diabolical scheme? Of course not! And the smart money knew it. During that Friday they started aggressively buying. They saw the irrational panic in the eyes of sellers and realized that a bell had rung. Thirteen trading days later, the stock market was back to where it was on September 10 (see Figure 3.5). Those who heard the bell made a percentage point a day on their money for thirteen days. The smart money knew that the world hadn’t changed. What had changed was Americans’ perception of the world. The world was no more dangerous on September 11, 2001, than it was on February 26, 1993, when Islamic militants killed six people in their first attempt to topple the World Trade Center—by exploding a bomb-laden Ryder truck in the basement parking garage. But since the towers only shook then rather than falling, the U.S. public and the stock market largely ignored this warning. Organized groups of religious fanatics, and others with anti-Western sympathies, will continue to try to destroy symbols of Western civilization and capitalism, as they did at the Munich Olympics in 1972 or when they blew up the Bombay Stock Exchange in 1995. And when they get lucky, as they did on September 11, people will panic and sell. And when the United States wins military victories—as in the Persian Gulf
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Figure 3.5 Stocks Versus Cash After 9/11 $11,000
$10,500
$10,000
$9,500
$9,000
$8,500
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11 /1 2/ 01
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$8,000 9/ 10 /0 1
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Cash
War in 1991, the war in Afghanistan in 2001, or the war in Iraq in 2003—they will cheer and buy. In the long run, Western values of democracy, pluralism, and religious freedom must prevail for reasons far more important than stock prices. But individual symbolic successes and failures, such as the toppling of Saddam Hussein or the destruction of the World Trade Center, will not determine the outcome of the struggle. All they will do is produce occasional periods of unjustified panic or euphoria, which for investors mean buying or selling opportunities.
March 11, 2003 I wrote a first draft of the previous paragraph in 2002, and sure enough, since that date there has been another bout of unneeded stock market
. . . A n d at t h e B o t t o m
selling that created buying opportunities. It occurred in March 2003 as investors correctly concluded that the George W. Bush administration was committed to war with Iraq regardless of what compromise solutions the United Nations Security Council would propose. While their political instincts may have been correct, their investment instincts were dead wrong, for selling before the war proved to be a big mistake. The media, with its speculation about a Middle Eastern conflagration, complete with chemical and biological weapons and flaming oil fields, had hyped the impending war into something far more scary than it turned out to be. As news of a relatively easy U.S. and British military campaign replaced the hype, the S&P 500 Index rose from 801 on March 11—eight days before the campaign began—to 1012 a little more than three months later, for a gain of more than 25 percent.
D OES WALL S TREET L IKE WAR ? Stocks rallied when the United States and its allies launched Operation Deser t Storm against Iraq in January 1991. It rallied again when the second Gulf war (Operation Iraqi Freedom) began in March 2003. It’s easy to get the impression that Wall Street likes war. Actually, it doesn’t. But what it dislikes even more than war is uncer tainty. As we see throughout this book, most investors don’t like to buy stocks during times of uncer tainty. In March 2003 stocks were cheap because there were no buyers—or at least there were fewer buyers than sellers. And there were fewer buyers than sellers because everyone was waiting to see whether war would break out. Once it did, the uncer tainty was gone, and it was possible to decide how much to bid for a stock. If peace had broken out instead of war, there would have been an even bigger rally, for Wall Street would have gotten what it wanted—cer tainty—without the costs of war. And the hidden costs of war include money diver ted from productive domestic activity and/or bigger budget deficits, as well as uncer tainties about the political outcome, even if the military outcome is fairly cer tain.
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Although the stock market performed well during World War II and the Korean War, that was only because stocks were still recovering from the trauma of the Great Depression. World War I was a terrible time for investors—at least after the United States entered the war in 1917. And the Vietnam War ushered in a bear market that lasted into the 1980s. In contrast, the first great bull market of the twentieth century began immediately after the end of World War I (the war to end all wars); the second was fueled by the end of the Cold War. Strangely enough, both booms ended exactly eleven years after peace was declared. November 11, 1918, was the date of the signing of the armistice ending World War I; the Great Crash came in 1929. The Berlin Wall fell in 1989, symbolizing the end of the Cold War ; the stock market boom topped out in 2000. Coincidence? Perhaps not. Maybe eleven years is how long it takes the stock market to first recognize the value of peace— and then to pay too much for it.
The Psychology of Market Bottoms As stocks initially descend from their peaks, the dominant sentiment is often to buy on dips—in other words, to take advantage of the price declines and buy more stocks. This sentiment is especially prevalent if the bubble had been building for a long time, because the longer it has been since the last bear market, the less investors can remember that stocks go down as well as up. As a result, there is often a so-called bear market rally, such as occurred in early 1930 (refer back to Figure 3.1) or in Internet stocks during the summer of 2000 (refer back to Figure 2.5). But when the rally stalls at prices below the previous high, some investors decide to use the rally as an opportunity to lock in what profits they still have. Thus they sell and send prices tumbling again. During this second tumble panic often sets in as investors realize they’ve missed two opportunities to sell high. Now the concern is no longer
. . . A n d at t h e B o t t o m
about maximizing gains, but about minimizing losses. And the only way to minimize losses is by selling. As stocks go down, panic to sell begets more panic until everyone who wants to sell has sold. At this point the market is finally at its bottom. What is sentiment like at this point? During the time that stocks were going down, every piece of news was interpreted negatively by investors who were looking for a reason to sell. If unemployment went down, it meant that the economy was going into a tailspin. If unemployment went up, it meant that the economy was growing too fast and inflation lay ahead. And pessimism begets more pessimism. In July 1932 no one could see an end to the Great Depression. On October 3, 1974, no one could see an end to the crisis of political confidence. On October 19, 1987, no one had any idea how far down the bottom was for the stock market. In the weeks following August 2, 1990, just about everyone feared that rising oil prices would wreck the world economy. In the days after September 11, 2001, everyone was bracing for the next attack by al-Qaeda. And in March 2003 the nation was beset by fears of war and instability in the Middle East. In all six cases irrational pessimism was the national mood, and in all six cases this irrationality froze most investors—like deer in a car’s headlights—preventing them from taking advantage of stocks at bargain-basement prices. The American Association of Individual Investors’ weekly poll of investor sentiment has documented this pattern of being most bullish at market peaks and most bearish at market bottoms. During the boom and bust of the last five years, the time when the highest percentage of individual investors were bullish was the first week of the year 2000. The new millennium had begun without any Y2K problems and the stock market was soaring, in part because of the money the Federal Reserve had injected into the banking system just in case Y2K bugs interfered with people’s access to their bank accounts. At that time, just two months before the market began to correct, 75 percent of individual investors said they were bullish. And the lowest bullish reading? It was 22 percent on February 20, 2003—when the media was talking about nothing besides the impending war with Iraq, and stocks were heading south as if under attack themselves.
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How to Recognize a Market Bottom The popularity of bell-bottom pants coincided with the 1970s bell at the bottom, just as the rising hemlines of the miniskirt era symbolized the bull market of the 1960s. And maybe it was not just coincidence. If the miniskirt represented confidence and sexual freedom, then bell-bottoms represented the new counterculture and doubts about U.S. institutions. But there has to be a better way to recognize market bottoms and tops. Twenty-twenty hindsight makes it clear that the best time ever to buy stocks for a ten-year holding period was September 1919—less than a year after the end of World War I. Between that time and September 1929 the value of an investment in stocks would increase more than fivefold, an annual rate of 19.94 percent. But in September 1919 earnings were declining because of the end of the wartime boom, yet a wartime excess-profits tax was still in place and inflation was on the rise. To top things off, the government began to enforce Prohibition, putting the (legal) beer, wine, and spirits industries out of business. In this environment, stocks were selling for less than ten times earnings. No one wanted stocks. Once again history would prove that it was a great time to buy them. When the market is at or near a bottom, the press is quick to headline the latest negative economic numbers or international crisis. On the other hand, the press tends to ignore unrecognized events that will change the economy for the better. One such event was Jimmy Carter’s 1979 nomination of Paul Volcker to head the Federal Reserve. Inflation had begun to surge out of control in the early 1970s as a result of higher gasoline prices. President Nixon tried to fight inflation with price controls. President Ford tried WIN (Whip Inflation Now) buttons. President Carter’s first appointment to head the Federal Reserve, J. William Miller, didn’t have a clue about how to whip inflation. But finally Carter, whether by luck or brilliance, found Paul Volcker. And Volcker understood that the only way to beat inflation was to control the supply of money by raising interest rates. Remember those supply and demand curves from Economics 101? Well, Paul Volcker knew what to do with them! And with inflation under control, the stock market produced real
. . . A n d at t h e B o t t o m
returns of 11.6 percent a year in the 1980s and 14.7 percent in the ’90s, meaning that real stock market wealth increased tenfold over those two remarkable decades. The first bell to ring at the bottom that preceded the 1982–2000 bull market was a now-famous 1979 Business Week cover story called “The Death of Equities” (equities are what stocks are called on Wall Street). By 1982 it seemed like every financial journalist in the country had written off the U.S. economy as unable to compete with Japan and the emerging “tiger economies” of East Asia. They said the United States was becoming a nation of burger flippers, while Asia was becoming the locus of production of steel, automobiles, and consumer electronics— the sources of true wealth in the late twentieth century. In 1982 the Great Lakes states from New York to Minnesota were known as the nation’s Rust Belt, and cars were seen heading south with bumper stickers reading, “Will the Last One to Leave Michigan Please Turn Off the Lights.” When Paramount Pictures affixed a huge King Kong balloon to the Empire State Building to promote the remake of that movie, it deflated. The sight reportedly caused a foreign visitor to comment, “Just like America: it’s big, it’s gaudy, and it doesn’t work.” By 1982 most Americans agreed. Few wanted to buy stocks in an economy in terminal decline. Anyone who listened to the media in 1982 could hear the bell ringing loudly and clearly—if only they knew what they were listening for. On August 12, 1982, stocks were selling at a P/E ratio of a mere eight times (depressed) earnings. But August 12 would prove to be the bottom. Stocks began rising that day and never looked back—at least not until March 2000. But what about a bell at the bottom following the recent crash from March 2000 levels? Just as near a market top, we can first look to the press. During the 1990s bull market, numerous investment books hyperventilated over how future long-term returns from the stock market should continue to be somewhere in the double digits, signaling a market top with their ever more rose-colored forecasts. But by 2002 the tone had definitely changed. Books like William Wolman and Anna Colamosca’s The Great 401(k) Hoax fretted that real returns from the stock market were likely
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to be 1.9 percent at best in the early part of the twenty-first century. If Business Week’s 1979 cover was the first bell signaling the greatest bull market in U.S. history, perhaps BW ’s July 2002 blood-red “Angry Market” cover, with its picture of a menacing bear, will prove to have been the first bell signaling the next bull market. The bell closest to the bottom may have been a speech given by Richard Grasso, then chairman of the New York Stock Exchange, on October 11, 2002. Speaking to an annual conference of stock traders in Boca Raton, Florida, Mr. Grasso said that the markets are no longer gripped by “irrational exuberance” but by an “irrational depression” that will not easily be turned around. In fact, with the benefit of the hindsight that Mr. Grasso lacked, we can now see that the irrational depression had been turned around two days earlier. October 9, 2002, has turned out to be the date on which one of history’s worst bear markets ended. A year later, stock prices were more than 30 percent higher despite the intervening sell-off caused by the Iraq War. There’s a good reason why such so-called contrarian signals work. After all, if everyone truly believes that it’s a new era in which stocks move only upward, then everyone has presumably already bought their fill of stocks. And if everyone knows that stocks “stink,” as several portfolio managers eloquently stated during the summer of 2002, then everyone capable of dialing their broker has presumably already sold. That’s why listening to conventional wisdom—and doing the opposite of what it suggests—is a sound investment strategy. But rather than having to make investment decisions based solely on sentiment and decibel levels, there is a way to quantify whether the stock market is irrationally undervalued or exuberantly overvalued. In Chapter 5 we’ll learn how. But first, I’ll explain why the stock market can be so irrational.
C H A P T E R
4
The Up-and-Down Stock Market
A
n unknown Wall Streeter once said,
The suckers haven’t permanently deserted the stock market. They are merely waiting until the prices get too high again. It’s a safe bet that stock prices will again get “too high” and that suckers will then return to buy stocks. There is no way this can be described as rational behavior, yet many a university finance professor still tries to make the case that the stock market is efficient or rational.
Is the Market Really Efficient? Many academics would say that you can never tell whether the stock market is poised for a correction or a rally. Their Efficient Market Theory proclaims that the decisions of thousands of well-informed buyers and sellers will always lead to a fair price. If stock prices subsequently go up or down, it is because of new information that no one could have known in advance. If the Efficient Market Theory is true, then stocks are always fairly priced and it makes just as much sense to buy them when they are trading at fifty times their earnings as when they are trading at five times.
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Although the Efficient Market Theory was not formally proclaimed until Princeton economist Burton G. Malkiel wrote A Random Walk Down Wall Street in 1973, it was expressed by another Princeton economist, Joseph Stagg Lawrence, in 1929 when he wrote: The consensus of judgment of the millions whose valuations function on that admirable market, the Stock Exchange, is that stocks are not at present over-valued. . . . Where is that group of men with that allembracing wisdom which will entitle them to veto the judgment of the intelligent multitude? Well, the multitude didn’t look so intelligent on October 29, 1929, nor did that “admirable market” look so efficient. Indeed, my answer to Efficient Market Theory is to look at the days leading up to October 29, 1929, or March 24, 2000. On those days it would be hard to make a case that stocks were fairly priced and that only unforeseen events led to the subsequent corrections. Figures 4.1 and 4.2 show how mutual fund investors allocated their assets near the most recent market peak and subsequent market bottom. Just after the March 24, 2000, market peak, when they should have been holding a lot of cash and bonds in response to the ringing bells, they held 69 percent of their assets in stocks, having bought a record $46 billion worth of stocks in February. Just before the October 9, 2002, market bottom, when they should have mortgaged the farm to buy stocks, they held 48 percent of their assets in stocks, having sold a record $30 billion worth of stocks in July. Figure 4.3 depicts this persistent pattern of buying when stocks are high and selling when stocks are low. As a result, while an investment in the S&P 500 Index more than doubled in value from the middle of 1993 to the middle of 2003, the result for the average investor was far worse, owing primarily to selling at the bottom and buying at the top. And the professionals who manage corporate pension funds did little better at timing the market. They had only 40 percent of their funds’ money invested in stocks near the market bottom, compared with 51 percent in stocks near the market top. Why this counterproductive and inefficient behavior? The next section will answer that question.
T h e U p - a n d - D ow n S to c k M a r k e t
Figure 4.1 Mutual Fund Asset Allocation on March 31, 2000
Figure 4.2 Mutual Fund Asset Allocation on September 30, 2002
Cash 8%
Cash 15%
Bonds 23% Stocks 69%
Stocks 48% Bonds 37%
Based on data from the Investment Company Institute.
Net buying (millions)
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Jan . Ju 199 ly 6 Jan 199 . 6 Ju 199 ly 7 Jan 199 . 7 Ju 199 ly 8 Jan 199 . 8 Ju 199 ly 9 Jan 199 . 9 Ju 200 ly 0 Jan 200 . 0 Ju 200 ly 1 Jan 200 . 1 Ju 200 ly 2 Jan 200 . 2 Ju 200 ly 3 20 03
–$60,000
Net buying of stock funds
Based on data from the Investment Company Institute.
S&P 500 Index
S&P 500
Figure 4.3 How Not to Buy Low
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What Prevents Market Efficiency? The short answer to this question is that human nature prevents market efficiency. The reason the Efficient Market Theory is wrong is that it is based on the rational man theory—that cornerstone of economics that says men and women will act rationally to maximize their wealth. But we human beings are not computers that can be programmed to analyze financial data and act rationally upon it. Instead, we are creatures of flesh and blood who act on the basis of emotion and misperception. Behavioral finance is the study of stock market decision making with the tools of psychology rather than those of mathematics and economics. Research in behavioral finance enabled a psychologist, Daniel Kahneman, to win a share of the 2002 Nobel Prize in economics. Behavioral finance has identified many human traits that prevent rational stock market behavior. Following are what I think are the big six.
1. Greed and Fear It doesn’t require psychological research to demonstrate that greed and fear are big factors in how people make financial decisions. A trip to a casino should suffice. Indeed, if human beings were rational about money, casinos wouldn’t exist, because a rational person intent on maximizing wealth would never enter one. But we do. And once we start winning, greed takes over. We win $500 at blackjack. That’s great, we think, but wouldn’t it be nice to win $1,000. So we double our bets. And if we win $1,000, wouldn’t it be nice to win $2,000. And think what we could do with $4,000 . . . and on and on. It’s no different in the stock market. During a boom it seems that everyone else is making money and we don’t want to be left out. If we’ve already made a nice return on our investment, we think about what our return could be if we stay in the game for a few more days—after all, the stock market is going up. On the days leading up to stock market highs, this was the sentiment on Wall Street: wishful thinking—ignoring the laws of gravity—greed fully in control. But the reverse occurs when the stock market is going down. Then fear of losing leads to equally irrational behavior, as we sell without regard to price because everyone else is selling and we don’t want to be
T h e U p - a n d - D ow n S to c k M a r k e t
left holding the bag—even though the bag may still have considerable value. Indeed, the P/E ratio may be more a measure of investors’ psyches than of stocks’ valuations. When the P/E moves above 20, investors are on their way to a manic high—below 10, they’re morbidly depressed. Not only do greed and fear lead to bad investment decisions, but an obsessive interest in the accumulation of wealth can become an addiction; and like any addiction it can lead to harmful behavior: compulsive gambling, income tax evasion, putting work ahead of family, and so on. It’s no wonder that all the world’s great religions warn against the love of money. Buddhism teaches that the pursuit of material wealth is characteristic of an early and immature stage of human development that men and women must move beyond on the road to enlightenment. Judaism teaches the concept of Jubilee, in which debts are forgiven and inequalities equalized every fifty years. Christianity teaches that “the love of money is the root of all evil” (1 Timothy 6:10).
2. Self-Confidence Granted, this is a necessary trait for success. And it is a trait that most investors have in abundance. The problem is that it makes us believe that stock market success is a result of skill, when more often than not it is a result of luck. It makes us believe we can analyze complex political and economic data and predict what the stock market will do. According to the late Amos Tversky, a Stanford psychologist and research partner to Dr. Kahneman: Overconfidence seems to be built into humans, in the sense that the mind is probably designed to extract as much information as possible from what is available rather than to assess how little is known about a particular issue. He cites as an example a study of doctors diagnosing pneumonia. The doctors said they were 90 percent sure of their diagnoses, but they were actually right only 50 percent of the time. The same overconfidence affects most investors, making them think they can predict what no one can predict: the short-term direction of stock prices.
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For this reason, a strong case can be made that pessimists make better investors than optimists, and that women are better investors than men because they tend to be realists rather than optimists when it comes to money. Research has suggested that this is correct, but it has yet to be conclusively proven. Then there is the evidence of Boston and Philadelphia. The construction of the Erie Canal in 1825 connected New York City with the Great Lakes, vaulting it ahead of Philadelphia as the nation’s leading center of commerce and finance. The trade of Babe Ruth to the New York Yankees after the 1919 season transferred baseball dominance from Beantown to the Big Apple. Today Boston and Philadelphia suffer a lack of self-confidence, perhaps even an inferiority complex, compared with their larger rival (although Bostonians seem especially loath to admit it). New York, on the other hand, abounds in self-confidence. Yet New York is a “sell-side” city, dominating the investment banking and stock brokerage side of the business, but not the money management, or investing, side of the business. In contrast, Boston and Philadelphia are both leading money management centers, and the home of the nation’s two largest mutual fund companies (Fidelity and Vanguard, respectively). For the record, the author of this book is a Philadelphia Phillies fan and is thus (like Boston Red Sox and Chicago Cubs fans) aware that strange, unexpected, and usually bad things can happen at any time. Such an awareness should be a prerequisite for a fund manager.
3. Herd Instinct Psychologists have performed experiments in which subjects are asked to answer simple questions for which the answer is clear. For example, is Circle A bigger than Circle B, when it is obvious that the answer is yes. However, when a majority of subjects are secretly instructed to answer no, then in a show of hands many of the uninstructed minority will also answer no. The reason seems to be an unwillingness to trust one’s own judgment if it is clearly a minority judgment. That’s because life experiences tend to teach us that the “herd” is usually right—and if it’s not, then it’s safer to be wrong with the majority than to try to prove that the majority is wrong. So how does this work in the stock market? Let’s say that Company X is expected to earn $2 a share this year and companies like Company
T h e U p - a n d - D ow n S to c k M a r k e t
X are trading at twenty times their earnings—thereby suggesting a price of $40. A rational investor would therefore pay no more than $40 for the stock. But let’s say that a stock analyst publishes a report saying the stock is going to $50. A few investors read the report and buy the stock, pushing its price up to $45. Our supposedly rational investor now questions his own judgment that the stock is worth only $40. Maybe I’m wrong and the market (herd) is right (efficient), he thinks. So he puts in an order to buy the stock, sending the price up to $46. The irony here is that because he believes the market is efficient, he makes it less efficient by driving the stock’s price even farther from its rational price of $40.
4. Pattern Recognition There is something about the human brain that causes us to see patterns where only randomness exists. Clouds look like dragons when we stare into the summer sky; ink blots become patterns that tell about our personalities on Rorschach tests. When the stock market is rising, we see only a pattern of further gains. When it is falling, we see only the decline—never a bottom. Take a look at the daily movement of the stock market shown in Figure 4.4. Do you see a pattern? It looks to me like the bulls were in command from day 6 to day 19, as the stock market rose from 89 to 118—a spectacular 33 percent advance. But since then the bears have regained their strength and look to put an end to the rally. Will the stock market go up or down from here? A good investor should be able to discern a pattern. And if the majority conclude that the bears will gain control and send the market down, they will sell and send the market down—for no rational reason, except the pattern. In the case of this figure, the odds are exactly fifty-fifty that this stock market will go up from here. That’s because the figure doesn’t show the trend in any actual stock market. Rather, it depicts the results of rolling two dice! The simple rules were that if the red die was a 1, 2, or 3, the market went down; a 4, 5, or 6, and it went up. The white die determined by how much it went up or down—1 to 6. But if you are determined to see a pattern here, that’s OK. As Nassim Nicholas Taleb has shown in his book Fooled by Randomness (2001), it’s only human nature.
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5. Myopia—Lack of Historical Vision Myopia can be defined as nearsightedness—or in the case of stock market behavior, as lack of historical vision. We human beings tend to place a lot more importance on recent events than we place on earlier ones. The most recent events are vivid in our memories; earlier ones get lost in a fog. We act on the latest news, neglecting the long-term pattern of news. If the evening news says that Gigantic Industries laid off five thousand workers this week, we think the economy is going to hell in a handbasket and we should sell stocks. We’ve either forgotten that Enormous Industries hired five thousand the week before, or we think that it’s old news. And if the stock market went down today because of the Gigantic Industries layoffs, we think it is likely to go down tomorrow and we put in sell orders for the next morning’s opening. If enough
Figure 4.4 A Clear Uptrend! . . . Or Has the Market Peaked? 120
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people do this, the stock market will, in fact, go down tomorrow, creating a self-fulfilling prophecy. And it will go down again the next day, unless there’s a big news story to cause the market to reverse direction. But the longer the market goes down, the stronger the trend is perceived to be and the bigger the news required to turn it around. And thus trends are born for no good reason. And these trends can help stock market bubbles to develop—or to burst. Another manifestation of myopia is that our point of reference in valuing an investment tends to be the price we paid for it. If we bought one hundred shares of Podunk Manufacturing at $20 a share and it goes
W HY D OES B AD N EWS M AKE THE S TOCK M ARKET G O U P ? Did you ever notice that following bad economic news—a jump in the unemployment rate, for example—stocks often go up? Do people on Wall Street like to see people on Main Street suffer, or what? Actually, how the stock market reacts to economic news depends on what’s on investors’ minds. If they are worried about inflation and rising interest rates, then yes, higher unemployment will help to calm their fears. (That’s because unemployed people usually don’t go out on spending sprees that would drive prices up.) And being less worried about the damage inflation can do to stock prices, investors would be more likely to buy stocks and drive their prices up. On the other hand, if the big worry is an economic slowdown and falling profits, then rising unemployment will worsen those worries and cause stock prices to fall. But even in this case there is an exception to the rule: if investors decide that rising unemployment will cause the Federal Reserve to lower interest rates in an attempt to put a charge in the economy, then they may buy stocks after unemployment rises. The bottom line is that there’s no way to know with any degree of confidence how the stock market will react to a piece of economic news.
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to $10, we think the stock is cheap because our frame of reference says that $20 is a fair price. We don’t reevaluate fair value in response to the facts that Podunk’s sales are in a death spiral, that they haven’t come out with a new product in five years, and that Podunk’s CEO and his leggy assistant were last seen boarding a plane bound for the Cayman Islands after the SEC announced an informal investigation of the company’s accounting practices. We’re not going to sell until the stock comes back to its “fair value” of $20, we think—as the stock price continues to move steadily southward.
6. Vanity—We Don’t Like to Admit We Were Wrong! Take the Podunk example just discussed. Not only does the purchase price establish fair value in our mind, but to sell for less would mean admitting we were wrong. As long as we hold the stock, we also hold on to the belief that we are right, that the market is wrong, and that other investors will eventually see the error of their ways and bid the price back above $20. But it’s even worse if we’ve told other folks about our brilliant buy of Podunk at $20. To sell below $20 means admitting not only to ourselves but also to friends, spouses, and significant others that we’re not the stock market whizzes we fancy ourselves to be. So instead of doing the rational thing—selling Podunk, taking our losses, and admitting we were wrong—we hold, and we hold, and we hold . . . as the stock keeps going down. If investors are driven by greed, fear, and vanity; believe they are better stock pickers than they really are, yet look over their shoulders to see what others are doing; see patterns where only randomness exists; and miss seeing the big picture because of myopia, why should we expect them to price stocks efficiently?
C H A P T E R
5
How to Tell Whether the Stock Market Is Fairly Valued
W
hy have Treasury bills historically done barely better than the rate of inflation, while stocks have provided annual returns about 7 percent above inflation? The answer comes from one of the oldest rules of investing: the greater the risk, the greater the reward.
Risk and Reward At one time Christianity, Judaism, and Islam all forbade charging interest on borrowed money—at least to other members of the same faith. Lending money and expecting it to be paid back with interest was called usury and was seen as a way in which those blessed by God with wealth took advantage of those not so blessed. Over time, however, the ban on charging interest has eroded in the face of arguments from economists such as Adam Smith and John Maynard Keynes. These economists pointed out that lending money to someone who can put it to good use benefits all of society. To encourage such lending, the lender needs to be rewarded for the risk—and the greater the risk, the greater the reward should be. There is real risk to investing in stocks. When you own a share of stock, you own a piece of a company. If the company goes bankrupt, your share could become worthless. Over time the law of supply and demand has determined that the reward for taking the risk of owning stocks should be a real return of about 7 percent a year. On the other
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hand, if you own a three-month Treasury bill, which is a short-term IOU from Uncle Sam, you can be sure of getting your principal back, plus interest, after ninety days. And if inflation causes interest rates to go up, you’re not locked into a low interest rate for a long period of time. You can reinvest your money ninety days later at the new higher rates. Of course, the downside of no risk is almost no real return from T-bills. Bonds lie between T-bills and stocks on the risk-reward spectrum. Government bonds have historically produced a better return than T-bills because they entail price risk (see Chapter 8). Corporate bonds (IOUs from corporations rather than from the federal government) have produced a slightly better return still, owing to their higher level of risk. But stocks are riskier than corporate bonds. If a company goes bankrupt, bondholders have first claim on anything of value; stockholders get anything that is left. Figure 5.1 shows this risk-reward relationship. Since 1963 stocks, as we would expect, produced the best reward, outpacing inflation by 5.7 percent per year. Treasury bonds were second best, beating inflation by 2.9 percent a year, while cash—actually, three-month Treasury bills— did 1.5 percent better than inflation. But risk, meaning how much you could lose in the worst year, was in the reverse order. Stocks lost 35.4 percent of their value in the worst year (1974), bonds lost 12 percent (1967), and T-bills also failed to keep pace with inflation, losing out by 4.1 percent (again in 1974). What this means is that someone who held all their wealth in stocks over this forty-year span (1963–2002) did well (and would have done much better if they sold at the market top in 2000), but they might have had a lot of sleepless nights back in 1974.
Pizza Parlors or Stocks? It is actually easy to recognize when a stock is grossly over- or underpriced if you stay focused on the numbers and ignore the hype. Consider the case of the shares of Cisco Systems, once considered a must-own stock for anyone who wanted to participate in the new age of Internet investing. The math for deciding whether to buy one hundred shares of Cisco Systems is no different from the math for deciding whether to buy
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Figure 5.1 Risk and Reward (1963–2002) 40%
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a stake in the pizza shop on Main Street. (Sorry, but I’m from New Jersey. The example has to be either a pizzeria or a sub shop.) Remember that when you’re buying a stock, you’re buying a percentage stake in a business, not playing the slots in Atlantic City. If a company has issued a million shares of stock and you buy one share, you own one one-millionth of the company. And when you’re buying shares in a mutual fund, you’re buying a piece of the U.S. (or global) economy. Anyway, folks invest in pizzerias for the same reason they invest in stocks like Cisco Systems. In the hope that growth will increase the value of their investment. But pizza parlors are even riskier than stocks because they are small operations—a big chain puts up a pizzeria down the block, a new highway bypasses Main Street, or some customers get sick from bad pepperoni, and you’re out of business and your investment is worthless. That’s why folks demand a high return for an investment in a pizzeria—maybe as high as a 20 percent return on their money. If a pizzeria is expected to earn $50,000 a year for its owner, an investor might be willing to pay $250,000 for the business, but no more. That means the going P/E ratio on a pizza parlor would be only five times earnings. (Although
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I know the price of a slice, I’m no expert on the going price of a pizza business—I’m just making the point that such a risky business should be rewarded by a high rate of return on investment.) Let’s say your cousin owns a pizzeria that is currently netting $50,000 a year in profits. Let’s also say that he offers to sell you a 50 percent stake in the business. The pizzeria is in a good location, and you figure that its earnings should grow for at least the next ten years. If your cousin offers you the 50 percent stake for $125,000, it’s probably a good deal—it’s consistent with the going rate in the pizza business. If you can tolerate risk (and haven’t done anything to offend the Sopranos), you should buy a stake in the pizzeria. But if a bidding war breaks out and another cousin offers $150,000 (or if Tony Soprano makes a bid), it becomes a no-brainer—you should walk away. Why pay more than the going price for the risk? It should be no different with the decision whether to buy a stock. On March 24, 2000, Cisco Systems was well on its way to earning 65¢ a share. Based on 130 years of stock market history, the normal P/E ratio for a stock has been about 15. That means that if Cisco were a normal stock, it would be worth about $10, or fifteen times its earnings of 65¢. Now granted, Cisco was recognized as one of the world’s greatest growth companies in 2000. Perhaps a P/E multiple of 30 was justifiable given its long-term potential. In fact, however, the closing price for Cisco Systems shares on March 24, 2000, was $77.88, or 120 times its earnings! But on March 24, 2000, Wall Street analysts were screaming “Buy!” about Cisco Systems: • Cisco Systems is the main supplier of the hardware that runs the Internet, they said. • It’s a one-of-a-kind investment opportunity, they said. • Its earnings will grow by 35 percent a year forever (or at least until we’ve bought our homes in the Hamptons), they said. What the Wall Street analysts failed to mention was that the future earnings of Cisco were no more certain than those of the pizza parlor
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on Main Street. In fact, Cisco’s earnings didn’t grow at 35 percent a year; instead, they shrank by almost 75 percent—to 18¢ a share—and eventually the stock was selling at $10.50 a share (see Figure 5.2). As this book went to press, Cisco Systems’ earnings were again on a growth trajectory, and the stock was again selling above $20 a share— but a lot of good that does for someone who bought in March 2000. OK, so maybe the pizza parlor and Cisco Systems are simplistic examples. But they make two important points. First, no matter how great a company is—whether a giant corporation or a pizzeria in a good location—if you pay too much, you’re likely to lose money. And second, with growth comes risk. If the growth is fairly certain, it may be all right to pay a little above the going rate. But if the uncertainty is high, you should demand a lower price. Now let’s see how we can apply these points to the stock market as a whole.
A Simple Tool for Valuing the Stock Market The stock market has been called a random walk up a 7 percent grade. This means that over a lifetime, an investment in the stock market is likely to produce a 7 percent annual real (adjusted for inflation) return. But in any one year, the return will be random—only averaging 7 percent over a long enough time frame. If the stock market is fairly valued, it is likely to produce something close to the normal 7 percent return over the next ten years, even though the returns in any one year of the ten will be random. But how do we determine whether the stock market as a whole, as opposed to an individual stock, is fairly valued? There’s an old doggerel that goes like this: A cow for her milk, A hen for her eggs, And a stock, by heck, For her dividends.
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Figure 5.2 Cisco Systems
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But in recent years, companies have paid out a smaller portion of their earnings as dividends than in the past. During the latter part of the nineteenth century, the average payout ratio was 74 percent. By the end of the twentieth century, this ratio had fallen to 35 percent. There are several reasons for this change in dividend payout policy on the part of corporations, but the main reason has to do with taxes. Prior to the 2003 tax law changes, the tax rate on dividends had been higher than the tax rate on long-term capital gains. As a result, many shareholders preferred stocks that paid low, or no, dividends. Instead, shareholders created their own dividends by selling shares when they could do so at a profit. Companies also bought back their stock, theoretically increasing the value of the remaining shares, rather than paying the money directly to shareholders as dividends. In fact, since 1997 corporate America has spent more money buying back shares than on dividend payments. Because the value of a dividend to a shareholder is dependent on the tax rate, and because the tax rate has changed over time, the dividend yield of the stock market is not a trustworthy measure of valuation. While there has been lively scholarly debate on the subject, the bulk of the evidence indicates that the P/E ratio is the best method of valuation if your goal is forecasting future stock market returns. Figure 5.3 shows the P/E ratio of the S&P 500 Index for every month beginning in 1875 based on average earnings during the previous five years. (I use a five-year average because earnings can be erratic from year to year. Five years is normally enough to balance out any low-earnings recession years with high-earnings growth years.) The figure also shows the subsequent ten-year total return from the index, adjusted for inflation. Several points leap out from Figure 5.3: • The average annual real total return has been about 7 percent. • The average P/E ratio has been about 15. • When the P/E line is high, the return line is low, and vice versa. There were ninety-seven months in which the P/E ratio was above 20. The average return during the ten years following these months was 1.7 percent per year above the rate of inflation. After forty-eight of these ninety-seven months, stocks failed to keep pace with inflation.
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Figure 5.3 P/E Ratio and Future Returns 40
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Based on data from econ.yale.edu/~shiller.
• There were 262 months in which the P/E ratio was under 10. The average annual return following these months was 12.5 percent above the rate of inflation, and there was no case in which stocks failed to outpace inflation. When the S&P 500 is trading near its normal P/E multiple of 15, you should expect a normal annual long-term return of about 7 percent better than inflation. There’s a simple reason for this. A P/E of 15 means that you are getting about 6.7¢ in earnings for every dollar you invest in the stock market (1 ⫼ 15 ⫽ 0.067). If the companies that make up the S&P 500 decided to pay these earnings out as dividends, you would receive a dividend yield of 6.7 percent. In that case, stocks would act almost like bonds. But not exactly like bonds. Their share price might still grow with inflation, whereas a bond’s price is fixed. As a result, the expected return in this example would be 6.7 percent plus inflation—in other words, a real return of 6.7 percent.
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W HAT A BOUT C ASH F LOW ? Some of you more perceptive readers may be asking, isn’t cash flow what’s really impor tant? To save the rest of you a trip to the Glossary (“What Wall Street Really Means”), let me explain that cash flow simply refers to how much money a company actually makes (or loses) in a given period of time. Earnings, on the other hand, is an accounting concept intended to show how the company is really doing. Here’s an example of one of the big differences: Let’s say I decide to open a sub shop (sandwiches, not naval equipment). In the first year, I spend $50,000 buying equipment. I end the year with $40,000 less cash than when I started, so my cash flow is minus forty grand. But my accountant tells me that I actually made money because I must “capitalize” what I spent on the equipment. By that she means that I don’t subtract it from earnings because I didn’t lose the fifty grand—I merely exchanged it for equipment that will have, say, a ten-year life. Instead of subtracting $50,000 from my revenues, I subtract $5,000 over each of ten years (that’s called depreciation) to normalize how the business is doing instead of taking the hit all in the first year. By saying that the cost of the equipment is $5,000 (depreciation) a year instead of $50,000 (capital costs) in one year, I end up with accounting earnings of $5,000 even though my cash flow was ⫺$40,000. The next year, I spend nothing on equipment. I end the year with $10,000 more than I started with, so my cash flow is $10,000. But to get to accounting earnings, my accountant makes me subtract another $5,000 for depreciation. So my accounting earnings is again $5,000. As this example shows, one of the things that accounting earnings is supposed to do is to normalize earnings to give a true picture of how a business is doing. Cash flow alone makes it appear that I had a terrible first year and a great second
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year, but that was only because I bought all the equipment in the first year. That’s why earnings are usually a better tool for evaluating how a company is doing than cash flow. Buy-side analysts (including myself) use whatever accounting measure we believe gives the truest picture of how a company is doing. For most of us, that’s operating earnings. Cash flow also explains why a company can theoretically pay out 100 percent of its earnings as dividends and still grow its earnings to keep pace with the rate of inflation. That’s because cash flow exceeds earnings by the amount of depreciation. And this difference can be reinvested in the business to at least keep the business growing at the rate of inflation even while paying out all the earnings as dividends. To grow faster would require the company to reinvest at least par t of its earnings—or at least that’s what finance theory says.
As we have already seen, companies now tend to pay out less than half of their earnings as dividends. Some of the earnings are used to buy back stock. Some are used to pay down debt or build up interestgenerating cash reserves. And some are invested in expansion of the business. In theory, if companies are paying out less in dividends, this should be good for shareholders because it means that management has found a better use for the money. Thus we should expect a return of more than 6.7 percent, shouldn’t we? Well, not exactly. History has shown that management hasn’t always put excess cash to the best of all possible uses. Benjamin Graham, the father of value investing, stated the reason why in 1948 in The Intelligent Investor, when he wrote: Efficient finance requires that the stockholders’ money be working in forms most suitable to their interest. This is a question in which management, as such, has little interest. Actually, it almost always wants as much capital from the owners as it can possibly get, in order to min-
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imize its own financial problems. Thus the typical management will operate with much more capital than necessary, if the stockholders permit it—which they often do. AT&T is a case in point. The telephone giant had record earnings of $1.74 a share in 1999. They paid 88¢ as a dividend to shareholders but invested $4.48 a share in new plants and equipment, much of it for new fiber-optic lines to enable them to compete as a carrier of Internet data. By 2001 the Internet boom was going bust, and data had not replaced voice as a profit center. Earnings had turned into a loss of $1.33 a share, and a rising debt load was pushing AT&T’s bond rating in the direction of junk status. The quarterly dividend was cut to 15¢ a share. And the price of a share of stock tumbled from a high of $64 in 1999 to less than $15 during 2001. In retrospect, management would have done better to pay out 100 percent of earnings as dividends and to limit capital spending to maintaining and upgrading the existing network. There are countless other examples of companies that spent for growth in the 1990s with disastrous results, instead of returning their profits to the shareholders. Perhaps even Microsoft, which has built up a cash reserve of about $40 billion, would have done better to pay a dividend and let its shareholders decide how to spend their profits. Actually, Bill Gates must have heard me. On January 16, 2003, Microsoft declared its first-ever dividend, albeit only a modest 8¢ a share. And then there is the touchy subject of stock options and loans to top management. Many companies, especially in the high-tech industries, offered their executives (and often entry-level employees as well) the option to buy company stock at a set price. During the boom years, the share price often far exceeded the set price, meaning that the company was essentially giving its stock away versus the price at which it could sell it to the public. Many of these companies then bought the stock back at a higher price to keep the number of shares steady. In this case, the cash essentially went from the companies’ coffers to the execs’ pockets, bypassing all the other shareholders. And then there was that $5.7 million Tyco International allegedly spent to decorate CEO L. Dennis Kozlowski’s Manhattan apartment. And those loans that Adelphia Communications made to its founder John J. Rigas to help him keep the Buffalo Sabres hockey team. A century ago such corporate chiefs were
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known as robber barons. A better name has yet to be coined for the corporate pirates of our own time. . . . It is these abuses that federal reform legislation in the form of the Sarbanes-Oxley Act is intended to curtail. Among other things, the act requires that chief executive and financial officers certify the truthfulness of a company’s financial reports. Whether the recent reforming zeal will have a long-term effect in making the markets more efficient or whether it will soon be business as usual remains to be seen. The answer depends on public interest and support for ongoing reform. But I digress, and by now you should get the picture. Just because companies are “reinvesting” more of their earnings and paying less out as dividends, don’t expect your return as a shareholder to be higher. Indeed, dividends are a very important part—and the most predictable part—of your expected return. Even though the ten years from 1993 to 2003 were a period of unusually low dividend payouts, dividends still made up 27.5 percent of the total return from S&P 500 stocks. Following the 2003 changes to the tax law that reduced the tax rate on dividends to 15 percent, corporations are likely to increase their payouts to shareholders, making dividends an even more important part of total return. Nevertheless, based on the historical evidence, the P/E ratio rather than the dividend yield is the best predictor of the future return from stocks. For every one-point increase in the P/E ratio, there has been a decrease of 0.7 percent in the annual return over the following ten years. The correlation between P/E ratio and subsequent return is ⫺0.54, which, as those of you who stayed awake during Statistics 101 know, is not likely a result of chance after more than 1,400 monthly observations. Table 5.1 shows the normal inflation-adjusted total return for each P/E ratio based on more than 125 years of actual data. For example, when the P/E is 15, the normal return has been 6.2 percent, but 10 percent of the time it has been more than 11.6 percent and 10 percent of the time less than 0.8 percent. Note that, as in Figure 5.3, these P/E ratios are based on average earnings during the previous five years. What if the stock market is trading at twenty times earnings, or more? Well, based on the figure, the normal return at that P/E ratio has
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Table 5.1 P/E and Subsequent Annual Returns 5-Year Trailing P/E
Average 10-Year Annual Return
Best Case (10% Chance)
5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35
13.2% 12.5% 11.8% 11.1% 10.4% 9.7% 9.0% 8.3% 7.6% 6.9% 6.2% 5.5% 4.8% 4.1% 3.4% 2.7% 2.0% 1.3% 0.6% ⫺0.1% ⫺0.8% ⫺1.5% ⫺2.2% ⫺2.9% ⫺3.6% ⫺4.3% ⫺5.0% ⫺5.7% ⫺6.4% ⫺7.2% ⫺7.9%
18.7% 18.0% 17.3% 16.6% 15.9% 15.2% 14.5% 13.8% 13.0% 12.3% 11.6% 10.9% 10.2% 9.5% 8.8% 8.1% 7.4% 6.7% 6.0% 5.3% 4.6% 3.9% 3.2% 2.5% 1.8% 1.1% 0.4% ⫺0.3% ⫺1.0% ⫺1.7% ⫺2.4%
Worst Case (10% Chance) 7.8% 7.1% 6.4% 5.7% 5.0% 4.3% 3.6% 2.9% 2.2% 1.5% 0.8% 0.1% ⫺0.6% ⫺1.3% ⫺2.0% ⫺2.7% ⫺3.5% ⫺4.2% ⫺4.9% ⫺5.6% ⫺6.3% ⫺7.0% ⫺7.7% ⫺8.4% ⫺9.1% ⫺9.8% ⫺10.5% ⫺11.2% ⫺11.9% ⫺12.6% ⫺13.3%
been 2.7 percent—about the same as the return from owning bonds— and in 10 percent of the cases there was an annual loss of 2.7 percent or more during the following ten years.
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You Say You Don’t Trust Reported Earnings? Just because Enron, WorldCom, Global Crossing, and not a few other companies reported earnings that weren’t there? Well, I don’t trust them either. Figure 5.4 shows the trend in S&P 500 reported and operating earnings per share versus corporate profits as tabulated by the U.S. Department of Commerce (DOC). Reported earnings per share are earnings reported by companies and are supposedly in accordance with Generally Accepted Accounting Principles, better known as GA AP. Operating earnings, also known as pro forma, or non-GAAP, earnings, are earnings that exclude nonrecurring or extraordinary events, such as big writedowns of the value of unsuccessful investments or a one-time loss or gain on the sale of a business.
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Figure 5.4 Pick Your Earnings!
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Notice how the year 2000 bubble in S&P 500 reported earnings does not exist in the government figure. The main reason for this difference is that DOC bureaucrats had no incentive to fudge the figures, whereas corporate brass did. The stock options that were supposed to motivate management to work harder to raise their company’s share price also motivated them to use creative and sometimes downright fraudulent accounting to raise reported earnings. Under pressure from Congress and the Securities and Exchange Commission, companies are moving toward accounting that is more conservative than that used before 2000, thus creating a distortion in the opposite direction. For that reason, the S&P 500’s P/E ratio based on reported earnings is often misleading. At times this number has been as high as 45, but only because companies have been recording losses by writing off some of the stupid investments that were made during the 1990s. This reduces reported earnings. But actual business results weren’t nearly that bad. (Thus the E in the P/E ratio is artificially low in the reported results, so the result of dividing P by E becomes too high.) In fact, the trend of operating earnings is closer to the trend of actual corporate profits as tracked by the DOC. The bottom line is that the best measure of the trend in corporate earnings is the DOC data, but the second best is S&P operating earnings. While accountants debate such arcane topics as how to value stock options and when goodwill should be written off to reduce GAAP earnings, investors in the real world, for better or worse, pay attention to operating income as defined by Wall Street analysts. So the P/E ratio of the S&P 500 Index based on operating earnings is the best shorthand way to tell whether stocks are overpriced. At the time of this writing in January 2004, the P/E ratio of the S&P 500 was almost 22, based on average operating income during the past five years. Historically, when the P/E has been at that level, the real return over the coming ten years has been only a measly 1.3% (refer back to Figure 5.3). Although positive, it is less than the normal return from government bonds and only slightly better than the return from cash. This means that our P/E tool was signaling that stocks were overvalued in January 2004. Of course, by the time you read this book the P/E ratio may be lower—or perhaps even higher.
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W HERE D O I F IND THE S&P 500’ S P/E R ATIO ? You’re not likely to find the S&P 500’s P/E ratio in your daily newspaper. And although financial publications such as the Wall Street Journal and BusinessWeek do publish P/E ratios, these ratios are based on either repor ted earnings or on what analysts think earnings will be during the current year or coming twelve months. (The problems with repor ted earnings were discussed earlier.) And a P/E ratio based on a single year’s earnings, whether historical or estimated by analysts, may not be a good indicator of valuation. That’s because when the economy is booming, earnings are likely to be strong and the P/E ratio is likely to be temporarily low. Likewise, during a recession earnings will be weak and the P/E ratio will be unduly high. (Remember that earnings are the denominator of the P/E equation, so when earnings go down the P/E ratio goes up, and vice versa.) The best place to find the historical P/E based on operating earnings is the website conquer thehype.com. If you don’t have Internet access, you can use the estimated P/E ratios found in the Wall Street Journal or BusinessWeek. In the Journal, look for “Est. P/E ratio” for the S&P 500 under “Markets Lineup” in the “Money & Investing” section. In BusinessWeek look for “S&P 500 P/E Ratio (Next 12 mos.)” under “Fundamentals” in the “Personal Business/Figures of the Week” section at the back of the magazine. But take these numbers with a grain of salt and add 10% or so to the P/E, especially if the economy is currently booming. In my opinion, you should not put too much emphasis on the P/E ratios shown for the trailing 12 months. Not only are they based only on a single year of earnings, they are also based on repor ted, rather than operating, earnings.
Although a P/E ratio based on analysts’ estimates of earnings for the next twelve months is probably not a good valuation tool to use for purposes of long-term investing, it may well give a good short-term signal
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when used in conjunction with interest rates. At least Federal Reserve Chairman Alan Greenspan seems to think so. In the next two sections, we will take a look at two tools that may signal the short-term direction of the stock market, beginning with Chairman Greenspan’s favorite model.
The Fed Model Alan Greenspan’s December 1996 observation that there was irrational exuberance in the stock market was based in part on what is called the Greenspan model, or the Fed model. This model, or formula, compares the expected earnings yield of the S&P 500 with the yield on the tenyear Treasury bond. The earnings yield is simply the inverse of the P/E ratio. It tells how much earnings you are getting for every dollar in price. If the P/E ratio is 20, the earnings yield is 5 percent (1 ⫼ 20), meaning you are getting 5¢ in earnings for each dollar of price. In the Fed model the earnings yield is based on the consensus earnings forecast of Wall Street analysts—not on reported earnings. Figure 5.5 shows how the Fed model worked from 1986 to 2003. A positive yield spread (right-hand scale) means that you get less earnings from a dollar invested in the stock market than interest from a dollar invested in a ten-year Treasury bond. In other words, stocks are expensive compared with bonds. The implication is that you should sell stocks and buy bonds. When Chairman Greenspan made his irrational exuberance observation, the earnings yield of stocks was only slightly below that of bonds. Although the yield spread had fallen from being strongly positive for stocks through much of 1995, it was still well within its normal range. In fact, Greenspan’s comment proved to be premature, as the bull market in stocks picked up steam and continued for another three years. It was not until the end of 1999 that the yield spread fell to ⫺2 percent, clearly signaling the overvaluation of stocks relative to bonds—and correctly predicting the impending stock market correction. At the end of September 2002, the yield spread rose above ⫹2 percent, signaling that stocks were selling at bargain-basement prices rel-
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Figure 5.5 The Fed Model 4%
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ative to bonds. And so far the model has been right again, as the stock market has rallied mightily from its October 2002 low. But the Fed model has one inherent weakness. It can tell us whether stocks are cheap or dear relative to Treasury bonds but not whether they are cheap or dear in an absolute sense. If the model says that stocks are cheap compared with bonds, this doesn’t mean that stocks will rise in price. It could mean that bonds are expensive and will fall in price to bring the two back into equilibrium. During the summer of 2003 there was downward movement in bond prices rather than upward momentum in stocks. Indeed, after bond yields fell to fifty-year lows in early June 2003, there was far more reason to expect a big correction in the bond market than an extended rally in the stock market. One reason is the return of the federal budget deficit. The economic and political environment in the spring of 2003 looked a lot like that of the mid-1960s, when following a national tragedy (the assassination of President John F.
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Kennedy), a newly elected president from Texas (Lyndon B. Johnson) was basking in the warmth of a high approval rating. Confidently, he took up the fight against communism with Vietnam as the battleground. At the same time, he pushed ahead with his Great Society programs to fight poverty at home. This policy of guns and butter led to (1) a big increase in the federal budget deficit as spending was increased on both defense and domestic programs, (2) a rise in inflation as the economy overheated, (3) higher interest rates as investors demanded higher returns to compensate for higher living costs and greater risk, and finally, (4) lower stock prices as stocks became less attractive relative to the returns from higher interest rates. Since September 11, 2001, a popular president from Texas is trying to fight a war on terrorism while cutting taxes. The result is likely to be (1) a big increase in the federal budget deficit . . . well, I think you get the picture. The bottom line is that history has shown low bond yields don’t stay low. As a consequence, the best long-term predictor of stock returns is not their relative valuation compared with Treasury bonds, but rathher the absolute valuation of stocks compared with their earnings—in other words, the P/E ratio.
Yield Curve Analysis Another problem with the Fed model—and with any model based on forecasting P/E ratios—is that it tends to give overly pessimistic signals during recessions, when analysts tend to be unduly pessimistic about prospects for earnings recovery. In fact, the Fed model gave its strongest sell signal during the 1991 recession, when in fact stocks were a good deal. One solution is to supplement such valuation models with yield curve analysis by comparing the yield on long-term (ten-year) and short-term (three-month) government securities. The theory behind this strategy is that low short-term rates are a signal that the Federal Reserve is trying to stimulate the economy by encouraging borrowing, while high short-term rates signal that the Fed is trying to slow the economy, or
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inflation, by discouraging borrowing. Long-term rates also tell a story. If short-term rates are low and long-term rates are high, this signals that the bond market thinks the Fed will succeed in stimulating the economy. That’s because bond traders are demanding a higher yield in anticipation of higher inflation as the economy strengthens. Because stocks generally benefit from economic recovery—and resulting higher profits—this is usually a good time to buy. Figure 5.6 uses vertical arrows to show when gaps between long- and short-term rates were wider than three percentage points. In fact, the points marked by the first two of these arrows correctly predicted strong economic growth and a rising stock market in the year ahead. The point at the third arrow, at the beginning of 2002, was less prescient, as the run-up in long-term bond yields in the wake of September 11, 2001, falsely predicted a strong economic recovery in 2002. In fact, the year saw sluggish economic recovery and almost a “double dip” back into recession. In retrospect, the signal was premature. From the
Figure 5.6 Yield Curve Analysis 16% 14% 12% Interest rate
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vantage point of January 2004, the signal that began to flash with the run-up in bond yields in June 2003 (the fourth arrow) appears to have been a true signal that economic recovery was finally on the way. Yield curve analysis can also be used to try to predict recessions. When short-term rates rise above long-term rates, it is a signal that bond traders think the Fed will be successful in slowing the economy down. This reversal of the normal pattern of long-term rates being higher than short-term rates produces what is known as an inverted yield curve. This condition was evident during most of 1989 and again toward the end of 2000. (See the starbursts in Figure 5.6.) In the first case, it was a bit early, but it did predict the 1991 recession. In the second case, the timing was better because a recession occurred in 2001. And in both recessions stock prices fell. The Fed model and yield curve analysis can supplement the use of a simple P/E-based valuation tool, but they are more market-timing techniques than long-term valuation techniques. As such, they may be more useful for predicting the short-term market direction than for giving clues as to whether stocks offer good prospects for the long haul.
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Steps to Take After the Bell Has Rung
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C H A P T E R
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Building an Investment Portfolio for the Long Haul
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uccessful fund management is not rocket science. In a bull market, savv y fund managers outperform their competition by buying volatile stocks that have outperformed other stocks in past bull markets. Once they hear the bell ringing at the top—signaling the start of a bear market—they beat their competition by replacing these stocks with socalled defensive stocks, those that have done relatively well in past bear markets, and by increasing the amount of cash they hold in their portfolios. The tricky part is hearing the bells. The sound isn’t always as clear as it was in October 1929 or at the beginning of the year 2000. If fund managers are not certain whether they’re still in a bull or bear market, they are likely to manage their funds so that they will perform like their benchmark indexes, at least in terms of the amount of risk they take. They may still try to outperform the index through stock picking. The basic principle is no different for you, the individual investor. First, you decide on your normal asset mix between riskier investments like stocks and safer investments like bonds and cash, based primarily on the following: • Age: The younger you are, the more of your money should be in stocks. • Family status: If you have no one depending on you for income, you can take more risk.
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• Liquidity needs: Will you need money soon to buy a house, or are you saving for retirement? • Risk tolerance: How well can you sleep at night if most of your money is in the stock market? Then, on those rare occasions when the simple valuation tool described in the last chapter sends a screaming buy or sell signal, you take action. The rest of this chapter tells you how to do it.
Investment Plans Before talking about how to invest, we need to talk about your investment plan, because the type of investment plan will determine the extent of your investment options. Four of the most common plans for long-term investment with an eye toward retirement are: • Workplace retirement plans: 401(k) plans for private sector employees; 403(b) plans for teachers and employees of nonprofit agencies; 457 plans for most government employees; and Keogh plans for the self-employed • Individual retirement accounts (IRAs) • Variable annuities • Taxable accounts with a mutual fund company, brokerage firm, or bank A 401(k) plan, if available, is usually your best option because of the following: (1) Your contribution reduces the amount of income subject to tax. For example, if you earn $50,000 a year and contribute $5,000 to a 401(k) plan, you are only taxed on $45,000 (your income minus the $5,000 contribution). (2) The income and capital gains that your investment generates are not subject to tax until you begin withdrawing them from the 401(k) plan. You can begin to withdraw without penalty when you reach age fifty-nine and a half. (3) Most employers match at least part of your contribution. Never pass up free money!
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The principal disadvantage of a 401(k) plan is that you are limited to the investment options that the plan allows. Although the typical plan allows fourteen different investment options, most do not permit you to buy individual stocks besides those of your own company. As I will explain later on, this rules out owning exchange traded funds (ETFs), which are funds that trade like stocks. But 401(k) plan participants are lucky compared with those in most 403(b) and 457 plans. Many of those plans rely on variable annuity programs offered by insurance companies. Typically, they offer a limited number of investment choices and carry annual costs that can eat up more than 2 percent of your assets each year. Not all employers offer 401(k) plans. Many still offer traditional defined benefit plans, in which it is the responsibility of the employer to decide how to invest the plan assets and to ensure that the defined benefit is paid out over the employee’s retirement years. These plans are a good deal for workers who stick around in one job long enough to become vested (eligible for benefits) and earn a high salary on which the postretirement pension payout is based. You know for sure what you’re getting during retirement years, and the federal government oversees these plans to make sure they are funded. Unfortunately, they’re not always a good deal for many younger workers who change jobs before becoming fully vested. For most folks, an IRA is the second-best option, but it’s the best option if you don’t have a retirement plan at work. And if you’ve already made the maximum contribution at work, you might want to put money into an IRA account to supplement your retirement savings from the plan. An IR A allows income and capital gains to build without taxes until you make withdrawals, just like a 401(k) plan. Unlike a 401(k), however, contributions may not be deductible from your taxable income if you or your spouse can participate in a qualified retirement plan, such as a 401(k), at work. The deductibility depends on your income. Other disadvantages of IRAs are limits on the amount you can contribute each year and the fact that—unlike a 401(k) plan—you can’t borrow against them. The main advantage of an IRA is that you get to choose your custodian. You can choose from a wide number of financial institutions that
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offer IRAs, and you can invest your savings in mutual funds, individual stocks, or bank CDs (certificates of deposit). A good choice for a custodian might be a mutual fund company that offers a large selection of no-load index and other mutual funds as well as offering a discount brokerage where you can buy stocks. And if you qualify for a Roth IRA—which you probably do if your annual adjusted gross income is below $160,000 for a married couple or $110,000 for a single tax filer— your investment income is not just tax-deferred, it’s tax-free. (But the contribution to the plan is not tax-deductible.) A third option is a tax-deferred variable annuity that you can buy from an insurance company. There’s no reason to buy this kind of product unless you still have more money to stash away after you have contributed the maximum amount allowable to your retirement plan at work and to your IRA. And even in that case, there may well be better options. A variable annuity has some similarities with an IRA. You can choose from a variety of mutual funds in the annuity plan and the earnings are tax-deferred until you start making withdrawals, which you can do without penalty once you reach the magic age of fifty-nine and a half. There is, however, one glaring disadvantage: an insurance-type annual premium that will usually amount to at least 1 percent of your assets. As well, the number of funds is typically more limited, and they often have high expense ratios. As a result, your assets will build up more slowly than in an IRA or a 401(k) plan. What’s more, there is usually a hefty surrender charge if you change your mind and want to sell before you have held the policy for ten years or more. Despite the tax advantages of 401(k)s, IRAs, and variable annuities, you might want to direct some of your savings into a taxable investment account with a mutual fund company or a brokerage firm, especially if you don’t want to tie up all your savings until you are fifty-nine and a half. True, you can borrow from a 401(k) or take a penalty for an early withdrawal, but these are usually not the best alternatives. The only disadvantage of a regular taxable account is that you need to pay tax on your investment income each year, rather than allowing it to grow taxdeferred. But this disadvantage has been substantially reduced by the tax cuts of 2003, which slashed the rates on dividends and long-term capital gains to 15 percent. The key 2003 tax law changes may be found in Appendix A.
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With a regular taxable account you can have an unlimited choice of investment options—but no tax advantage. For that reason, if you have both taxable and tax-deferred accounts, make sure that you put investments that are likely to generate the biggest tax liabilities in the tax-deferred accounts. Such investments would include bonds and any stocks that you plan to sell at a gain before holding them for a full year. High dividendpaying stocks could also be included, but with the tax on dividends now down to 15 percent, this is not as crucial as it once was. The plethora of rules governing 401(k) plans and IRAs are summarized in Appendix B. If you are more concerned about saving for a child’s college education, refer to Appendix C, where your options are summarized. Note that the appendixes offer only summaries of complex regulations. You may need to consult a tax or financial professional to learn how the rules apply to your individual circumstances.
If Not Stocks, Then What? Now that we’ve looked at where to park your long-term investments, the big question is one of asset class—meaning stocks or something else. The two main alternatives to stocks in a long-term investment account are cash or bonds. Of course, there are also real estate, gold, commodities, collectibles, and so on, but let’s concentrate on the two main alternatives that are readily available in most tax-deferred retirement accounts. Treasury bonds are long-term IOUs from the U.S. government. (Technically, they are called notes if they are issued to come due in one to ten years, but for simplicity this book refers to them by the general term of bonds.) Because they are issued by the U.S. government, they are among the safest long-term investments. They pay a fixed amount of interest (called the coupon) twice a year. If you buy a $10,000 bond with a 7 percent coupon, it will pay $350 twice a year for a total of $700, or 7 percent. If you buy an individual government bond and hold it to maturity, it’s a lot like owning a certificate of deposit (CD) from a bank. You know what the interest rate will be and how much you will receive in interest over the life of the bond. If you hold the bond until it comes due (to maturity), the only risk is that interest rates will have
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changed. If they go down, you won’t be able to get 7 percent if you want to reinvest the interest. If they go up, you’re still stuck with the 7 percent rate on the bond itself while everyone else is getting a higher rate of interest. You can buy U.S. government bonds directly from the Treasury Department’s website, treasurydirect.gov, but the most common way to invest in Treasury bonds is to buy shares in a government bond fund. If you buy a bond mutual fund, you hold a percentage stake in hundreds of bonds bought by the fund, and the price of a share of the fund will change every day with the price of the bonds as they are bought and sold on the open market. Now let me try to explain what seems to be the most difficult concept for most folks to understand: why the price of a bond goes down when the yield (interest rate) goes up, and vice versa. Let’s say you buy a new ten-year $1,000 bond with a coupon of 7 percent from the U.S. government. That means you will get $70 a year in interest (because $70 ⫼ $1,000 ⫽ 0.07, or 7 percent). And you’ll get your $1,000 back in ten years when the bond matures. But let’s say that after a year you need to sell the bond. Let’s also say that prices of clothing, food, concert tickets . . . everything has gone up. Now folks need more income from their investments. Nobody will accept only 7 percent on a government bond, so no one will pay $1,000 for a bond that only pays $70 a year. To sell the bond, you need to lower the price (the denominator in the $70 ⫼ $1,000 ⫽ 7 percent equation) until $70 divided by the price of the bond equals more than 7 percent—let’s say 8 percent. In this case, the bond will sell for $875 because $70 is 8 percent of $875 ($70 ⫼ $875 ⫽ 0.08, or 8 percent). There you have it—the yield has gone up from 7 percent to 8 percent, and the price has gone down from $1,000 to $875! The practical implication of this is that when interest rates are low, it’s a bad time to buy bonds. If investors foresee higher inflation—or higher risk in one form or another—they will demand a higher yield to compensate. And this means the value of a bond will go down. So not only do you get little income from the bond, but there is a good chance the price of the bond will go down as well. On the other hand, when interest rates are high, it’s a great time to buy bonds: you get a high interest rate, and the price of your bond will go up when interest rates decline.
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One way to defend against the danger of higher interest rates and therefore lower bond prices is to buy Treasury Inflation-Protected Securities, better known as TIPS. As with other Treasury bonds themselves, the most common way to buy TIPS is through a TIPS bond fund (which might be called an inflation-protected bond fund). TIPS are Treasury bonds that increase in value when prices increase. For example, let’s say you buy a $10,000 TIPS with a 2 percent coupon. Let’s also say that a year later inflation, as measured by the consumer price index for urban consumers (CPI-U), is 6 percent, meaning that consumer prices have risen by an average of 6 percent over the past year. In this case, the face value of the bond will increase by 6 percent, to $10,600, and the two 1 percent semiannual interest payments will be 1 percent of $10,600, or $106 instead of $100. Whereas a regular Treasury bond will go down in value when inflation rises, a TIPS will go up, thereby protecting you against inflation. This also means that TIPS provide more diversification than standard T-bonds. When inflation rises, both stocks and bonds normally do poorly. TIPS, on the other hand, increase in value when prices go up. But in investing as in life, there’s no such thing as a free lunch. Because inflation risk is removed, the yield on a regular T-bond will normally be more than the yield on a TIPS plus the expected rate of inflation. Therefore, unless inflation rises by more than the market expects, you’ll do better with the standard T-bond. Still, the diversification and inflation-risk-reduction qualities of TIPS could make them a better alternative than standard T-bills in a long-term investment portfolio. The biggest problem with TIPS is simply that they are not always available in a 401(k) plan—it all depends on what options your plan administrator chooses to offer. But when the choice is yours, as in the case of an IRA or a plain old non-tax-deferred investment account, TIPS are a viable option. Another option that’s available in some 401(k) plans are guaranteed investment contracts (GICs). A GIC is like a bond insofar as it has a fixed interest rate and a fixed maturity date. Unlike a bond, however, the price never changes because the issuer, usually an insurance company, agrees to pay the face value when the owner wants to sell. Thus a GIC falls somewhere between a traditional bond and a TIPS—while a bond goes down in value when prices rise and a TIPS goes up, a GIC’s
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price stays the same. For that reason, a GIC is known as a stable value product. The yield on a GIC is usually a bit higher than on a Treasury bond of the same length. And GIC yields rise and fall with Treasury bond yields, though with a time lag. Besides government bonds, there are corporate bonds—IOUs issued by corporations instead of by the U.S. government. As such, they’re not quite as safe, because corporations can go bankrupt and default on their debt. (In theory, so can the U.S. government. But there’s one big difference: the government can raise taxes to avoid the risk of bankruptcy. In fact, the U.S. government has never failed to make good on its debt obligations.) Most corporate bond funds invest in a diversified mix of highquality corporate bonds. As a result, the risk is only slightly higher than the risk of a government bond fund, so the yield is only slightly higher as well. Over the long haul, high-quality corporate bonds have provided a return about 0.5 percent a year better than government bonds. The second major alternative to stocks is cash. In the language of finance, cash includes money held in short-term accounts, such as checking, money market, and on-demand savings accounts, as well as Treasury bills. Investment professionals often measure the return from cash by the return from three-month Treasury bills and consider such T-bills to be the ultimate risk-free investment. But for most folks cash in an investment portfolio means a money market fund, which is a mutual fund that invests in short-term debt securities including T-bills. While banks generally have accounts called money market accounts, mutual fund companies tend to give their money market funds names, such as capital preservation fund, cash reserves fund, prime reserve fund, or the like. But any fund that invests in high-quality, short-term debt; maintains a fixed price of $1 per share; and pays the interest earned on the debt to shareholders in the form of additional shares is a money market fund regardless of the name. Because money market funds invest in T-bills and other high-quality, short-term debt (usually maturing in less than thirteen months), the return on money market funds is similar to the return on T-bills and has historically been lower than the return on other types of mutual funds. However, money market fund managers do try to get the best yield possible while limiting themselves to high-quality, short-term debt investments. As a result, money market funds can provide returns a bit better
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than the historical return of “cash” in the form of three-month T-bills. In fact, during the 1993–2002 period, the average money market fund produced a return that was 1.71 percent above the rate of inflation. It’s true that only federally insured bank money market funds can be considered as safe as T-bills, but no money market fund has ever failed to maintain its $1 share price—even if it’s meant that the mutual fund company had to eat some losses. The bottom line for most folks is that a mix of a stock fund, a government or investment-grade corporate bond fund, and a money market fund is all that is needed as the bedrock of a sound long-term investment portfolio.
W HAT A BOUT M UNIS ? Munis, or municipal bonds, are bonds issued by a state or local government agency. They are exempt from federal tax and usually from state tax in the state in which the issuer is located. Because they are tax-exempt, they pay a lower rate of interest than comparable taxable bonds. As such, they have no place in a tax-exempt account or in taxable accounts of folks in a low tax bracket. There’s a simple formula to determine what a taxable bond, or bond fund, would need to pay in interest to be better than a muni, or muni fund, in a taxable account. Divide the interest rate on a muni by one minus your marginal tax rate (the rate you pay on each additional dollar of income; it’s the percentage in the “Plus This %” column in the tax rate table in Appendix A). And also add in your state’s marginal tax rate if the muni is exempt from tax in your state. For example, if you are married and filing jointly and your taxable income is $60,000, your marginal tax rate is 25 percent, according to the table. If a muni fund is paying 3 percent, you would plug 3 percent (0.03) and 25 percent (0.25) into the formula to produce 0.03 ⫼ (1 ⫺ 0.25) ⫽ 0.04, or 4 percent. This means that the fund would only make sense if you couldn’t find a comparable taxable bond fund with a yield of 4 percent or better.
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Choosing Your Asset Mix Now that we have taken a look at the three principal assets for longterm investing—stocks, bonds, and cash—we can move on to the question of how to divide your portfolio among these three asset classes.
Stocks Versus Bonds or Cash There’s an old rule of thumb for divvying up a long-term investment portfolio that’s served many people well: stock percentage equals 100 minus your age; bonds or cash are the remainder. Let’s say you’re thirty years old: 100 ⫺ 30 ⫽ 70. Therefore, you would have 70 percent in stocks, with the remaining 30 percent in bonds or cash. (But first keep enough additional money in cash to meet emergencies, such as loss of a job or unexpected expenses. This could be in a money market fund or any other account that would allow money to be withdrawn at any time without major penalties. This should normally equal about six months’ worth of take-home pay, but more or less depending on how many people are depending on you.) This rule has two good features: it’s simple and it works most of the time. But “most of the time” isn’t good enough. It doesn’t work at market bottoms or market tops, when you need to adjust your asset mix to exceptional circumstances. Even if you’re thirty years old, you don’t want to have 70 percent of your investment portfolio in stocks when a stock market bubble is about to burst. And you want to have more than 70 percent in stocks after the crash when the stock market is near its bottom. The solution is to add a second part to the old rule of thumb: When the S&P 500 is trading at less than twelve times earnings, you should add to the stock percentage. When it’s trading at more than twenty times, you should subtract. How much to add or subtract depends on how much additional risk you want to take on when the market offers good value—and how much additional safety you want when a high P/E ratio means high risk. But an increase or decrease of 10 percent or 15 percent at extremes of under- or overvaluation does not seem unreasonable. I’ll be the first to admit that these two rules could be improved by adjusting for economic conditions, geopolitical risk, inflation, Federal
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Reserve policy, oil prices, and so on. But who has time to fine-tune these rules for the hundreds of factors that influence the stock market? When National Football League players went on strike in 1987, the team owners hired a motley assortment of ex-college stars, minor league players, and NFL has-beens to replace them. Teaching these make-do players to properly execute the complex offensive and defensive plays used by NFL teams proved to be about as easy as herding cats. Most coaching staffs gave up trying and adopted a strategy known as KISS (keep it simple, stupid). Instead of teaching every play in the playbook, they would concentrate on getting a few simple plays right. And the teams that executed a few plays well beat those teams that executed many plays badly. The KISS principal is a good one for investors, too—even if you think you’re a lot smarter than the typical NFL lineman. Using a simple two-part rule of thumb and getting it right sure beats using a complex series of asset allocation equations and getting it wrong. Some might say that these rules of thumb are too conservative. As people are living longer after retirement, and as historical evidence continues to mount that stocks outperform bonds over the long run, the accepted norm for the stocks-to-bonds ratio in a long-term investment portfolio has risen from 50/50 to 60/40 or higher. If you are willing to take a bit more risk for a bit more return, you can add 5 or 10 percent to the stock allocation and subtract a like amount from the bond allocation regardless of valuations. And you can also vary from the first rule’s allocations by 15 percent or more if P/E ratios move far above or below the 12 and 20 P/E ratio thresholds. Keep in mind that these are just rules of thumb. Your personal circumstances and tolerance for risk should determine your actual allocations. Here are some examples of how to use these two rules: Claudio and Clarabelle Glockenspiel are a married couple with two kids. Claudio is thirty-nine and Clarabelle is forty-one. They have a total of $130,000 in savings. They earn $80,000 a year between them, and their combined take-home pay is $5,000 a month. They should keep at least $30,000 (6 ⫻ $5,000) liquid in a money market fund or short-term CDs. This leaves $100,000 for long-term investment. Because their ages average out to forty, they keep 60 percent
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(100 ⫺ 40) of their savings, or $60,000, in stocks in normal times, with the rest in bonds or cash. They go to the website conquerthe hype.com and find that the P/E ratio of the S&P 500 Index is 16. That’s dead center of the range of 12 to 20, so they stick with the planned mix of $60,000 in stocks and $40,000 in bonds or cash. What if the P/E ratio is 21 instead of 16? That would mean that stocks are expensive. Using part two of the rule, they should reduce their stock holdings by 10 percent or 15 percent. Instead of $60,000 in stocks they decide to hold $45,000 in stocks and $55,000 in bonds or cash. Likewise, if they find that the P/E ratio has fallen to 11 (stocks are cheap), they might decide to add 15 percent to their stock position. Instead of $60,000 in stocks they hold $75,000 in stocks and $25,000 in bonds or cash. But what if the P/E ratio moves briefly up to 20 and then stocks start to go down in price? Let’s say the Glockenspiels check the website and find that the P/E ratio is between 18 and 19. They could stick to a 60/40 stocks-to-bonds ratio, but Claudio is worried. Stocks are going down, he says, and 18 to 19 isn’t cheap. Rather than spend another day worrying about the decline in their stock holdings, they decide to move to a 50/50 mix. For them, it may be the right decision. After all, there’s nothing magic about the number 20, and Claudio is right that 18 to 19 isn’t cheap. Better to reduce the risk of the portfolio even at the cost of some upside potential than to lose sleep over investment declines. And better to sell at a P/E of 18 or 19 than when the market really is cheap. But enough of the Glockenspiels already—let’s take a look at someone else: Bill Goats is a thirty-year-old computer programmer who owns a townhouse, which he shares with his Irish setter and an occasional significant other. With no big expenses, other than replacing the furniture destroyed by his (not very bright) canine companion, Bill has managed to build an investment portfolio of $100,000. He has rolled over most of his portfolio into an IRA because he changes jobs often
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and takes his 401(k) savings with him following each change. Bill is a dreamer who hopes to someday start his own software firm. With no immediate plans to marry and with only one (red-headed) quasi dependent, he is willing to take some risk. He checks out the P/E ratio of the S&P 500 and finds that it is 15. Because he’s thirty years old, the rule-of-thumb asset allocation would be 70 percent stocks and 30 percent bonds. With the P/E ratio within its normal range, there’s no reason to adjust this ratio based on valuation. But because Bill can tolerate risk, he adjusts it based on his own comfort level to 80 percent stocks and 20 percent bonds. And because Bill has an IRA, he is able to hold the bonds in the form of a TIPS fund, thereby reducing his risk compared with what it would be if he held the bonds in a typical government bond fund.
T HE F OUR B EST M ONTHS FALLACY Some financial writers have opined that you should always keep most of your money in the stock market, or else you risk missing the months when the stock market makes a year’s wor th of gains in a single month. Table 6.1 shows the four best months from 1987 to 2002. It’s true that the gains in the four best months are as good as normal gains for a full year, but the Four Best Months argument misses two things. First, the losses in the four worst months were larger than the gains in the four best months. That’s because after stock market bubbles burst, stock prices tend to plummet even more quickly than they rose as the bubble was inflating. Second, if you only reduced your stock exposure when P/E ratios were abnormally high—say, over 20— you would have missed only one of the four best months. And that month was March 2000, just as the bubble burst. On the other hand, reducing your stock exposure at 20⫹ would have helped to preserve your savings in two of the four worst months. And if you were really conservative and cut your exposure just before the P/E reached 20, you would have preserved your wealth in all four of the worst months.
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Table 6.1 Four Best and Worst Months for Stocks (1987–2002) Best Months
P/E at Start
Total Return
Jan. 1987 Dec. 1991 Mar. 2000 May 1990
16.3 17.4 26.5 16.3
13.5% 11.4% 9.8% 9.8%
Worst Months Oct. Aug. Sept. Feb.
1987 1998 2002 2001
P/E at Start
Total Return
19.7 25.8 19.8 23.8
⫺21.5% ⫺14.5% ⫺10.9% ⫺9.1%
A final question to consider is how much company stock to own. You may think you work for the greatest company in the world; you may be able to buy your company’s stock at a discount; and your employer may make a contribution to your plan in the form of company stock. Even so, you should limit how much you own for two reasons. First, owning any one stock is riskier than owning a basket of stocks in a mutual fund. Second, you are doubling up on risk when you invest heavily in your own company. If the company runs into hard times, not only is your job at risk, but the value of your investment in the company is likely to go down as well. If you don’t believe me, ask any former Enron employee. At the beginning of the year 2000, the average worker with a 401(k) plan had 42 percent of his or her retirement money invested in company stock. Following the lessons of Enron, WorldCom, and so on, that number came down to 24 percent as of August 2003, but it still needs to come down a lot farther.
Bonds Versus Cash The one remaining problem with this strategy is the bonds versus cash dilemma. How do you decide which to own? As a general rule, you should own bonds for their higher interest rates. The only time to hold cash instead of bonds would be when long-term interest rates are so low that the only way for them to go is up—implying that the only way for bond prices to go is down. But if you can own TIPS or GICs instead of bonds, the problem of price risk is solved. What do you do if TIPS or GICs aren’t an option in your retirement plan? Then you need to figure out whether bonds offer enough of a yield advantage over cash to justify their risk of price declines. Take a look at Figure 6.1. The figure shows that interest rates on ten-year U.S.
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Treasury bonds have been on a downward trajectory for the last twenty years. That means their price has been in an upward trajectory. This has been the case for two reasons: • Inflation, which had been running out of control in the 1970s, was finally tamed in the 1980s by the tight money policies (see the “What Makes Interest Rates Go Up and Down” sidebar) of Federal Reserve Chairman Paul Volcker. But it took a while for bond investors to become convinced that inflation was finally licked and that there was no need to demand high interest rates as protection against rising prices. As a result, bond yields came down only gradually during the Reagan years (1981–1988). • The federal budget deficit, which expanded during the Reagan years, began to shrink during the Clinton presidency, which ended with a budget surplus. While President Clinton may have been liberal in his social policies (some have referred to the Clinton years as the era of “sex between the Bushes”), he was conservative in his fiscal policies, and this fiscal conservatism enabled bond prices to continue rising.
Figure 6.1 10-Year Treasury Bond Yields and Inflation 14% 12% 10% 8% 6% 4% 2% 0% 3
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But the Clinton years are over, and while inflation shows no signs of breaking out of its chains, the federal budget has moved from surplus to deficit big time, what with tax cuts and the costs of maintaining troops and nation building in Iraq and Afghanistan. This means a bigger supply of bonds because the government has to borrow to cover the deficit. And an increase in supply without an increase in demand means lower prices—and higher yields—for bonds. So there is no reason to believe that bond prices will continue to rise. Indeed, it looks like June 13, 2003, when the yield on a ten-year Treasury bond fell to 3.11 percent, may have marked the peak for bond prices. In the current environment, it’s no longer a no-brainer that bonds will do better than cash. So should you hold cash instead of bonds, with your money that’s not invested in stocks? A simple rule of thumb is that the yield on bonds—or a U.S. Treasury bond fund—should be at least two percentage points more than the yield on cash in the form of a money market fund. If you are not getting at least two percentage points more in interest from a bond fund, why hold bonds? You are not being rewarded for the risk that they will fall in price, and you are not being adequately protected against inflation. So hold cash instead, in the form of a money market account (sometimes known as a capital preservation fund). Then when stocks or bonds offer better value, the cash is there to be put to better use. Let’s say that based on the P/E ratio, our musical friends, the Glockenspiels, have determined that they should have 60 percent of their portfolio in stocks and 40 percent in bonds or cash. They go to the website of Clarabelle’s retirement plan and look at the information about the plan’s government bond fund and money market fund. (If these options are not available, Clarabelle may want to complain to her human resources department.) They find that the current yield of the bond fund is 3 percent, while the money market fund is yielding at about 2 percent. The 1 percent advantage over the money market fund rate is not good enough to cover the risk of a decline in bond prices. So they opt to hold much of the 40 percent in cash. Even if the money market fund is yielding only 1 percent, it’s still a good deal. It’s a safe place to park their money until bond yields become more attractive. And if the money market fund is paying as high a yield as the bond fund, there’s even less reason to hold bonds.
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W HAT M AKES I NTEREST R ATES G O U P
AND
D OWN ?
The answer to this question depends on whether we’re talking about shor t-term or long-term rates. Shor t-term rates are rates on shor t-term debt. Shor t-term rates determine how much you will earn on Treasury bills, money market accounts, and shor tterm CDs. Long-term rates are rates on government bonds, home mor tgages, and other long-term debt. The Federal Reserve Bank sets the rates for shor t-term borrowing by raising and lowering the Federal funds rate, which is the rate banks charge one another for overnight loans. When the Fed thinks the economy is growing too slowly, it lowers shor t-term rates to encourage borrowing, spending, and growth of the money supply. When the Fed thinks the economy is growing too fast (overheating) and threatening to create inflation, it raises interest rates to discourage borrowing and spending. When the Fed is lowering rates, it is said to be carrying out a “loose” monetary policy because it is allowing the money supply to grow. When it is raising rates, it is said to be “tightening” or adopting a “tight” monetary policy because it is tightening its grip on the money supply in order to restrain its growth. But buyers and sellers in the market, rather than the Fed, set long-term rates. And long-term rates don’t move in lockstep with shor t-term rates. In fact, they can move in the opposite direction, much to the dismay of the Fed. Two things can make interest rates go up even when the Fed is cutting shor t-term rates: increased inflation and increased uncer tainty about inflation. In a perfect world, with no inflation and no uncer tainty, interest rates would be low and steady—just enough to make up for the inconvenience of having your money tied up for a fixed length of time. (The longer it is tied up, the higher the rate would have to be.) But in the real world there’s also inflation, so the interest rate has to cover the rise in prices while your money is tied up. If inflation is expected to be 2 percent a year instead of zero, the interest rate on a bond would have to increase by 2 percent to make up for the higher prices when the bond comes due.
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But in the real world there’s also uncer tainty about inflation. As this uncer tainty increases, interest rates rise to at least par tly cover a worst-case scenario of out-of-control inflation. That’s why mor tgage and other long-term interest rates shot up in the summer of 2003. Prior to the June meeting of the Federal Open Market Committee (FOMC), the Fed committee that sets the Fed funds rate, Federal Reserve Chairman Alan Greenspan and other Fed governors had been worrying aloud about weak economic growth and the risk of deflation (falling instead of rising prices). This got people thinking that the FOMC would take the drastic step of cutting the Fed funds rate from 1.25 percent to 0.75 percent, thus making it almost free to borrow money. But when the Fed only cut the rate to 1 percent, that got bond buyers thinking that maybe the Fed was not as worried about economic weakness and deflation as the public thought. In fact, maybe the rate-cutting the Fed had already done would produce a robust economic recovery and a return of inflation. And that uncer tainty caused bond traders to demand a higher interest rate on long-term bonds.
A Good Way to Buy Stocks Buying individual stocks, other than the stock of the company you work for, is usually not an option with 401(k) plans, but it is for IRAs and for regular taxable accounts. It’s easy enough to open up a brokerage account and buy stocks. And with positions in about ten stocks in different industries, you can create a reasonably well-diversified portfolio that should perform much like the overall stock market. But unless you’re into stocks as a hobby, why bother? It’s a lot of work to do the research necessary to create a portfolio that will match the performance of the stock market, much less to create a portfolio that will beat it. Market professionals spend a lifetime trying to do this and only half succeed.
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WALL S TREET
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V EGAS ?
People have called the stock market a loser’s game: for every winner there has to be a loser—and after commissions and other trading costs, there are more losers than winners. But that’s not really correct, because losing to the stock market doesn’t mean losing money. Losing means not keeping up with a market that has, on average, been up 7 percent a year after inflation. In other words, you can lose to the market but still make money—just less than 7 percent a year. For a true loser’s game, try Las Vegas or Atlantic City. While the expected return of investing in stocks is 7 percent minus costs, the expected return from gambling is 0 percent minus costs, which include a house profit on top of the cost of all that glitz.
A good way to keep costs down and come close to that 7 percent real return that stocks have historically generated is to buy an index fund. Index funds, which were pioneered by John C. Bogle of the Vanguard Group in the 1970s, are funds that seek to match the performance of the stock market as a whole. They do this by buying a proportionate share of all the stocks in the index—or by using mathematical techniques to accomplish the same purpose. Because index funds don’t try to beat the market, their costs are low. There are no expensive research analysts, and trading costs are low because there is no need for constant trading. The only time these funds need to trade is when shareholders buy or sell shares in the fund or when the stocks in the index change. As a result, index funds should match the overall performance of the stock market, minus a small percentage for costs. In fact, according to Lipper, a fund evaluation service, the average index fund designed to track the S&P 500 Index produced a total annual average return of 9.64 percent during the ten years that ended on June 30, 2003. This was only 0.4 percent less than the 10.04 percent annual average total return of the index itself, the difference being expenses and trading costs. And after inflation, the average index fund returned a perfectly normal
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annual return of 7.03 percent per year, meaning the average index fund holder just about doubled her wealth in the decade (actually, she gained 97 percent in real terms). A final point is that, despite the stock market bubble and inevitable correction, the total return of the S&P 500 over the ten years that ended on June 30, 2003, was 7.41 percent per year better than the rate of inflation, and the total return of the average index fund was 7.03 percent. In other words, despite the ups and downs, the stock market performed pretty much in line with its historical averages. But that should be no surprise because at the start of the ten years, the S&P 500 was trading at a fairly high, but not abnormal, P/E ratio of 19.6 times its average earnings during the previous five years. No bubble plus no crisis equaled normal results.
Which Index? When someone asks, “What did the market do today?” the answer is often something like “Up 50” or “Down 20 points.” This is common lingo for saying that the Dow Jones Industrial Average rose 50 or fell 20 points, respectively. But the Dow is really just a shorthand measure of the stock market. It’s the combined price of the thirty stocks listed in Table 6.2. As such, it doesn’t reflect the movement of all stocks. What’s worse, it overemphasizes the price movement of the higherpriced stocks. For example, if the price of 3M (formerly Minnesota Mining & Manufacturing) stock moves 10 percent, the resulting change in the Dow will be greater than the combined effect of 10 percent moves in the prices of Hewlett-Packard, AT&T, Walt Disney, McDonald’s, SBC Communications, and Intel—simply because 3M is a highpriced stock. But despite this anomaly, the Dow continues to be the most commonly mentioned index simply because it’s been around the longest—since 1896. While Main Street thinks of the Dow as the market, Wall Street tends to watch the Standard & Poor’s 500 Index because it is more representative of the overall market. The simplest way to get exposure to the stock market is to invest in a mutual fund that has the S&P 500 Index as its benchmark. This index, which is maintained by the Stan-
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Table 6.2 The 30 Dow Stocks in August 2003 Company 3M Procter & Gamble Int’l Business Machines United Technologies Caterpillar Wal-Mart Merck Johnson & Johnson Coca-Cola American Express Citigroup DuPont Altria International Paper General Motors Exxon Mobil J. P. Morgan Chase Boeing Home Depot General Electric Honeywell International Eastman Kodak Alcoa Microsoft Intel SBC Communications McDonald’s Walt Disney AT&T Hewlett-Packard
Ticker Symbol
Percent of Index
MMM PG IBM UTX CAT WMT MRK JNJ KO AXP C DD MO IP GM XOM JPM BA HD GE HON EK AA MSFT INTC SBC MCD DIS T HPQ
10.68% 6.79% 6.18% 5.62% 5.11% 4.42% 4.26% 3.93% 3.44% 3.40% 3.39% 3.29% 3.06% 2.93% 2.82% 2.79% 2.53% 2.45% 2.45% 2.15% 2.13% 2.11% 2.04% 1.97% 1.85% 1.80% 1.69% 1.66% 1.62% 1.49%
dard & Poor’s Corporation, consists of the shares of the largest companies in the United States. (Until recently, it also included a few important foreign companies, such as British Petroleum [BP] and Canada’s Nortel Networks. But it now consists only of companies based in the United States.) Moreover, it is market capitalization weighted, which simply means that the biggest companies in terms of stock market val-
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uation have the biggest weighting in the index. With five hundred stocks instead of thirty, it accounts for about 80 percent of the value of the total stock market. For all practical purposes, the S&P 500 is the U.S. economy, and it’s the most commonly used benchmark, or standard, against which the performance of mutual funds and other accounts managed by investment professionals is judged. So if you want your investment portfolio to grow with the U.S. economy, what you really want is for it to keep up with the S&P 500. You should keep in mind, though, that the index is not chosen simply by picking the five hundred largest U.S. stocks based on the market capitalization. The selection committee at Standard & Poor’s tries to create an index of solid companies with good growth potential. In other words, the S&P 500 Index is like a stock fund that tracks the largest stocks traded in the United States, but with a slight tilt toward financial strength and growth. Because of the S&P 500’s bias toward large companies, growth companies, and financially sound companies, one could make the case that the S&P 500 does not truly represent the entire U.S. stock market. In fact, there are other indexes that more truly capture the performance of the overall stock market. These indexes include the Wilshire 5000 Total Market Index, the Russell 3000 Index, and the Dow Jones Total Market Index. A broader market index, such as the Wilshire 5000, which includes five thousand stocks that, combined, account for more than 98 percent of all U.S. stock market value, has produced results that are virtually identical with those of the S&P 500 Index over the past fourteen years (1989–2003). This can be clearly seen in Figure 6.2, which shows the performance of the S&P 500 Index versus the Wilshire 5000 between March 31, 1989, and June 30, 2003. The bottom line is that the S&P 500 rose 230%, versus 221% for the Wilshire 5000. Moreover, S&P 500 stocks paid more in dividends than Wilshire 5000 stocks did. While purists may say that you should try to tie your portfolio to the broadest possible market index, the recent evidence seems to say that the narrower indexes, which include mostly larger, safer dividendpaying stocks, give the best performance. We’ll take a look at the advantages and disadvantages of small company stocks in the next chapter,
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Figure 6.2 Which Index? 600 500 400 300 200 100
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0
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but for now it seems that you should do just fine with most of your stock investments in a fund that matches the performance of the S&P 500.
Do-It-Yourself Index Funds: Spiders, Cubes, Diamonds, and Vipers There are two ways to invest in the S&P 500 or other market indexes: through an index fund or through an exchange traded fund (ETF). ETFs are funds that are bought and sold like stocks, instead of being distributed by mutual fund companies. Like index funds, most ETFs are designed to mimic specific stock indexes, and they do so by owning the stocks in the index in the same proportions as the index. The two
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most popular ETFs are Spiders, which track the S&P 500, and Cubes, which track the NASDAQ 100, a volatile index heavily laden with technology stocks. Their nicknames come from their ticker symbols—SPY and QQQ—on the American Stock Exchange. Two other ETFs deserve mention. Vipers (ticker symbol VTI) seek to match the combined performance of all three major U.S. stock markets: the New York Stock Exchange, the NASDAQ stock market, and the American Stock Exchange. Diamonds (ticker symbol DIA, for Dow Industrial Average) are designed to match the performance of the Dow. One problem with ETFs is that they are generally not available through 401(k) accounts. However, if you have a brokerage account as part of an IRA or in a regular taxable account, you can invest in ETFs. Assuming you are able to, why buy Spiders, Cubes, Vipers, Diamonds, or some other ETF rather than an equivalent index fund? There are advantages and disadvantages of each approach.
Advantages of ETFs 1. Tax advantage: Mutual funds are required to distribute capital gains to shareholders when they sell a stock for a profit during the course of a year. This is why mutual fund shareholders are often shocked to find they have to pay taxes on their mutual fund even if it is worth less at the end of the year than at the beginning. This is less of a problem for index mutual funds because they do less buying and selling and therefore incur fewer capital gains. But it is even less of a problem for ETFs because of the way they are structured. In practice, the capital gains tax liability of ETF holders is negligible until they sell the shares. Owners of both ETFs and index funds, however, are liable for the dividend income of the underlying shares (which gets reported on Form 1099-D to both the shareholder and the IRS), so there is no advantage one way or the other when it comes to dividends. 2. Lower expense ratios: (The expense ratio is the cost of running the fund as a percentage of the fund’s assets.) For Spiders the ratio is 0.12 percent, for Vipers 0.15 percent, and for Cubes 0.18 percent. The largest S&P 500 Index fund, the Vanguard 500, also has an
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expense ratio of 0.18 percent, but about 0.4 percent is more typical for index funds. 3. Intraday trading: You can buy shares in an ETF whenever the stock market is open, and like a stock its price moves up and down throughout the trading day. An index fund, like any mutual fund, is priced once a day, when the market closes. (The value of all the stocks and other assets owned by the fund is tallied up and divided by the number of shares outstanding.) You don’t know the price at which you’ve bought a mutual fund until the stock market closes and the fund is priced.
Disadvantages of ETFs 1. Commissions: Buying or selling an ETF entails a commission just like buying or selling a stock. If you use a discount broker, this is likely to be about $19.95, though it can be as little as $8 for active traders with a deep discount broker. But there’s still the bid-ask spread. As with any stock, the price at which you can sell an ETF is always a little less than the price at which you can buy. With the more actively traded ETFs, the difference is usually only a few cents a share, but these nickels and dimes can add up if you buy and sell frequently. With index funds, there is no bid-ask spread and usually no commission (sales charge). Which is more important—the lower expense ratio of an ETF or the absence of commissions with an index fund? Well, it depends on how frequently you buy and sell ETFs and in what quantities. If you trade infrequently, the lower expense ratio can offset the commission plus the bid-ask spread over the long run. 2. Dividend reinvestment: Most ETFs are not allowed to buy more stocks with their dividend or interest income until the end of the month or quarter. If the stock market is going up, this can hurt performance, but the actual impact has seldom been more than 0.15 percent per year. 3. Price uncertainty: Because ETFs are bought and sold on the stock market, their price reflects supply and demand as well as the under-
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lying value of the stocks in the fund. As a result, there may be differences between the price at which these funds trade and the value of their assets. In contrast, the price of an index fund, or any mutual fund, is exactly the daily closing price of its assets. We have already seen that the average S&P 500 Index fund came within 0.4 percent of matching the annual performance of its index over the ten years ending June 30, 2003. Table 6.3 shows that Spiders did even better, coming within 0.17 percent of the index’s performance. However, after factoring in commission costs in buying the Spiders, the advantage over a no-load index fund with a low expense ratio would practically disappear. The bottom line is that both ETFs and most index funds are good, low-cost ways to match the performance of the S&P 500. But beware of index funds that have a high expense ratio, because expenses are the main factor determining the difference in performance between funds that track the same index. Remember that it shouldn’t cost a lot to track an index. Appendix D lists the ten largest index funds and the twenty-four largest ETFs. If you want to track an index other than the S&P 500, ETFs give you a lot of options. There are ETFs to track almost every major U.S. and foreign index, including indexes that track individual sectors of the U.S. economy.
Monitoring Your Portfolio How often should you have to take a look at your portfolio? Sometimes less is better. The biggest mistake many investors make is to overreact to quarterly mutual fund statements—selling funds that have performed poorly and buying funds that have performed well in the previous quarter—with the result of selling at the bottom and buying at the top. Indeed, a study by the research firm Dalbar found that during the 1982–2000 bull market, when stocks produced an average return of almost 15 percent a year, the average stock market investor made only 5 percent a year. The only way the average investor could have trailed
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Table 6.3 Index Funds Versus ETFs 10-Year Performance Comparison ( June 30, 1993, to June 30, 2003) Not Adjusted for Inflation Fund Type S&P 500 Index S&P 500 ETF (Spiders) Average S&P 500 Index Fund
$1,000 Becomes
Annual Growth Rate
$2,600 $2,565 $2,510
10.04% 9.87% 9.64%
Adjusted for Inflation $1,000 Annual Becomes Growth Rate $2,044 $2,016 $1,973
7.43% 7.26% 7.03%
Assumes reinvestment of dividends. Average index fund based on data from Lipper.
the market by this big a margin would have been bad market timing— selling low in reaction to stock prices that had already fallen. For example, selling immediately after the October 1987 crash or the October 1998 Russian debt default and then buying back into the market after prices had risen. There should be no need to change your allocation among stocks, bonds, and cash more than once a year. The exception to this rule would be if you see signs of a bubble or a stock market panic. In those cases, don’t wait for a year to pass. Go to conquerthehype.com or buy a financial publication and check out the P/E ratio of the S&P 500 to determine whether the market is in fact over- or undervalued. And if it is, adjust your stock/bond/cash mix according to the simple rules given in this chapter. Here’s an example: A year has gone by since you last took a long, hard look at your longterm investment portfolio. You are a relatively conservative fortyone-year-old, who a year ago decided that the optimal stock/bond allocation was 60 percent stocks and 40 percent bonds when stock market valuations are normal. The P/E ratio a year ago was between 12 and 20—in other words, normal. So you designated that the maximum allowable amount of your salary should go into your retirement plan, with 60 percent invested in a stock fund and 40 percent in a bond fund. Today you decide it’s time to see if your portfolio needs any adjustments. You find that the P/E ratio remains within its
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normal range, but your portfolio now consists of 62 percent stocks and 38 percent bonds because stocks increased more in value than bonds during the past year. What’s more, you are a year older, so the optimal stock/bond mix has changed slightly. For a relatively conservative forty-one-year-old, the optimal mix is 59 percent stocks (100 minus age) and 41 percent bonds. So you are out of sync by 3 percent. What to do? Simple—you do an exchange in which you sell shares in your stock fund that are worth 3 percent of the total value of the portfolio and buy shares in the bond fund with the money.
C H A P T E R
7
Beyond Plain Vanilla
T
he last chapter focused on the most basic investment types: S&P 500 index funds, bond funds, money market funds, and ETFs that track the basic indexes. This chapter is written for folks who are a bit more adventurous and who want to take a look at funds that try to beat the market, as well as at some other more specialized types of mutual funds.
Active Funds Versus Index Funds Active funds—or more accurately, actively managed funds—are funds that try to beat rather than match a benchmark. Active funds have been around far longer than index funds, the first having been established in Boston in 1924. However, it was between 1965 and 1968 that the mutual fund industry really took off, led by a handful of funds that far outperformed the market averages by investing in the shares of rapidly growing companies. Although these funds were clobbered by the bear market that began in 1969, by that time they had already caught the nation’s attention as the amount of money invested in stock funds almost tripled during the 1960s. The best known of these funds was Fidelity’s Magellan Fund, which was founded in 1963 and closed to most new investors in 1997 because it had grown so large that it could no longer buy positions in some stocks without driving the price up.
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At first glance, it would seem that active funds should be able to outperform index funds. After all, they are managed by professionals with the support of teams of analysts with advanced degrees who research the prospects of various companies to determine which have the greatest potential. The problem is that the price of stocks is determined largely by the buying and selling of active funds and other professional investors competing against one another. For every winner who does better than the index, there has to be one loser who does worse. But that’s before factoring in the costs of the research and additional trading required to try to beat the index. According to Morningstar, a company that evaluates mutual funds, the average active fund investing in large-cap stocks has an expense ratio of 1.28 percent. This means that for every $100 you put into the fund, $1.28 is used to cover the fund’s expenses, including marketing expenses (also known as 12b-1 expenses) in the case of some funds. In contrast, some index funds have expense ratios as low as 0.15 percent. As for trading costs, the typical active fund sells and replaces at least 80 percent of its holdings each year, also adding to costs. The result is that while the S&P 500 Index produced an average annual total return of 10.04 percent for the ten years that ended on June 30, 2003, the average active fund with a goal of beating the S&P had an average annual total return of 8.29 percent. The difference can be attributed primarily to higher expenses and trading costs. It’s not a trivial difference. As shown in Table 7.1, $1,000 placed in the average index fund ten years ago would have turned into $2,510; the same $1,000 invested in the average active fund would have turned into $2,218. And that’s before commissions. While most index funds do not charge a commission to buy shares in the funds, most active funds do. This fee can be as high as 5 percent for smaller specialized funds. And there is often a redemption fee as well, to discourage short-term speculation. (This latter fee, which is often waived for shareholders who have held for a designated length of time, is probably a good thing, because it encourages long-term investing in the more turbulent sectors of the economy.) So is there any reason to consider an active fund? I think the answer is a cautious yes. For one thing, an index fund is like a plane on auto-
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Table 7.1 Index Funds Versus Active Funds 10-Year Performance Comparison ( June 30, 1993, to June 30, 2003) Not Adjusted for Inflation Fund Type S&P 500 Index Average S&P 500 Index Fund Average Active Fund
$1,000 Becomes
Annual Growth Rate
$2,600 $2,510 $2,218
10.04% 9.64% 8.29%
Adjusted for Inflation $1,000 Annual Becomes Growth Rate $2,044 $1,973 $1,743
7.43% 7.03% 5.71%
Assumes reinvestment of dividends. Average index fund based on data from Lipper and Morningstar.
matic pilot. As long as there are clear skies and no turbulence, everything is fine. But when there’s a crisis, a pilot needs to take over. With an index fund, everything is fine as long as the stock market is going up. But if there is a boom that’s about to bust, the index fund will go right down with the market—unless you act as the pilot by stepping in and selling the fund. With an active fund there is a pilot: the fund manager. If she sees stormy skies ahead, she can raise cash and take other steps to cut losses in a bear market. In fact, many active funds did this in 2000. The average active fund was down only 4.97 percent that year versus a decline of 9.1 percent for the S&P 500 Index. Unfortunately, most of those active managers who took evasive action in 2000 jumped back into the market too soon in 2001. Nonetheless, the average fund did a tad better than the index over the three years ending June 30, 2003 (down 10.95 percent per year versus down 11.19 percent). Once we move beyond funds that use the S&P 500 as their benchmark—to funds that invest in smaller companies or in emerging markets—there is a lot more reason to believe that active fund management can add value. That’s because smaller companies or companies in emerging markets are not studied by as many analysts as are large U.S. companies. So each analyst may be able to unearth new information that is useful in deciding whether the company is a buy or a sell. That may partly explain why the average small-cap fund outperformed the benchmark small-cap indexes from June 30, 1993, to June 30, 2003. However, the biggest reason was probably that small-cap fund
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managers bought the shares of companies that were bigger than the typical company in the benchmark indexes at a time when the stocks of larger companies were outperforming those of smaller companies. Similarly, most managers of foreign funds have been able to outperform the benchmark indexes for foreign stocks simply by minimizing their investments in Japan during that country’s extended bear market. Regardless of how they did it, the point is that small-cap and international fund managers have found ways to outperform their benchmark indexes— and thus to outperform index funds.
W HAT I F N O O NE T RIED TO B EAT THE M ARKET ? What would happen if everyone decided to abandon active funds and invest only in index funds? Once indexers owned the entire stock market, stock prices would never change except when a company issued more shares. No one would pay any attention to fundamentals, so as the for tunes of individual companies got better or worse, these changes would not be reflected in share prices. As a result, some stocks would become grossly overvalued and others grossly undervalued relative to the earning power of the issuing companies. This would create great oppor tunities for active managers—if there were any. At some point, someone would notice this oppor tunity and begin to pick stocks instead of just trying to match the market. The first person to do so would likely become very rich by buying undervalued stocks. And his or her success would attract more active managers. And finally, the pendulum would swing in the opposite direction as everyone would demand active management in place of indexing. But in reality the pendulum will never swing all the way to 100 percent indexing or 100 percent active management. When too many managers index, active managers gain the advantage. And when too many manage actively, their competition against one another becomes self-defeating and indexers gain the upper hand.
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A final reason to consider an active fund is that there are a lot more fund options if you don’t limit yourself to index funds. It’s unusual to find an emerging market index fund or a sector index fund other than a technology fund among 401(k) plan options. Following are some investment opportunities beyond the plain vanilla of an S&P 500 Index fund. Many of these alternatives are available only as actively managed funds, but even if an index fund is available, an actively managed fund may be the better choice.
Growth Funds and Value Funds Growth funds own primarily stocks with high expected earnings growth. These stocks usually have high P/E ratios, have high price-to-book ratios (meaning they cost a lot relative to the book value of their assets), and pay out little in the way of dividends. Value funds own just the opposite: stocks that offer good value in the form of low P/E ratios, low price-tobook ratios, and high dividend yields. Over the long haul there is some evidence that value funds do better than growth funds. By my calculations, the average value fund has produced a total return of about 10.2 percent a year over the last thirty years, versus about 9 percent for the average growth fund. While a thirty-year history may not be enough to prove that value stocks are a better investment than growth stocks, it makes sense. After all, if the stock market produces the best returns starting when its P/E ratio is low, stocks with low P/E ratios should also produce the best returns. It’s also consistent with contrarian thinking: if everyone is chasing growth, growth stocks will be too expensive and value stocks will produce better results. True, there have been periods when growth stocks handily outperformed value stocks, but there’s no sure way to know in advance when you are entering into one of these periods. Growth stocks suddenly began to blow past value stocks in 1999, as can be seen in Figure 7.1. In fact, the late 1990s bubble was really just a growth stock bubble in which value stocks never participated. But when the bubble burst, growth
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Figure 7.1 Growth Stocks Versus Value Stocks 220 200 180 160 140 120 100
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stocks fell back to the level of value stocks, and the two have moved together ever since.
Equity Income Funds Equity income funds are funds that invest in stocks with high dividend payments. As such, they have some similarities to value funds, but the emphasis is on high dividend yields rather than low P/E ratios. While the evidence seems to suggest that value beats growth over the long run, there is little evidence that high dividend yields beat low P/E ratios. In fact, during the twenty-five-year period that ended June 30, 2003, the total returns of value funds and equity income funds have been almost identical. However, equity income funds do have the ad-
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vantage of greater stability because more of the return comes from predictable dividend income rather than from unpredictable price gains. Recently, however, equity income funds have not provided the stability that is expected of them. That’s because they tend to invest heavily in electric utilities, telephone companies, and some financial and energy companies—the mature, slow-growing companies that pay the biggest dividends. As such, they were hurt in the past few years by the disastrous forays of some of these companies into trading power rather than producing it (Enron), buying power plants in developing nations (many utilities), and making huge investments in fiber-optic data networks (WorldCom, Montana Power). In fact, in the twelve months that ended on June 30, 2003, equity income funds lost money for their investors (⫺1.96 percent on average), while the S&P 500 produced a small but positive total return (⫹0.25 percent). Perhaps results will be better in the future if, under the pressure of tougher regulation, stodgy moneymaking utilities return to their knitting and once again become stodgy moneymaking utilities. Moreover, equity income funds have become more attractive for taxable accounts because of the tax law changes that reduce the tax rate on dividends to 15 percent. More demand by investors looking for dividend income may well cause these stocks to perform better in the future. And in a taxdeferred account it doesn’t matter whether your return is coming from dividends or share price gains. The bottom line: if you want to own a stock fund but you also want safety, an equity income fund is a good way to go. But because equity income funds emphasize dividends rather than growth, they can normally be expected to act a bit like a hybrid of stocks and corporate bonds—though with the emphasis more on stocks. So if you already have a stock fund and a bond fund in your portfolio, the advantage of adding an equity income fund is not clear. Sure, they’re more defensive than other stock funds, but there’s a quaint Wall Street adage that says, “When they raid the brothel, they take all the girls.” What this means is simply that when sellers drive prices down, they drive prices down for all the stocks. In a big stock market sell-off, you’ll lose money more
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slowly in equity income and other so-called defensive funds. But you’ll lose money all the same. The only sure defense against loss in a bear market for stocks is to hold bonds or cash instead of owning stocks.
Sector Funds Sector funds invest in stocks from only one sector of the economy. The stocks in the S&P 500 Index are subdivided into ten such sectors. At the peak of the Internet bubble in 2000, technology was by far the largest in terms of market value. As shown in Figure 7.2, the financial sector, consisting of banks and insurance companies, was the largest in October 2003. Sector funds have been around for a long time. After the stock market crash in 1929, mutual fund companies tried to win back investor confidence by trying to sell funds that invested in sectors where stocks
Figure 7.2 S&P 500 Sectors (October 2003) Materials Utilities Telecom services Energy
Financials
Industrials
Technology
Consumer discretionary Consumer staples
Healthcare
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were going up, rather than in the entire stock market. Human nature being what it is, most investors piled into sectors that had already gone up and ended up buying high only to watch their investment shrink. This caused sector funds to fall out of fashion, but they returned to vogue in the 1980s. They’re a great way to invest—but only if you can know ahead of time which sector is going to have the best performance. Figure 7.3 shows the 1993–2003 performance of stocks in the two best-performing sectors, healthcare and technology, and in the two worst-performing sectors, telecommunications services and utilities. In 1999, when tech was pulling away from the pack, it looked like tech investors would be buying oceanfront penthouses while other investors would settle for remodeling their kitchens. But by the time the race was over, the tortoise had again beaten the hare, as healthcare stocks produced the best returns. But who would have thunk it? After all, at the beginning of the ten-year period, healthcare stocks were being pummeled out of fear of what First Lady Hillary Rodham
Figure 7.3 Sector Versus Sector
Ju ne D 19 ec 93 . Ju 199 ne 3 D 19 ec 94 . Ju 199 ne 4 D 19 ec 95 . Ju 199 ne 5 D 19 ec 96 . Ju 19 ne 96 D 19 ec 97 . Ju 199 ne 7 D 19 ec 98 . Ju 199 ne 8 D 19 ec 99 . Ju 199 ne 9 D 20 ec 00 . Ju 200 ne 0 D 20 ec 01 . Ju 200 ne 1 D 20 ec 02 . Ju 200 ne 2 20 03
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S&P 500
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Figure 7.4 $1 Invested on June 30, 1993—10 Years Later $5 $4 $3 $2 $1
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Clinton’s task force to overhaul the healthcare system would do to industry profits. Once again the time of maximum uncertainty proved a good time to buy. Figure 7.4 shows what $1 invested in each of these ten sectors on June 30, 1993, would have turned into ten years later, compared with inflation and returns from the S&P 500. Even though this was not a decade of big dividend payouts, financial stocks as well as healthcare did better than tech stocks when dividends were considered. But even with dividends, the high-yielding utility stocks (think Enron) barely beat out inflation, while a dollar invested in telecom stocks (think WorldCom) didn’t even keep pace with inflation. But who would have thunk it when telecom service stocks were flying high in anticipation of data revenues supplementing voice revenues as Internet traffic filled the lines! Just as the problem with growth and value funds is figuring out which to buy, the problem with sector funds is figuring out which sector will
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do best in the years ahead. In the 1960s consumer staple funds did well, as companies like Coca-Cola, PepsiCo, McDonald’s, and Procter & Gamble grew into multinational giants. In the 1970s it was energy, as prices soared in response to reduced supply from the Middle East. In the 1980s it was funds that invested in industrial companies, as the restructuring of U.S. companies began to pay off. And as we just saw, it was healthcare in the 1990s. What will it be over the next ten years? My hunch is energy. With turmoil in the Middle East, President George W. Bush and Vice President Dick Cheney realize that oil prices must be kept high to encourage domestic exploration. But it’s only a hunch. I do not know. Nor does anyone else. Another way to use sector funds is to own sector funds that invest in the most volatile sectors when stocks are cheap. The more volatile sectors are likely to go up more than the market when the market is going up—and down more than the market when it is going down. Technology is such a sector, and Internet stocks are the most volatile stocks within this volatile sector. They are also a group of stocks that I have had the opportunity of observing firsthand as adviser to Daiwa Asset Management Company’s U.S. Internet Fund since its inception in December 1995. The problem is that just as in the 1930s, most folks still jump into sector funds after the sector is nearing its peak. Daiwa, however, launched the world’s first Internet fund in December 1995, well before the Internet bubble started to build. Despite the bursting of the Internet stock bubble in 2000, the total return from Internet stocks from the end of 1995 to the middle of 2003 has been 4.98 percent a year—nothing to brag about, but at least a positive result. Internet funds that were launched as the bubble was peaking—and there were three such funds launched in the United States in the fall of 1999—produced disastrous results for the shareholder. With the more volatile sector funds, it’s often a good idea to take money off the table by not reinvesting capital gain dividends in the fund. For example, a Daiwa U.S. Internet Fund shareholder who bought the fund at inception but invested his dividends at market rates rather than reinvesting them in the fund would have doubled his money by the middle of 2003. (Sorry, my fellow Americans—the fund is registered for sale only in Japan.)
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International Funds International funds invest in the stocks of foreign companies. They are different from global funds, which invest in both U.S. and foreign companies. Advocates of international funds point out that the United States accounts for less than one-third of the world’s output of goods and services and only a bit more of its stock market value. Why invest in less than one-third of the world?, they ask rhetorically. International investing allows you to invest in some of the world’s most dynamic economies while diversifying your assets. In my view, the biggest drawback of international funds is that they have most of their assets in Western Europe and Japan. It’s hard to make a case that the economy of either is more dynamic than that of the United States. Both lack the U.S. risk-taking frontier spirit, which has helped to create our great growth companies, such as Microsoft, McDonald’s, and Wal-Mart. In continental Europe cautious bankers continue to influence the allocation of capital, while in Japan cautious bureaucrats play a similar role. It’s true that Japan is the home of the successful venture capital firm Softbank, but its founder, Masayoshi Son, is a Korean-Japanese entrepreneur who got most of his inspiration while studying in California. And while Germany has produced one of the world’s three software giants in SAP, this company was founded by former employees of IBM. It’s also true that the U.S. risk-taking spirit may have run amok for a while during the height of the Internet bubble, as capital was allocated to projects that should never have seen the light of day. Nonetheless, over the long run, the United States’ willingness to fund high-risk, high-reward business plans with cheap equity capital has given this country a growth advantage over Europe and Japan. As a result, the industries in which the United States has an advantage are information technology (IT) and biotechnology, as well as the service industries that are the growth engines in a postindustrial world. In contrast, many of the leading European and Japanese companies are involved in mature, slow-growing industries such as finance, auto making, or electronic equipment. But even if we limit the discussion to manufacturing, the United States is gaining compared with Europe and Japan. According to the Bureau of Labor Statistics, U.S. manufactur-
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ing productivity improved by 3.8 percent a year during the 1990s compared with 2.8 percent a year for Japan and Germany and 2.7 percent for Britain. Demographics are another U.S. advantage. A high birth rate by developed world standards, supplemented by immigration, should result in the U.S. population rising from 278 million in 2001 to 394 million in 2050, according to the Census Bureau. In contrast, the population of Japan is forecast to fall from 127 million to 101 million, while Germany’s is forecast to plummet from 83 million to 57 million. Not only does this mean there will be more demand for houses, cars, and services in the United States, but low birth rates in Europe and Japan mean that a shrinking working-age population will be forced to support a growing retired population. And an older population means a less risk-taking population, making it harder to find start-up money for risky enterprises. As shown in Figure 7.5, Japanese stocks have performed dismally since the Tokyo stock market bubble burst at the end of 1989. For a while after 1989, European stocks, driven upward by excitement over the opportunities that the fall of the Iron Curtain presented, kept pace with the U.S. market. The reality soon sank in, however, that rebuilding the infrastructure of Eastern Europe would require huge investments before rewards were realized—especially for Germany, which would be footing the costs of rebuilding the decrepit East German infrastructure. As a result, when U.S. stocks began to take off in 1995, European stocks lagged far behind. And even before U.S. stocks tumbled in 2000, European stocks had begun to fall because of slow economic growth. As a result, $100 invested in European stocks at the end of 1987 would be worth about $260, while $100 kept in the United States would be worth about $400 on June 30, 2003. And this is despite the fact that the value of the euro soared from 85¢ in the summer of 2001 to $1.15 two years later. Perhaps after more than a decade of underperformance, European and Japanese stocks are due to outperform. But based on the cultural and demographic considerations discussed earlier, I doubt that they can outperform over the long run. What about the argument that you need to invest internationally for purposes of diversification, rather than have all your eggs in a U.S. basket? The problem with investing internationally for diversification is that during times of crisis in an increasingly globalized world, all stock mar-
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Figure 7.5 U.S.A. Versus Europe and Japan 700 600 500 400 300 200 100 0 D ec .1 98 7 D ec .1 98 9 D ec .1 99 1 D ec .1 99 3 D ec .1 99 5 D ec .1 99 7 D ec .1 99 9 D ec .2 00 1
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kets tend to tumble together. This can be seen in Figure 7.6, which shows how foreign stock markets reacted to the events of September 11, 2001. Although 9/11 marked an attack on the United States, the world’s stock markets reacted in unison. The only difference was that the selling started on overseas bourses immediately after the planes hit the towers. But unless you owned stocks directly on those foreign exchanges, you would not have been able to sell because the U.S. markets were closed. Another consideration involves your retirement plans. If you plan to retire in the United States, you want your investment portfolio to grow with the U.S. economy and the U.S. cost of living. The way to do that is through investing in U.S. stocks. If you’re investing in foreign economies, you are really preparing yourself for retirement abroad. (Of course, if you are sure that you are going to retire in a foreign coun-
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Figure 7.6 World Stock Markets After 9/11 105
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try, it makes sense to put some of your retirement investments in the stock and bond markets of that country, to make sure they keep pace with costs there.) In any event, you get international diversification whether you want it or not when you invest in an S&P 500 Index fund. Even though all of the companies in the index are U.S. companies (though they might be officially headquartered in a tax haven such as Bermuda to try to escape U.S. taxes), many of the larger ones earn half or more of their income from exports or foreign operations. And even many small-cap companies earn a large chunk of their income from exports. While I see little advantage to most international funds, there is one subclass of foreign funds that is worth your consideration: emerging market funds, which invest in companies in developing nations, such as China, India, and Brazil. These countries do in fact have much more
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growth potential than the United States, Europe, or Japan, because they are still in the process of industrializing. In fact, the same government study that showed U.S. industry gaining in productivity versus Europe and Japan in the 1990s showed emerging markets outpacing the United States—by a margin of 9.7 percent to 3.8 percent a year, in the case of South Korea. Emerging market investing gained popularity in the 1980s, and those investors who got in early reaped king-sized returns, as shown in Figure 7.7. But the 1990s have been a different story, owing primarily to a series of currency devaluations and defaults that began when the Federal Reserve started raising interest rates in 1994. As the figure shows, emerging market investors lost money in the 1990s and have done worse than investors in U.S. stocks over the long haul. But the losses were con-
Figure 7.7 U.S.A. Versus Emerging Markets 700 600 500 400 300 200 100 0 D ec .1 98 7 D ec .1 98 9 D ec .1 99 1 D ec .1 99 3 D ec .1 99 5 D ec .1 99 7 D ec .1 99 9 D ec .2 00 1
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U.S. stocks
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centrated in the four years from 1994 to 1998, when the Morgan Stanley Capital International Index of emerging market stocks lost 56 percent of its value. Notwithstanding the extreme volatility, there is something to be said for putting some of your money in emerging markets. For one, some emerging nations actually do emerge. The United States was considered an emerging market in the second half of the nineteenth century. British investors helped to build the railroads that opened the frontier and started the United States on the road to superpower status. Japan was considered an emerging market in the 1950s but produced huge returns for investors as economic growth accelerated during the next three decades. Today countries such as Mexico and South Korea are developing the entrepreneurial spirit and political and legal stability that could produce a similar great leap forward. In fact, South Korea already has perhaps the world’s most sophisticated communications infrastructure with the world’s highest penetration of broadband Internet access through PCs and cellular phones. (Of course, investing in South Korea also involves the risk of investing in a country that shares a border with the world’s poorest and most unpredictable nuclear-armed nation. And peace, as well as war, is a risk because of the huge rebuilding costs that would fall on the South if the nations should ever reunite, as East and West Germany did.) And then there is China, which recently pulled ahead of Mexico as the number two source of imports for the United States. (Canada remains number one.) China is following the Japanese path of industrial development: from cheap toys made by cheap labor, to sophisticated electronic products, to becoming a center for research and development as well as manufacturing. Recently, American semiconductor companies (such as Intel) have been investing heavily in China and would be spending even more were it not for security restrictions that prevent the export of certain advanced technologies. Today it seems that most businesspeople on a flight to Tokyo stay on board the plane and continue on to Beijing. Another attraction of emerging market stocks is that they are not strongly correlated with U.S. stocks. In plain English, when U.S. stocks take a tumble, emerging market stocks may not. True, the correlation is increasing as the world’s economy becomes increasingly intertwined,
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but an emerging market fund can still add some real diversification to your portfolio. Table 7.2 shows that movements in the S&P 500 explain only 32 percent of the movement in emerging market stocks, while a portfolio of emerging market stocks has also been less volatile than the S&P 500 Index (because boom-and-bust cycles don’t occur simultaneously in all emerging markets). The bottom line: For those of you who want to move beyond plain vanilla stock funds, a position in an emerging market stock fund—or perhaps even a China fund—might not be a bad idea. In terms of best investment opportunities, the 1980s were the Japanese decade and the 1990s belonged to America. I wouldn’t be surprised if the rest of the Aught-Aughts—or whatever this decade is called—belonged to China, Mexico, South Korea, and a few other emerging nations.
Small- and Mid-Cap Funds Small-cap funds are funds that invest in small companies—or more precisely, companies with a small market capitalization, typically less than $2 billion. For comparison, the average market capitalization of an S&P 500 company is currently more than $15 billion. The market capitalization of a company measures how much a company is worth. It’s sim-
Table 7.2 How Different Types of Stocks Move Together . . . but Not with Bonds or Gold
Asset Type S&P Growth Stocks S&P Value Stocks NASDAQ 100 Stocks S&P SmallCap Stocks Dow Jones Technology Stocks Foreign Stocks Emerging Market Stocks Gold 7–10-Year Treasury Bonds
Percent of Movement Explained by Move in the S&P 500 Index
Volatility Compared to S&P 500 Index
92% 87% 66% 65% 63% 53% 32% 0% ⫺3%
0.98 1.05 1.47 0.94 1.74 0.81 0.93 low 0.43
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ply the price of a share of stock multiplied by the number of shares. As such, it changes from minute to minute when the stock market is open. The case for small-cap funds is similar to the case for emerging market funds. Small companies have much more upside potential than large companies, just as emerging markets have more upside potential than developed markets. And because small-cap funds are riskier investments, they should reward that risk with higher returns. Small-cap investing was popularized by a Chicago-based research firm called Ibbotson Associates. Ibbotson publicized a stock chart going back to 1926 that shows small company stocks outperforming other common stocks by a good margin. Between 1926 and 1990 Ibbotson found that while common stocks overall produced a 10.1 percent annualized total return, small caps gained 11.6 percent a year—a huge difference compounded over a sixty-four-year time frame. More recent evidence has cast doubt on whether small caps outperform large caps over the long run. Figure 7.8 compares the total return of the Russell 1000, an index of large company stocks, with that of Figure 7.8 Small Caps Versus Large Caps 3500 3000 2500 2000 1500 1000 500
D ec .1 97 D 8 ec .1 98 D ec 0 .1 98 D ec 2 .1 98 D ec 4 .1 98 D ec 6 .1 98 D ec 8 .1 99 D ec 0 .1 99 D ec 2 .1 99 D ec 4 .1 99 D 6 ec .1 99 D ec 8 .2 00 D ec 0 .2 00 2
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the Russell 2000, a small company index. In the 1980s large company stocks did a bit better than those of small companies, but in the 1990s they left small company stocks in the dust. This was because during the boom years investors flocked to large technology, healthcare, and financial firms rather than trying to find value in the thousands of smaller companies that made up less than 20 percent of the stock market’s value. Even if small-cap indexes were to outperform large caps, a small-cap index fund would be likely to lag behind the performance of its benchmark index by a wider margin than would a large-cap fund. This is largely because of the higher trading costs of buying and selling smallcap stocks. Fewer willing buyers and sellers means a fund drives the price up when buying and down when selling. Recent evidence also shows that small-cap stocks, as a group, may not be more risky than large-cap stocks. That’s because there’s safety in numbers. While any one small company is at more risk of going out of business than a large company, the bankruptcy of any one company will have a small effect on a fund that owns positions in perhaps one hundred or more different small company stocks. What’s more, because most small company stocks did not fully participate in the stock market bubble of the 1990s, they didn’t have as far to fall when the bubble burst. From August 31, 2000, to September 30, 2002, as the large-cap Russell 1000 lost 45 percent of its value, the small-cap stock Russell 2000 index was down 31 percent. More recently, however, the volatility of small-cap indexes has been similar to that of large-cap indexes. And because small companies pay out less of their earnings as dividends, the reward from owning small-cap stocks must come more from uncertain price gains than from relatively certain dividends. Mid-cap funds are funds that invest in midsize companies, currently defined by the Lipper consultancy as those with market capitalizations between $2 billion and $8.5 billion. A standard benchmark is the S&P MidCap 400 Index. In theory, a mid-cap fund falls between a largecap fund and a small-cap fund in both expected risk and expected reward. Nonetheless, during the ten years that ended on June 30, 2003, the total return of the S&P MidCap 400 Index surpassed that of both
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large-cap and small-cap indexes. Advocates of mid-cap stocks would say that this is because mid-cap companies occupy the sweet spot on the growth curve. They have moved past the stage where there is a high risk of failure, yet they are still growth companies that have not yet reached the mature, slow-growth phase. Table 7.3 summarizes the performance of large, medium, and small company indexes over the ten years that ended on June 30, 2003. Unfortunately, the indexes don’t have a long enough history to tell whether mid-cap outperformance is a long-term phenomenon or something unique to those ten years. As we saw in the section on active funds versus index funds, active management can probably add more value to a fund that invests in smaller companies. Table 7.3 bears this point out. While active small-cap funds outperformed their benchmark index, active mid-cap funds underperformed. The bottom line: There’s no assurance that a small-cap or a mid-cap stock fund will outperform a large-cap fund over the long pull. Nor can there be assurance that they will be less volatile. Owning a small- or mid-cap fund in addition to a large-cap fund will, however, reduce risk a bit because large-, mid-, and small-cap stocks don’t necessarily move in lockstep. In mathematical terms, the movement in the S&P 500 determines about 80 percent of the movement in a small-cap index and close to 90 percent of the movement in a mid-cap index. If you decide to buy a mid-cap fund, an index fund would probably be best. For a small-cap fund, an active fund may be best. (Of course, in a 401(k) plan you probably won’t have this choice.)
Table 7.3 Large-Cap, Mid-Cap, and Small-Cap Stocks (Average Annual Total Return from June 30, 1993, to June 30, 2003) Stock Size
Market Capitalization
Benchmark Index
Index
Average Fund
Versus Index
Large Medium Small
>$8.5 billion $2–$8.5 billion <$2.0 billion
S&P 500 S&P MidCap 400 Russell 2000
10.04% 12.69% 8.25%
8.29% 10.38% 8.98%
⫺1.75% ⫺2.31% ⫹0.73%
Average fund performance is based on data from Lipper and Morningstar.
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High-Yield Bond Funds And then there are high-yield bonds (also known as junk bonds). These are the bonds of less-creditworthy companies. Because the chances of default are greater, they pay a higher yield, usually several percentage points above the yield on investment-grade bonds, to compensate for the higher risk. Because high-yield bond funds, like other corporate bond funds, hold bonds issued by many different companies, they are not hit that hard if one company goes bankrupt and defaults on its debt. The danger in investing in high-yield bonds comes if the economy plunges into recession. In a recession, many high-yield bond issuers can run into trouble making good on their debt, so high-yield bond funds usually take a big hit when the economy slows. High-yield bonds often act more like stocks than like bonds. When the economy improves, they tend to rise in value—along with stocks— because the risk of default is reduced. In fact, the total return from high-yield bonds as the economy moved from recession to prosperity between 1991 and 1993 was 24.6 percent a year, according to Citigroup Smith Barney’s high-yield bond index. But because of the “bad” years when the economy slowed, the average total return from high-yield bonds between 1990 and 2002 was a more mundane 8.1 percent a year. Indeed, holders of high-yield bonds lost money in 1990 and 2000, both of which were years before the economy entered a recession. Investment-grade bonds also benefit from reduced default risk when the economy is healthy, but the biggest risk with high-quality bonds is a change in interest rates, not default. As a result, high-yield bonds march to a different drummer than do corporate and government bonds, so a high-yield bond fund can help to diversify a portfolio.
Socially Responsible Funds These are funds for folks who want to make the world a better place through their investments. Originally, most socially responsible funds (SRFs) were stock funds that avoided companies involved in the so-
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called sin industries of tobacco, alcohol, and gambling. Then sprang up SRFs that refused to invest in firms with nuclear or military connections. Others avoided environmentally polluting companies or those that do animal testing or operate sweatshops. Still others tried to avoid all of these. Many SRFs also began to engage in corporate activism—trying to change the policies of corporations through their votes as shareholders. Recently, following the scandals involving Enron, WorldCom, and Martha Stewart, many have begun to emphasize corporate governance—avoiding companies with questionable accounting or management practices. Some scholars have argued that such ethical investing policies will result in poorer investment returns. They say that less-ethical investors will simply snatch up the profitable “sin stocks,” negating any boycott and keeping the profits for themselves. In practice, however, most SRFs have done quite all right. Avoiding tobacco companies has meant avoiding the effects of class-action lawsuits against the tobacco companies. Avoiding polluters has meant avoiding the cost of cleaning up their wastes. And more recently, avoiding companies with unethical management has kept the SRFs from some of the stock market’s biggest disasters. Indeed, the stocks in the Domini Social Index 400, which is the best-known index of stocks suitable for SRFs, had a total return of 10.75 percent for the ten years that ended on June 30, 2003, versus 10.04 percent for the S&P 500. Table 7.4 lists some of the more popular SRFs. Unfortunately, as the table shows, none of the five SRFs that have been around for ten years or longer was able to match the performance of the index. This is due in part to higher expense ratios than most stock funds. All that screening and shareholder activism have their costs. Still, the returns weren’t all that bad, the average return being 8.91 percent a year. And socially responsible investing is growing rapidly. SRFs, including those that invest some of their assets with community groups, now account for well over 12 percent of all U.S. managed assets. So should you put some of your money in an SRF? Well, first of all you should make sure that the fund’s beliefs match your beliefs. While most of us would agree that pollution is not a good thing, does that
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Table 7.4 Socially Responsible Funds Fund Name
Assets 10-Year Maximum Expense (in millions) Return Load Ratio
American Trust Allegiance $20 Aquinas Growth $52 Aquinas Value $36 Bridgeway Ultra Large 35 Index $7 Calvert Social Investment Equity A $484 Citizens Core Growth A $285 DEVCAP Shared Return $16 Domini Social Equity I $1,050 Dreyfus Premier Third Century Z $532 Green Century Equity $28 MMA Praxis Core Stock Fund B $116 Neuberger Berman Socially Responsible Fund $159 Noah Fund $9 Parnassus Equity Income Fund $437 Parnassus Fund $346 Security Social Awareness A $9 Sierra Club Stock Fund $3 Walden Social Equity Fund $31 Women’s Equity $15
— — — — 8.66% — — 9.53% 6.43% — — — — 10.47% 9.46% — — — —
0.00% 0.00% 0.00% 0.00% 4.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 3.00% 5.00% 0.00% 0.00% 0.00%
1.45% 1.50% 1.49% 0.15% 1.24% 1.34% 1.75% 0.92% 1.02% 1.50% 1.75% 1.13% 2.20% 0.96% 1.00% 1.49% 1.86% 1.00% 1.50%
Based on data from the Social Investment Forum.
mean we should oppose nuclear power plants if the alternative is coalfired plants that contribute to global warming? And while we might also agree that drunken driving, which kills 19,000 Americans every year, is a sin, it’s not so clear-cut that brewing beer is a sin. You might do more good by investing in an SRF fund that owns a brewery stock and uses its shareholder votes to discourage advertising aimed at teenagers, rather than own a fund that shuns brewers altogether. To find out the values and objectives of specific SRFs, you can check out the Social Investment Forum’s website at socialinvest.org. And if you can’t find a fund that’s suitable (or if all your investment money is in a 401(k) plan that doesn’t offer an SRF), why not put your money in an index fund and give the 1 percent a year or so that you save in expenses to organizations that you think will make the world a better place?
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Balanced, Life Cycle, and Asset Allocation Funds The strict definition of a balanced fund is one that holds a fixed proportion of stocks and bonds, usually 60 percent stocks and 40 percent bonds. However, any fund that holds both stocks and bonds is often referred to as a balanced fund. The problem with a balanced fund, strictly defined, is that it does not make adjustments based on market conditions or the circumstances of the individual fund holder. In some so-called balanced funds the fund manager may change the mix of stocks and bonds based on her opinion about their relative prospects. It’s necessary to read the fund prospectus to find out whether the manager has wide leeway to change the mix or whether there is a strict set of guidelines controlling the asset allocation.
H OW TO R EAD
A
P ROSPECTUS
Admit it. You’ve never read a prospectus before investing in a fund. OK, maybe you’ve glanced through a prospectus and looked at some of the char ts, such as the one showing past performance of the fund. But you’ve never felt up to the daunting task of reading one from cover to cover. The good news is that most mutual fund companies are recognizing the need to make their prospectuses more readable. But even so, it’s not possible for most folks to make it from beginning to end without first drinking a double espresso. Still, it’s impor tant that you understand the key points in a prospectus before investing or sending money. (Why the phrase “or sending money,” you may ask. I’ve been told that, unfor tunately, some Americans are so financially illiterate that they don’t know what the word investing means. So the prospectus writers need to also include the simpler phrase “sending money.”) Following is a list of some of the key information in a prospectus that you need to understand before investing in a fund (or sending money):
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➤ Fund objective: This should be stated up front in plain English, using language such as “long-term capital growth,” “income,” or “preservation of capital,” to list three common objectives in descending order of implied risk and reward. ➤ Principal investment strategy: The prospectus should clearly state how the fund intends to achieve its objective. For example, most prospectuses include language such as this: “Under normal conditions, the Fund will invest at least 65 percent of its net assets in the common stocks of dividendpaying companies.” Make sure that what the fund invests in is consistent with your understanding of the fund’s objective. ➤ Risks: Most prospectuses include a laundry list of everything that could go wrong. It may take a while to read, but do it anyway. You may find an impor tant risk that you had not already considered. ➤ Past performance: Take a look at the total return over a long period of time, ideally ten years if the fund has been around that long. And pay as much attention to the volatility of the return as to the return itself. A good prospectus will tell you how much the fund lost in its worst quar ter and worst year, as well as how much it made in the best of times. Compare the total return and volatility history with those of other funds with the same objective and with different objectives. But keep in mind that, as the prospectus will say, “past performance is no guarantee of future performance.” Past performance can give clues about probable future performance, but past performance cannot accurately predict future performance. Also, good prospectuses will show the total return after taxes using conservative assumptions about the shareholder’s tax status. This is impor tant if the fund is intended for a taxable account, but it is not relevant if you intend to hold the fund in a 401(k), an IRA, or another tax-deferred account. ➤ Expenses: This is a biggie. First, see if there is a sales charge (commission) on either the purchase or sale of the fund. Even if you intend to hold the fund for a long time, sales charges can significantly reduce the return from your investment. All else
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being equal, you should look for a fund that is 100 percent noload, meaning that there are no fees or charges when you buy or sell fund shares or reinvest dividends. Also, most fund companies allow for commission-free exchanges within their own family of funds, at least as long as the exchanges are not too frequent. Make sure that the prospectus provides for such a commissionfree exchange. Funds that normally charge a commission often waive the sales charge if the fund is being bought for a taxdeferred account, but the sales charge should be a major consideration otherwise. Next, look at the expense ratio—the fund’s total annual operating expenses as a percentage of assets. This will include the management fee, other expenses, and in some cases, a fee to cover the cost of distributing the fund, known as a 12b-1 fee. It doesn’t matter so much what the mix of fees is; the impor tant thing is the total expense ratio. If it is higher than that of other funds with a similar objective, there should be a good reason. In general, index funds, money market funds, and government bond funds should have the lowest expense ratio, while specialized funds requiring research, such as an emerging markets stock fund, will have the highest expense ratios. The expense ratio is impor tant because it tells you how much of your total return will be eaten up by fees. If you are investing in an asset class, such as government bonds, with a historical normal total return of only 2 percent to 3 percent above the rate of inflation, a high expense ratio could seriously eat into your expected return. ➤ Dividends, distributions, and taxes: This section is impor tant if the fund is to be held in a taxable account because it will help you to calculate your expected tax liability from the fund. The smaller the payout of dividends and capital gains, especially shor t-term capital gains, the smaller your liability. Your tax liability from dividends paid by a fund is not affected by whether you reinvest your dividends or receive them in cash. If your objective is to build up wealth over the long haul, you should normally request that your dividends be reinvested.
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➤ Who runs the fund? While it may be ideal to have a fund manager with some gray around the temples who has been running the fund since its inception, the reality is that this is rare. Mutual fund managers frequently change jobs in the United States, so even if the manager has been there a long time, there’s no guarantee he or she will stay much longer. And with a change in management, there could be a change in investment style and subsequent performance. For that reason, there are advantages to funds that are managed by a team rather than by a single prima donna. ➤ Is this fund appropriate for me? Some fund prospectuses will have a section that discusses the appropriateness of the fund for folks in different circumstances. It is definitely wor th reading and may help you to avoid some common mistakes.
A life cycle fund is a form of balanced fund designed specially for people of a certain age or length of time until retirement. A life cycle fund for folks in their thirties would be geared for growth, consisting mainly of stocks, including some foreign stocks and perhaps even emerging market stocks. One for folks in their fifties would be geared more toward preservation of value, consisting of a substantial share of bonds, along with dividend-paying stocks. It’s a sensible concept but one that requires that you remember to shift from fund to fund as you pass milestone birthdays. (There are a few funds that do this for you. They shift their assets to a more conservative mix as they approach their target termination date.) Life cycle funds have been described as peace-of-mind portfolios, but there is a price to be paid for peace of mind. Because life cycle funds normally don’t increase their holdings of stocks when stocks are undervalued, you miss out on those opportunities for big gains. Asset allocation funds try to solve the problem of lost opportunities. They are designed to shift their assets between stocks and bonds—and sometimes between domestic and foreign stocks—based on valuation differentials or other criteria. Their shortcoming is that they are not tailor-made for specific age groups or risk profiles, so they may be too risky for folks in their sixties but too conservative for twentysome-
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things. Now if only someone would combine the features of a life cycle fund with an asset allocation fund . . .
Convertible Funds A convertible debenture is a corporate bond that can be converted into a fixed number of shares of common stock of the issuing company. The exchange ratio is normally fixed so that it only makes sense for the debenture holder to convert if the stock exceeds a certain price target at which the stock and debt would be equal in value. A convertible fund is one that invests in these securities and sometimes in preferred stock as well. Convertible debt sounds like a great deal. You get an interest-paying corporate bond plus the opportunity to realize a profit if the corporation’s stock moves up in price. Even if the stock price goes up but never quite reaches the target, the convertible will rise in value because of the growing possibility of reaching the target. But as with everything else related to the stock market, there’s no free lunch here. The interest rate on a convertible is normally less than that on other corporate bonds, and sometimes there’s no interest at all. So if the stock doesn’t move up in price, you end up behind. We might expect the performance of a convertible fund to be similar to that of a balanced fund, because both are stock-bond hybrids. In fact, during the ten-year period ending June 30, 2003, convertible funds outperformed balanced funds by more than a percentage point a year— 8.72 percent versus 7.61 percent—according to Lipper. The outperformance came entirely during the final five years, when the stock market bubble inflated and burst, meaning that convertible funds exhibited better defensive characteristics than balanced funds in a volatile market. But a lot of this outperformance may have been because of the strategies adopted by the fund managers rather than an inherent superiority of one fund type over the other. In any event, convertible funds are not too common among 401(k) choices, but they can make sense in an IRA as an alternative to a balanced fund.
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Gold Funds People who advocate investing in gold are often called gold bugs. They can bug you with their doomsday claims that the sky is falling and that gold is the only safe asset to hold. If, in fact, they are right and stock prices plummet, gold may indeed be a good way to preserve your wealth. In fact, as Figure 7.9 shows, the price of gold soared during the 1970s bear market for stocks, then fell after the bull market began in 1982. And there are both gold funds and individual gold stocks that provide ways to invest in gold without filling your safe deposit box with the real thing. However, there are two problems with the gold bugs’ case. First of all, while gold did produce huge returns in the 1970s—after the dollar’s value was no longer pegged to gold and inflation soared—it has plummeted in value since 1980, as inflation was brought under control (see Figure 7.9). Looking forward, inflation is not high on the list of worries of most economists. They say that gains in productivity and the ability to outsource work to low-wage countries are likely to keep prices from rising too rapidly. If they are right, we are unlikely to soon see conditions like those of the 1970s that would cause gold to soar in price. Another problem with gold is that because it is no longer the basis for valuing money, demand for gold to fill national vaults is less important than it once was. In fact, jewelry is now the main use for gold. Because of this, the price of gold will fluctuate like any other metal based on demand (for jewelry) versus supply (production from mines). And given that the demand for jewelry increases when stock prices rise and people feel wealthy, the linkage between stock prices and gold prices might move from a negative to a positive relationship. (Recently, as seen in Table 7.2, there has been no relationship between the two.) The bottom line: gold still provides good diversification from stocks, but there seems to be no good reason to expect gold to produce better returns than stocks in the foreseeable future—unless you believe inflation will soon awaken from its twenty-year sleep.
Nominal price
Real price
9 1 3 5 7 9 1 3 5 7 9 1 3 5 7 9 1 96 97 97 97 97 97 98 98 98 98 98 99 99 99 99 99 00 .c 1 .c 1 .c 1 .c 1 .c 1 .c 1 .c 1 .c 1 .c 1 .c 1 .c 1 .c 1 .c 1 .c 1 .c 1 .c 1 .c 2 e e e e e e e e e e e e e e e e e D D D D D D D D D D D D D D D D D
$0
$50
$100
$150
$200
$250
$300
$350
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$550
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Figure 7.9 Price of an Ounce of Gold
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L IMIT O RDERS
AND
O PTIONS
Limit orders are one technique that some investors use to reduce risk in a stock por tfolio. A limit order is an order placed with a stockbroker to sell a stock if it falls to a cer tain price. Its purpose is to limit losses by selling before the stock falls even more. You can use the same strategy with a mutual fund by deciding in advance to sell if the share price falls to a cer tain level. That said, I don’t generally recommend the use of limit orders. What they do is lock in losses. If you are worried that stock prices are too high or that you are taking too much risk, it’s usually a better idea to sell some of your stocks or stock funds now rather than to give an order to sell later at a lower price. An option is just what it sounds like: the right, or option, to buy or sell an asset at or up to some specified future date at a specified price. There can be options on any asset, but perhaps the most impor tant are those on real estate, stocks, and stock indexes. Options have value because they lock in a buying or selling price without actually requiring that you buy or sell at that price. An option giving you the right to buy is called a call option; one giving you the right to sell is called a put option. Options can be used either to increase potential risk and reward (speculation) or to reduce it (hedging, or insurance). Let’s take a look at how you can use put options, as an alternative to selling stock, to reduce risk. Say you have 80 percent of your investment por tfolio in stocks, with much of it in an S&P 500 Index fund. If you are beginning to worry about high valuations, you could sell par t of your position. Or you could buy a put option on the S&P 500 Index through your stockbroker. Let’s say the S&P is at 990. Put options would be available at various fixed prices (called strike, or exercise, prices) at which the index could be sold on specified dates one, two, three, and more months ahead. Options are sold in lots of 100, with a lot being called a
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contract. You could buy a contract for a put option at 990 that would be good for a month. If the 990 option were selling for $20, a contract would cost $2,000. If at the end of the month the S&P 500 was trading above 990, the contract would expire wor thless because no one would want the right to sell something for 990 if it was wor th more. You would lose $2,000 on the contract, but if the value of your por tfolio increased by more than $2,000, you would be ahead overall. You essentially bought yourself insurance that you for tunately didn’t need. But let’s say that during the month your worries about overvaluation prove to be warranted as the S&P plunges from 990 to 890. The right to sell at 990 is now wor th $100. Your contract of 100 put options is wor th $10,000. If the value of your por tfolio goes down by $8,000, your net wor th is unaffected because you make $8,000 by buying the option at $2,000 and selling at $10,000. But at this point, we have moved far beyond plain vanilla. The preceding example is merely designed to show you how options can be used as insurance to protect a por tfolio. If you are thinking about using options for this purpose, I recommend that you study a good investment textbook or get some professional advice. And you need professional advice even more if you are thinking about using options for speculation.
Real-World Choices Now that we’ve reviewed a number of options beyond plain vanilla for a long-term investment portfolio, let’s look at the real world—the options that are available in a typical 401(k) plan, as depicted in Table 7.5. If you have a 401(k) plan at work, your plan may have either more or fewer options, but Table 7.5 shows a fairly typical number: fifteen (the actual average number of options per plan is fourteen). It does not show the option of a self-directed brokerage account, because most
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401(k) plans do not offer this choice. However, if you have this option in your 401(k) plan, or if you do long-term investing through an IRA or a regular taxable account, you can substitute ETFs for index funds. Table 7.5 Typical Choices in a 401(k) Plan
Fund Type Technology Mid-Cap Index Small-Cap Emerging Market Stock Company Stock S&P 500 Stock International Stock Equity Income Growth Stock Balanced High-Yield Bond Corporate Bond Government Bond Inflation-Protected Bond Money Market
Historical Normal Total Return After Inflation 7.0%⫹ 7.0%⫹ 7.0%⫹ 7.0%⫹ 7.0% 7.0% 7.0% 6.0% 6.0% 5.2% 3.0%⫹ 3.0% 2.5% 2.0% 1.0%
Risk of Loss
Correlation with the S&P 500 Index
Very High High High Very High Highest High High Moderate to High High Moderate High Moderate to High Moderate Low Low
High High Moderate to High Low to Moderate Depends on Company Highest Moderate Moderate to High High Low to Moderate Low to Moderate Low Low Very Low Very Low
U NDERSTANDING TABLE 7.5 “Historical Normal Total Return After Inflation” is based on as much historical data as is available. Returns have differed over different time periods, so I have tried to use as many different time periods, and the longest time periods available, to determine what are normal returns. Nonetheless, there is still some judgment in the estimation of these normal real returns. Actual future returns will differ—maybe for the better, maybe for the worse—from these estimated norms. But it is hoped that the ranking of the normal returns—in descending order of expected return—is directionally correct. In any event, you
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should expect the risk of these fund choices to decline along with their normal returns. “Risk of Loss” means risk that the value of your asset can go down in value. Note that only the inflation-protected bond fund and the money market fund are described as low risk. Inflationprotected government bonds will rise in face value with increases in inflation, thus protecting your principal. However, you should read the prospectus of a fund that invests in such bonds to make sure that the fund invests only in bonds offering this protection. As for money market funds, the mutual fund industry has, at least until now, never allowed the per share value of a money market fund to vary from the $1 standard—even if it has meant that the investment company had to eat losses. All the other choices are definitely at risk of losing value—even government bond funds, as we will see in the next chapter. “Correlation with the S&P 500 Index” indicates whether the asset is likely to respond in the same way as the S&P 500 stocks to changes in economic or geopolitical conditions. A rating of high means that a 10 percent upward or downward movement in the S&P 500 Index is likely to be accompanied by a similar movement in the fund. A rating of moderate means that the asset is likely to move in the same direction but only about half as much. A rating of low means there is little relationship between changes in the S&P 500 Index and changes in the asset. All other things being equal, if you have a lot of your por tfolio invested in an S&P 500 Index fund, or assets that have a high correlation with the S&P 500 Index, you should invest the remainder of your por tfolio in assets that have a low correlation.
Now let’s take a look at the fifteen typical 401(k) investment choices themselves. We will start with the S&P 500 Index fund, because it can be the core holding in most long-term investment portfolios. As we’ve seen already, the historical normal return has tended to be about an inflation-adjusted 7 percent, but the risk of loss has been high—about
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one time in eight, the value of a stock portfolio has declined over the course of a decade. The best choice for the second-largest holding is usually a bond fund. In this example, there are four to select from: a high-yield bond fund, a corporate bond fund, a government bond fund, and an inflationprotected bond fund. While it may be OK to put some of your money into a high-yield bond fund, it is too risky to be considered for a major portion of your portfolio. So this leaves three alternatives. In most cases, I would opt for the inflation-protected bond fund, provided the prospectus makes clear that it is a TIPS fund. Because inflation risk is removed, your expected return will be less than from a traditional government bond fund. But because a TIPS fund entails less risk—and may provide more effective diversification than a traditional bond fund—investing in a TIPS fund allows you to take a bit more risk with the rest of your investment portfolio. Now let’s turn to some of the other choices. For the technology fund, the mid-cap index fund, the small-cap fund, and the emerging market stock fund, I show the historical normal return as 7 percent plus. Because these investments are more volatile, and therefore have more risk of losing money than an S&P 500 Index fund, investment theory says that they should provide a greater return. In fact, there is no clear historical evidence that any of these asset classes outperform the S&P. Mid-cap stocks had the best performance during the ten-year period ending June 30, 2003; small-cap stocks seem to have outperformed prior to the 1982–2000 bull market; emerging market stocks had a good run prior to 1994; and technology stocks were the only place to be from 1998 to 2000. But I cannot find evidence to convince me that these asset classes outperform over the long run. The 7 percent plus means that in theory they should outperform. In practice, it is uncertain. If you want to take the risk of owning a fund that invests in one of these asset classes in the hope of higher returns, an emerging market fund would offer the greatest diversification, but at a very high level of risk. In other words, in any given year there would be a good chance that it would lose money—but not necessarily in the same year that a portfolio of American stocks was losing money.
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A technology fund offers great upside potential in a bull market, but also has a high correlation with the S&P 500. Translated into English, this means that when the S&P takes a downward turn on the kiddie roller coaster, a tech fund is likely to be taking a stomach-turning plunge on the real thing. As for the mid-cap fund, I made it an index fund in this hypothetical 401(k) plan. If it were an active fund, its expected return would be at least 1 percent less because of the costs of active management. And even as an index fund, its attractiveness is limited by its high correlation with the S&P 500 Index. Likewise, because I got to pick the hypothetical choices, I chose to make the small-cap fund an actively managed fund, given the evidence that active management can add value here. Nonetheless, I see no compelling need to own it because it would also have a fairly high correlation with the S&P 500 and because the evidence that small caps outperform over the long run is not 100 percent convincing. Next on the list in order of expected reward is company stock. For the average company, the historical return would be 7 percent, the same as for the stock market as a whole. But if you work for a start-up hightech firm, both risk and potential reward would be much higher. And if you work for an electric utility—at least one that sticks to the business of generating and distributing electricity—the risk and potential reward would be lower. But regardless, as discussed earlier, it’s best not to hold any more company stock than required by your retirement plan rules. Along with an S&P 500 Index fund, I show an international stock fund as having a 7 percent historical normal return. In fact, international stocks did much better for the seventeen years from the beginning of 1973 to the end of 1989. But for the next fourteen years they lagged badly. The reason for the up-and-down performance has been the largest foreign market, Japan. Prior to the end of ’89 the Japanese stock market bubble was inflating; since then it has been deflating. Over a long enough time period, there is no reason to think that investing in the major developed overseas stock markets will produce results significantly better or worse than investing in stocks at home. And as dis-
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cussed in the section on international funds, I see no reason based on economic dynamism for foreign stocks to outperform. Still, after fourteen years of underperformance, international funds may well at least match the performance of the S&P 500 going forward. Plus they provide diversification. If you are adventurous, there’s no reason not to put a small portion of your 401(k) in an international fund. But there’s no necessity either. Just below S&P 500 Index funds and international funds in terms of normal returns, I show equity income funds and growth funds. Your 401(k) fund may offer a value fund in lieu of an equity income fund. Regardless, growth funds, equity income funds, and value funds all have historical normal returns below that of S&P 500 Index funds, assuming they are actively managed. The reason is the management fees and trading costs as the fund manager implements a stock selection strategy rather than an index strategy. If your 401(k) offers an indexed value or growth fund—one that tracks the S&P/Barra value or growth index, for example—that fund would likely perform roughly in line with an S&P 500 Index fund over a long time period. But an actively managed growth, value, or equity income fund is likely to underperform, without adding significant diversification. The next choice is a balanced fund. The historical normal total return of 5.2 percent after inflation is based on a fund that holds 60 percent stocks and 40 percent government bonds. As discussed earlier, different balanced funds employ different asset allocation strategies, so the expected return from a particular fund may differ. If you are a complete slacker and never want to rebalance your portfolio, this would be the one asset to hold, because it provides both stock and bond exposure. However, if you are willing to hold at least one stock fund and one bond fund and to rebalance them based on the principles in this book, then there is no need to own a balanced fund. The expected return from a high-yield bond fund depends on how much risk the fund intends to take. The only way to find this out is to read the prospectus. In any event, the expected return should be greater than the 3 percent normal return from an investment-grade corporate bond fund, but the risk will be much greater as well.
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We’ve already discussed the other three bond funds in this hypothetical 401(k), so that leaves only the money market fund. As discussed in Chapter 6, the only time it makes sense to own a money market fund in a long-term investment account is when the yield is almost as high as the yield on bond funds. The bottom line: if you are a true slacker, you can get by with just a balanced fund in your 401(k), especially if it’s a life cycle fund or a wellmanaged asset allocation fund. If you are a plain vanilla investor, all you need is an S&P 500 Index fund, a bond fund, and occasionally a money market fund. And you should only need to rebalance your portfolio once or twice a year. If you like variety and are willing to read prospectuses, you can increase your diversification by adding some funds that aren’t plain vanilla—but there can be no assurance that this will increase your returns.
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C H A P T E R
8
Four Myths That Could Keep You Out of the Market
I
f you’ve made it this far, it should be clear that stocks can be a sound long-term investment, provided you buy them when they are reasonably priced—or better yet, underpriced. But many folks sit on the sidelines, holding too much cash, when they should have exposure to stocks. This chapter takes a look at four myths that can keep you out of the stock market when you should be in it.
Myth #1: Wall Street Strategists Will Tell You When to Get Back in the Market The job of Wall Street strategists is to provide advice to clients about investment strategy. The most important advice they provide concerns the asset allocation decision: what percentages of a portfolio should be in stocks, bonds, and cash. Richard Bernstein, a quantitative strategist at Merrill Lynch, has tracked the recommendations of the top strategists at Wall Street brokerages back to 1985. His findings may be surprising to some. He found that buying stocks when most strategists are bearish and selling when most strategists are bullish produced even better results than buying when P/E ratios are low and selling when they are high. Indeed, Bernstein found that the stock market has never gone up in the twelve months after the average recommended allocation to stocks has been above 65 percent (the year 2003 was the first exception to the rule; on
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January 1, 2003, the average recommended allocation to stocks was 67 percent and the S&P 500 rose 25 percent during the course of the year). When the recommended allocation has been below 50 percent, the average return for stock investors has been better than 25 percent a year. Figure 8.1 shows the average recommended allocation to stocks by the chief U.S. strategists at Wall Street firms. Unfortunately, this data has only been compiled since early 1997, but what it shows is that in May of 1997, when the great bull market that began in 1982 was again showing signs of running out of steam, the voice of Wall Street was telling us to have only half of our assets in stocks. Three years later, after stocks had doubled in value (the S&P 500 went from a low of 733.54 on April 18, 1997, to an all-time high of 1552.87 on March 24, 2000), their recommendation was to hold 60 to 65 percent of our assets in stocks. If you followed their advice, you would have had more stock exposure at the start of the bear market that followed than in the bull market that preceded. And as the bear market progressed, what did strategists advise? Why, of course, raise exposure to stocks! Never mind that the Fed had just finished raising interest rates in an attempt to keep the economy, and the stock market, from overheating. Never mind that at the end of the year 2000, stocks were still trading at a P/E ratio of 23 times (peak-of-cycle) earnings. The reason for this disconnect is actually quite simple. Strategists tend to be bullish when economic and political conditions are good for stocks. But when conditions are good, everyone is buying. By the time you read their recommendations, stocks already fully reflect the good news and are fully valued or overvalued. Conversely, the strategists are bearish when conditions are bad—rising inflation, threat of war, threat of recession, and so on. But under those conditions, most folks have already sold, so stocks are cheap.
Myth #2: It’s Best to Wait Until the Investment Outlook Is Clear Before Investing in Stocks “Better safe than sorry.” “Look before you leap.” The conventional wisdom is always telling you not to act until you have all the information
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you need. But with the stock market, you never have enough information. You never know what the economy will do or what political surprises are around the bend, much less what individual companies will do. But neither does anyone else, which is why stocks are always cheap during times of maximum uncertainty. When a bell is ringing at the bottom, it’s best to act quickly rather than wait for the chime to become crystal clear. That’s because no one can know the exact moment when the stock market is at its bottom until after the fact. But if you invest at a time of great uncertainty, the potential rewards for such risk taking are enormous. For example, someone investing in the stocks in the Dow Jones Industrial Average on July 8, 1932—during Herbert Hoover’s last year of presidency and during the depth of the Depression—would have seen the value of their investment rise by 94 percent in less than two months. Someone who jumped into the stock market on the morning of October 20, 1987— the morning after the great one-day crash—could have reaped a 12 percent one-day gain. But leaving aside the Great Depression and the Crash of ’87, there’s always some uncertainty that keeps investors from acting. For example, October 9, 2002, was the date of a market bottom. There were no big news stories that day—just vague long-term uncertainties, as always. There was worry that the economy was slowing into a “double-dip” recession, having only sluggishly emerged from the previous year’s slowdown, and that as a result company profits would not be as good as analysts were predicting. There was worry that there would eventually be a war in Iraq, but war was not imminent in October 2002. There was uncertainty about the upcoming congressional elections, less than a month off, with polls showing that both the Republicans and Democrats still had a shot at controlling Congress. But amidst all that uncertainty, there were some things that were certain. It was certain that the S&P 500 was trading at less than sixteen times earnings. And according to Table 5.1, when the S&P 500’s P/E ratio has been 16, the real return over the next ten years has averaged 5.5 percent. (Sure, the earnings themselves were uncertain, but they always are.) It was certain that investing in a ten-year Treasury bond would result in a mediocre return of about 3.6 percent if held to maturity. It was certain that a typical money market fund would provide a return of only about 1 percent.
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With twenty-twenty hindsight we can see that the correct investment decision in October 2002 would have been to buy stocks despite the uncertainty. Although the feared war with Iraq did happen, and the occupation of that country has been as costly and difficult as many warned it would be, the total real return from the S&P 500 Index was 35 percent between October 9, 2002, and October 9, 2003.
Myth #3: Real Estate Is Always a Better Investment than Stocks There are two reasons to buy real estate: to live in or to invest in. Let’s look at the first reason first. For most folks, buying a home to live in is a much better financial strategy than renting and investing any difference between mortgage payments and rent. With home ownership you are investing in a real asset; when you rent you are helping to cover the cost of someone else’s investment. But the real kicker is the tax advantage, because both the interest on the mortgage and real estate taxes are deductible for federal income tax purposes. Uncle Sam is effectively subsidizing home ownership. And the higher your tax bracket, the bigger the subsidy. As well, there is the psychological benefit of home ownership. You have full control over your home. No landlord can raise the rent, tell you that you can’t renovate to suit your lifestyle, or evict you to turn your home into a condominium. (True, your local government can raise property taxes, tell you that you can’t raise llamas in your backyard, and even force you to sell under eminent domain, but you still have much more control than a renter.) Last but not least, there is financial leverage in real estate investing because you typically put no more than 20 percent down and borrow the rest. If you put $40,000 down on a $200,000 house and the house doubles in price, your stake has increased more than sixfold: from $40,000 to $240,000, plus however much of the mortgage you have paid down. But does that mean you should buy more house than you need or that you would do better to put money into upgrades than into the stock market? Not necessarily. Despite big gains in home prices recently, the
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long-term track record is unimpressive. Between 1980 and March 31, 2003, the typical U.S. home appreciated in price by 4.7 percent a year versus an average inflation rate of 3.7 percent. In other words, home prices outpaced inflation by only 1 percent a year. That’s pretty much the result you would expect from a money market account. And not nearly as good as you would have done with stocks or bonds over the same time frame—even after factoring in the tax advantage, including the exclusion of up to $500,000 in capital gains on the sale of a principal residence by a married couple. But what if we leave out the last five years (March 31, 1998, to March 31, 2003), when low interest rates caused stock, bond, and real estate prices to rise? The answer is that from 1980 to 1998, housing price gains barely kept ahead of inflation, rising at 4.2 percent a year versus a 4 percent annual increase in consumer prices. Over that eighteen-year span, an investment in real estate did worse than most money market accounts—at least before factoring in the tax advantage. As you can see from Figure 8.2, it has only been during the last five years (1998–2003) that home prices made their big gains in inflation-adjusted (2003) dollars. Notice that I started this discussion about real estate by saying “for most folks.” The figures stated are national averages, and like most national averages they hide huge differences from region to region. The average New England home that sold for $100,000 in 1980 sold for $465,500 in early 2003. In contrast, the average home that sold for $100,000 in 1980 in the nation’s West South Central Region (Texas, Oklahoma, Louisiana, Arkansas) sold for $184,000 in 2003. Most folks in that region have homes that are worth a lot less today than twentythree years ago after factoring in inflation. In general, home prices in New England, in the Mid-Atlantic states, and on the West Coast have been soaring in value, while those in the South, Southwest, and Midwest have mostly been going nowhere. The only exceptions have been a few big cities. Home prices were up 58 percent in greater Minneapolis–St. Paul, 50 percent in Miami, and 48 percent in Tampa–St. Petersburg versus an average nationwide increase of 38 percent during the five years that ended with the March quarter of 2003.
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Figure 8.2 Median U.S. Home Price $190,000 $180,000 $170,000 $160,000 $150,000 $140,000 $130,000 $120,000 $110,000 $100,000 $90,000 $80,000 $70,000
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One reason for the regional disparities is that college-educated Americans—those who can generally afford to pay more for homes— are increasingly mobile and willing to move to cities that offer good jobs and vibrant lifestyles. Cities where knowledge industries are based, in particular Boston and San Francisco, have been big draws. As well, New York and Los Angeles continue to attract those who dream big. Seattle and Minneapolis are large enough to offer most everything that New York and Los Angeles have to offer (assuming you don’t need a choice of twenty-five Thai restaurants), but small enough to offer a high quality of life. Some smaller cities, too, have seen big real estate price gains because of changing perceptions. Twenty years ago Portland, Maine, was thought of as a dying old industrial and fishing town. Today
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it’s a magnet for refugees from the big cities of the Northeast who are seeking a quieter pace of life. On the flip side, ambitious young people continue to flee the smaller cities and towns of the Great Plains and much of the South and Midwest. Midland-Odessa, Texas, has seen the smallest home price gains of any metropolitan area in the country during the twenty years from 1983 to 2003—only 39 percent, about half the pace of inflation. If you are thinking about real estate as an investment, consider that worldwide there have been more and bigger booms and busts in the real estate market than in the stock market. That hasn’t been true of the U.S. real estate market as a whole, but only because booms and busts have been limited to individual regions of the country. In fact, one of the world’s biggest real estate bubbles did take place in the United States: the Great Florida Real Estate Bubble of the 1920s. While the facts of the stock market bubble of the ’20s are well documented, the dimensions of the Florida real estate bubble have taken on mythological proportions. According to Frederick Lewis Allen’s book Only Yesterday: An Informal History of the 1920s (1931), real estate values in Miami and Palm Beach peaked in 1925 with land prices rising as much as sixfold in the previous ten years. Interestingly, the real estate bubble burst before the stock market bubble. By 1929 prices had returned to their pre-bubble levels, with the bursting greatly aided by a September 1926 hurricane that killed 243 people (400, according to Allen, who may have a tendency to exaggerate). Recently, many have fretted that a real estate bubble has developed in parts of California and the Northeast. In metropolitan San Jose, California, the typical home price was $534,400 at the beginning of 2003. In the oceanfront town of Avalon, New Jersey, of 159 houses up for sale during the summer of 2003, the asking price on 103, or 65 percent of the total, was more than $1 million. True, there’s one huge difference between Florida in the 1920s and California or the Northeast today, and that’s supply and demand. In the ’20s Florida had an abundant supply of vacant land. Investors eventually caught on to the fact that instead of bidding up the price for a lot, they could just wait for another piece of property to go on sale farther up the coast. And on the demand side, Florida was not easy to get to.
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The railroad was still the principal means of access, requiring an overnight trip from the big cities of the North. This limited demand for Florida real estate. Eventually, the laws of supply and demand caught up with property prices in Florida and brought them back to earth. Today in places like Avalon, New Jersey, or San Jose, California, geographic and environmental constraints have cut off the supply of new land for building, while their desirability as places to live ensures continued demand. Because of this, I don’t expect to see a Florida-style bust. Still, the high valuation of real estate in such places means there is definite risk of price declines, especially given the sensitivity of real estate prices to interest rates. Not only does real estate entail the same risk of price declines as does the stock market, but the risk tends to come at roughly the same time. It was no coincidence that the Great Florida Real Estate Bubble occurred in the 1920s, the same decade as a stock market bubble. Similarly, the Japanese stock market bubble coincided with a run-up in real estate prices. In fact, the appreciation in Japanese land prices was one of the causes of the stock market bubble as the increased value of property owned by corporations helped boost their share prices and improved their ability to get bank loans. As a general rule, real estate and stock prices move together because low interest rates and an increase in bank lending push up prices of both stocks and real estate. That means that real estate does not necessarily diversify your assets. True enough, real estate prices continued to rise rapidly even after stocks began to fall in 2000. But the reason for this divergence was that the stock market correction was caused by fear of an economic slowdown, combined with a realization that stock prices were too high, not by an increase in interest rates. Therefore, in this stock market correction, owning real estate did provide diversification and protection. In fact, for many folks the increase in the value of their homes canceled out the decline in the value of their stock holdings. And their ability to take out home equity loans or to refinance their mortgages at a lower rate put money in their pockets, thus enabling them to spend and pull the country out of its 2001 recession. The bottom line: don’t count on your home being a better investment than stocks and bonds unless (1) you live in a region that’s mov-
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ing up the popularity scale and (2) interest rates are stable or declining, making it possible for buyers to afford the mortgage payments on a higher-priced home. And if you are thinking of real estate as an investment, keep in mind that regional real estate prices can go through boom-and-bust cycles just like the stock market and that real estate prices can tumble at the same time as stock prices.
A N A MAZING F ORTY Y EARS The for ty-year period from 1963 to 2003 saw some amazing occurrences: ➤ A man walked on the moon (1968). ➤ The United States beat the Soviet Union to win an Olympic gold medal in hockey (1980)—an event that seemed to symbolize recovery from a decade of self-doubt. ➤ The Soviet Union collapsed, the Berlin Wall fell, and the Cold War ended (1989). ➤ The United States gave up in the war in Vietnam (1975) and the “war on pover ty” but twice went to war with Iraq (1991 and 2003). ➤ The U.S. economy saw stagflation, inflation, then disinflation, along with massive deregulation of industry. ➤ The United States built up huge trade deficits—first with Japan, then with China—and became a debtor nation. ➤ The Internet and cellular phones transformed the world into a global village. ➤ New York and Washington came under attack (2001). But in terms of stock and bond market behavior, it was, on average, a pretty normal for ty-year span. Inflation was tame at the beginning of the period and at the end. As a result, the yield on a ten-year Treasury bond was almost the same on December 31, 2002 (3.82 percent) as on December 31, 1962 (3.85 percent), but in between it had risen as high as 14 percent as inflation raged. Throughout it all, the average return from a ten-
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year Treasury bill was a slightly better-than-normal 2.87 percent above the rate of inflation. And the average annual total return from S&P 500 stocks was a slightly worse-than-normal 5.74 percent. But the worse-than-normal return should not be a surprise. After all, the P/E ratio of the S&P 500 was an abovenormal 19 on December 31, 1962. My point here? A lot may happen and a lot may change in for ty years, but not the long-term real returns from stocks and bonds.
Myth #4: Bonds Are Safe In one sense, U.S. government bonds are very safe. In its two-hundredplus-year history, the United States has never defaulted (failed to pay back its borrowers). This means if you hold a bond to maturity, you’re sure to get a fixed interest payment twice a year as well as getting the bond’s face, or par, value on the due date. But this doesn’t mean there’s no risk. The biggest risk is price risk. The price of U.S. government bonds changes from minute to minute as buyers and sellers demand higher or lower interest rates. For an example, we need only look at the events of July 15, 2003. On that day Federal Reserve Chairman Alan Greenspan testified before Congress that the central bank would keep short-term interest rates low as long as needed to ensure an economic recovery. Also, the White House said that the government’s deficit would be about $455 billion in 2004, not the $150 billion that it had predicted five months earlier. This roiled the bond market: economic recovery means higher inflation down the road, while a bigger deficit means the government needs to borrow more, increasing the supply of government bonds. As a result, the price of a ten-year Treasury bond with a face value of $1,000 fell from $991.56 to $970.94 in one day. Back on June 13 the bond was selling for $1,043.12. In other words, the price of the bond fell by almost 7 percent in little more than a month. Not a problem, if you intend to hold the bond for its full ten-year term, but definitely a problem if you need to sell.
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Over a longer period of time, losses in the bond market can be quite substantial. The worst period ever for bond market investors was the three-year span from 1967 through 1969. In 1967 bond prices tumbled on worries that spending on the Vietnam War would lead to big federal government deficits. During the year the price of long-term Treasury bonds fell enough that bondholders suffered losses close to 9 percent even after interest payments. By the end of 1969 the loss had reached 14 percent. And in terms of purchasing power, an investment in government bonds was down 25 percent because price increases were beginning to accelerate. During the same three years S&P 500 stocks produced a boring, government bond-like return of 3.1 percent after inflation. In other words, in times of growing inflation, bonds provided no safety at all, while stocks offered protection. Another bad year for bonds was 1994. During the preceding year many hedge funds had made big bets that interest rates would continue to fall—and that bond prices would therefore continue to rise. On February 4 of that year, the Federal Reserve, worried that the economy was growing too fast, began to raise interest rates. In response, the hedge funds decided that it was time to take profits. They began dumping bonds, causing bond prices to fall. During the following nine months investors in ten-year government bonds suffered losses of almost 12 percent, as the decline in the price of the bond far exceeded the interest the bond was paying. While hedge funds may not be as big a factor in bond price movements today as they were in 1994, foreign investors have become a bigger factor. In 2003, 32 percent of all U.S. government bonds were owned by foreigners. If foreigners begin to worry about the rising federal deficit and its potential impact on the U.S. dollar, they may decide to cut their exposure to bonds, thereby causing bond prices to fall, much as hedge fund selling caused them to fall in 1994. The longer the remaining term of a bond, the more the price will move up and down. That’s because there is a longer period of time before the bond owner receives the face value of the bond. In the meantime, movements in interest rates will determine how much someone is willing to pay for the bond. For example, you could sell a ten-year $1,000 Treasury bond that was due to mature tomorrow for very close
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to $1,000 regardless of what was happening to interest rates because the buyer would be sure of getting exactly $1,000 the next day. But for a bond that is still ten years from maturity, even a small change in interest rates will have a large effect on the price. Even if you own bonds indirectly by owning a mutual fund that invests in bonds, the price risk is still present. A bond mutual fund owns many bonds, but the prices of bonds of the same maturity (time until they are due) all move together. Therefore, the price of a share in most long-term U.S. government bond funds also fell by close to 7 percent between mid-June and mid-July 2003. If you had all your money in a bond fund for safety, you lost 7 percent of your money. So far we’ve talked only about the bonds issued by the safest borrower: the U.S. government. There are also corporate bonds and corporate bond funds. These pay different interest rates depending on the financial soundness of the companies issuing the bonds and their length to maturity. Companies such as Standard & Poor’s, Moody’s, and Fitch rate the safety of corporate bonds. The better the rating, the lower the interest rate required to compensate for the risk. Bonds with higher ratings are known as investment-grade bonds. Those with poorer ratings are known as high-yield, or junk, bonds. But even if you’re investing in investment-grade corporate bonds, there’s one additional risk you need to know about. Many corporate bonds have call provisions, which often take effect after the bond is ten years old. Call provisions give the corporation that issued the bond the right to call it back, meaning pay it off, before its stated maturity date. Why would corporations do this? The only reason would be because interest rates have fallen and they can now borrow money more cheaply. Good for them, but not good for the bondholder, who receives cash at a time when interest rates are low. If investment-grade corporate bonds are risky, high-yield bonds are even riskier. They often have poor grades because the companies issuing these bonds already have a lot of debt relative to their ability to earn income. As a result, they may be unable to make the interest payments on the debt or pay it off at maturity. And then there are international bond funds. These invest in bonds issued by foreign governments. But even if a fund invests only in the safest foreign government bonds, such as those issued by Switzerland,
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Germany, or the United Kingdom, there is another kind of risk: currency risk, the risk that the value of the Swiss franc, the euro (Germany’s currency), or the British pound will go down in value versus the U.S. dollar. And if the fund is an emerging market bond fund, that means it takes greater risk by investing in the bonds of less-developed countries. Emerging market bond funds get clobbered when a big emerging nation defaults on its debt. This happened most recently with Russia in 1998 and Argentina in 2001. You can minimize your risk by owning only short-term government debt (called bills instead of bonds) or shares in U.S. Treasury short-term bond funds, but the downside is that you will receive less interest. A short-term bond fund is somewhere between a long-term bond fund and a money market fund with regard to risk and interest rate.
C H A P T E R
9
Eight Steps Not to Take After the Bell Has Rung
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f you decide to invest in the stock market, you might get advice from a wide variety of sources: from stockbrokers and TV and newspaper pundits to your cousin Vinnie, who works in the mailroom of Podunk Manufacturing. This chapter tells you what advice you should ignore.
Market Timing This book advocates maintaining a steady stock/bond mix, adjusting it only for changing life circumstances and—on rare occasions—in response to extreme under- or overvaluation of stocks. Market timing refers to the strategy of frequently increasing or decreasing your stock holdings in response to expected short-term stock market movements. In my opinion, this strategy doesn’t work because no one can predict short-term stock market movements. Studies have found that there is some serial correlation in the movement of stock market prices. In plain English, that means that if stock prices go up a lot one day, there is a good chance they will go up the next day as well. But these same studies have found that over the longer run, serial correlation is replaced by reversion to the mean. In other words, that means that after stock prices have gone up a while, they are likely to reverse direction again and go down toward their long-term mean, or average, trend line. Putting all of this together, it means that over the short or medium term the movement of stock prices is random, because there is
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no way of knowing when the short-term trend will end and reversion to the mean will begin. As a result, all that people who try to time the market accomplish is to lose money in the form of trading costs.
Wall Street Research Wall Street research refers to research reports prepared by brokerage firm analysts in support of buy, sell, or hold recommendations. In the aftermath of the 2000–2002 stock market correction, much of the blame for the stock market bubble has been directed at Wall Street analysts for making overly optimistic earnings forecasts and setting unrealistic price targets for stocks. Investigations by the Securities and Exchange Commission and the New York State Attorney General’s office determined that the relationship between brokerage and investment banking was one of the causes of this optimistic bias as investment bankers pressured analysts within their firms to say good things about companies with which they hoped to do business. With the passage of the SarbanesOxley Act by Congress and a settlement between New York State and the major brokerages, many of the causes of potential conflict of interest should have been eliminated. But even if all biases are eliminated from Wall Street research, a fundamental problem remains: how do you know whose research is right? The prices of the most widely owned stocks are largely determined by the recommendations in the huge volume of research produced about these stocks by Wall Street analysts. This research is called fundamental research because it examines the fundamentals of a company: its products, its markets, its competitors, its financial condition, its prospects to generate earnings and cash flow, and so on. Based on this research, investors—and often the analysts themselves—try to calculate what a fair price for the stock should be. And if Efficient Market Theory is correct, based on all this research, stock prices will be fair, thus providing no reason to buy one stock as opposed to another. But let’s say that Efficient Market Theory is wrong and that one analyst is right and the consensus price set by all analysts is wrong. Even if we figure out which analyst was right, will she be right in the future, or was she just lucky this time?
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Another problem with Wall Street research is that analysts tend to recommend companies with good management and good growth prospects. As a result, such companies tend to trade at high prices relative to their earnings. But although most analysts are bright people with superior analytical, deductive, and communications skills, they don’t have crystal balls. Surprises happen. Constantly. And when bad things happen to good companies, their prices have farther to fall than the prices of bad companies, which are low to begin with. Analysts too often forget that their job is to identify good stocks, not good companies. So are buy, sell, and hold recommendations worthless? Not completely. If an analyst changes a recommendation in response to new information that will drive a stock higher or lower, the recommendation has value. Especially if it is a sell recommendation, because they are rarer than buy recommendations even after Sarbanes-Oxley’s efforts to take the hype out of research. (Honestly, though, there should be more buy than sell recommendations. It makes sense for analysts to choose companies with good prospects as objects of research, while ignoring the dogs.) But as soon as the information becomes known or the recommendation becomes public, there will be buying and selling in response, and the price will adjust to what it should be based on the new information. By the time you read the research report, there may be nothing left to be gained by buying or selling.
F UNDAMENTALISM In Wall Street parlance, fundamentalism refers not to rigid religious dogma but rather to a strategy of picking stocks based on in-depth study of a company’s business. When it comes to fundamental research, knowledge can be a dangerous thing. In early October 2001, I attended a luncheon presentation by an analyst who covered Internet infrastructure software (don’t even try to figure out what that means). People were afraid to fly in the immediate aftermath of the events of 9/11. This meant that software sales reps were not flying around the country closing deals before the end of the quar ter on September 30. But at the presentation the analyst mentioned one exception: the
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Vignette Corporation of Austin, Texas, a company that develops customer relationship management software (the software that enables businesses to interact with customers via company websites). He said that Vignette’s salespeople got right back on airplanes and made customer visits during the last weeks of September. Aha, I thought. These brave Texans are going to win business from their cowering competitors. I recommended Vignette stock for a fund that I advise. Wrong move! A few days later, Vignette warned that analysts’ estimates for the September quar ter were too optimistic. Sales would actually be well below the consensus estimates. So what went wrong? The analyst did his job. He observed that Vignette salespeople were doing something different from what their competitors were doing. He thought this was significant and repor ted it to his clients. I did my job. I analyzed this new information and concluded that Vignette’s sales force consisted of early birds who would get the worm of September sales closings. Unfor tunately, although the information was right, the conclusion was wrong. As it turned out, the reason the Vignette sales force was so anxious to climb aboard airplanes was that they had had a disastrous July and August. (Economists would later determine that the economy had been in the midst of a recession during these months.) Their sales quotas, if not their jobs, depended on closing some deals before the quar ter ended. A few terrorists with box cutters weren’t going to stop them. But when they got to their destinations, they found that their would-be customers were still spending their days watching CNN. The outlook for their businesses was clouded by the uncer tainty of how the events of 9/11 would affect their customers’ buying habits. In this environment, they were not about to sign large software licensing contracts. And for Vignette, a disastrous July and August were followed by a worse September. So much for in-depth fundamental analysis, right down to the travel patterns of a company’s sales force.
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Charting Charting is another word for technical analysis: the attempt to predict stock price movements based on the pattern of past stock price movements. Technical analysts say that a stock’s price chart shows all you need to know about a stock. It tells you at what price it attracted buyers and at what price it attracted sellers in the past and thus will tell you at what price it will attract them in the future. Those who don’t believe in technical analysis say the future price of a stock will be determined by events that cannot be known in advance and that the best charting in the world won’t help to predict the future price of a stock. (Less polite nonbelievers compare charting with palm reading or trying to divine the future by examining sheep entrails.) Personally, I think charting has little value in predicting long-term price movements. It may, however, have some usefulness in predicting short-term price movements—if for no other reason than a lot of people believe in it and will buy and sell stocks based on its price targets. So if neither fundamental nor technical research can help you pick which stocks will do best, is there any basis for trying to pick stocks as opposed to owning a mutual fund? Probably not. Which brings us to day trading, where instead of picking stocks, players try to make money by buying and selling the same stocks over and over again.
Day Trading Day trading means buying and selling stocks frequently during the course of a day in an effort to capture gains from small price movements. Day trading has been made possible by the Internet, which allows orders to be executed almost instantaneously and at a low cost. As a result, day trading usually means online trading. There are online trading shops where you can spend the day, if you are so inclined. During the boom years many online traders made a lot of money. The stock market was moving in a generally upward direction, so trad-
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ers could take advantage of any short-term dip in the price of most stocks—especially technology stocks—to buy and then sell later in the day at a higher price. Some day traders used elaborate charting methods to decide when to buy and sell. Others treated day trading as an art rather than a science and relied on instinct and experience. During the bear market many online traders were wiped out as prices generally moved farther down after they bought on dips. Some, however, adapted by switching from a strategy of buying on dips to one of short selling, the perfectly legal strategy of selling borrowed stock with the promise to buy it back at a later date. Of course, for the strategy to work, the price must be lower at a later date. But for many who didn’t adapt to changing market conditions, their downfall was made certain by the fact that online trading can be both addictive and anonymous. Like poker players desperately trying to win back their losses by doubling their bets, many online players racked up larger and larger losses. And they could keep playing while hiding their losses from friends, spouses, and significant others. In one respect, day traders provide a service to the stock market. By increasing the amount of trading activity, they help to ensure that there will always be a buyer available when you went to sell, and vice versa. But day traders also contributed to the 1990s bubble because many used mindless momentum strategies—buying stocks that were going up regardless of the company’s fundamentals—thus driving the shares of unsound companies ever higher. These are the day traders who were wiped out when the bubble burst. In the final analysis day traders are competing against one another just like stock pickers—only they are doing it at a faster pace, meaning that commissions, even at a minimal cost per trade, will eat up their profits at a faster pace. Would I recommend day trading? Not unless spending a day in front of a computer screen watching your wealth fluctuate from second to second is your idea of fun. But then again, isn’t that essentially what millions of people do at the slots in Las Vegas and Atlantic City, where the house take is even higher?
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IPO Opportunities An IPO, or an initial public offering of stock, is the means by which a company opens itself up to wider ownership by selling a stake of itself on a stock exchange. Typically, 10 or 20 percent of a company is sold to the public in the initial offering. An IPO accomplishes two things: it raises money for the company, and it creates a market for the company’s stock, thus providing a means for the initial investors to harvest their profits. Investors who bought—and held on to—$1,000 worth of shares in the IPO of Home Depot in 1982 now have stock worth about $800,000. Those making—and holding on to—a similar investment at Microsoft’s IPO four years later would have stock worth about $400,000 today. The 1990s saw some similar success stories. Cisco Systems stock is up about three hundred times since its IPO in 1990, despite its 2001 correction. The shares of America Online, now known as Time Warner (having taken the name of the media giant that it bought with its high-flying stock), are up almost two-hundred-fold since its 1992 IPO. Outside of the technology sector, Starbucks and Bed Bath & Beyond both went public in 1992, producing hefty rewards for initial shareholders, though the multiples of their IPO prices have been in the double, rather than triple, digits. Then in the mid-1990s the IPO market really started to attract widespread attention with the success stories of Netscape (’95), Yahoo! (’96), and Amazon.com (’97). Netscape was bought out by America Online before the Internet bubble fully inflated, but initial investors in Yahoo! and Amazon.com saw their shares increase in value 230 times and 75 times, respectively. News of these high-profile IPOs made it easy for start-up companies to sell their stock to the public. In 1998, 1999, and 2000, no less than 1,443 companies went public—many doing so before they had a viable business plan, much less their first profits. Indeed, most of the companies that went public during those three years, especially the technology companies, did so before they were ready. But that didn’t stop
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investors from bidding up their prices as soon as trading opened. At the peak of the mania, MarketWatch.com went public (on January 14, 1999). The underwriting broker sold the stock to initial buyers that day at $17 a share. The final price for the day was $97.50. The next day, shares changed hands at $130, marking MarketWatch.com as one of the quintessential “hot” IPOs. But the shares would never sell for that high a price again. The company, which operates websites offering financial news, is still in business, but its shares have not traded above $11 since September 2000. In fact, most of the companies that had their IPOs during the bubble years either have failed, have been acquired by larger companies at a low price, or are surviving only because of the cash they raised from their IPOs. It’s difficult to find many of the 1,443 IPOs that have proven to be good investments—except to those people who were able to buy at the IPO price and sell into the buying mania a few days later, a stratagem known as flipping. But few individual investors were able to buy at the IPO price because shares being sold by the company were usually reserved for institutional investors and the best clients of the underwriting brokers. So individual investors ended up buying shares in the stock market after they had already begun soaring in price. Since the crash, sanity has returned to the IPO market. During the first four months of 2003, the only IPOs were for ETFs, some financial companies, and one South African telecommunications firm. Since then, a few more companies have gingerly begun to test the IPO waters. But those few IPOs can still generate some excitement—and risk for folks who jump in on the first day of trading. For example, Digital Theater Systems, a maker of home entertainment products, sold its first shares to the public on July 9, 2003, at $17 a share. The next day, they were trading as high as $25.79. But as of this writing they haven’t reached that price again. The bottom line: IPOs are a lot like lottery tickets. For every Microsoft, there are a thousand companies that never live up to the IPO hype. IPOs can still be a good deal if you can buy at the initial offering price, but for most individual investors that’s not an option. And buying at the market price on the first day of trading is usually not a good move—especially if the IPO is “hot.”
E i g h t S t e p s N o t t o Ta k e A f t e r t h e B e l l H a s R u n g
Overdiversification The typical 401(k) plan now offers a choice of fourteen investment options, most of them mutual funds. Wouldn’t the simplest solution be to take an equal-sized position in all of them? Actually, it’s probably a better idea than putting all your money in one fund, but let’s see what the results would actually be. Based on Table 7.5, which depicted typical choices in a 401(k) plan, the expected real return from an equal position in each of the fifteen fund options would be 5.4 percent a year. Turns out that in this example, you would get exactly the same expected return from the equal-mix strategy as from a “normal” 60/40 stock/bond mix. But what you would give up would be the ability to easily adjust your portfolio in response to under- or overvaluation of stocks. And the diversification benefits would be little more than what three funds—a stock fund, a bond fund, and a money market fund—would give you, because these three fund types normally do not move together.
Patriotic Investing Patriotic investing refers to buying stocks to support the market during a national crisis, such as in the aftermath of September 11, 2001. In fact, I would make the case that patriotic investing is actually unpatriotic. If you buy shares because you believe they are undervalued, that’s one thing, but if you buy because you think you are supporting your country in a time of crisis, that’s another. In the latter case, you are misleading the markets, driving the price of stocks higher than they should be, and causing a misallocation of capital. And in any event, once the crisis passes and self-interest takes over, prices will fall to their fair levels. Patriotic investing, like all investing for emotional reasons, merely interferes with the stock market’s intended function of accurately valuing stocks. That’s what happened after 9/11. Before that date, the stock market was in a long-term process of selling off from the excessive valuations of the year 2000. In August 2001 the stock market was also beginning to come to grips with the realization that the economy might
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be in a recession. As a result, August 2001 was a bad month for stocks, with an investment in S&P 500 stocks losing 6.3 percent for the month. Then came 9/11. The ensuing panic caused the August sell-off to become a rout when the markets reopened on September 17. And that’s when patriotic buying began. Yes, it lifted stock prices. But the patriotic investors, unlike the smart money, which was taking advantage of the panic that followed 9/11 in the hope of short-term gains, failed to recognize that the recovery in stock prices was premature and that stock valuations were still excessive compared with corporate earnings prospects. Moreover, sustained economic recovery was still not in the picture. As a result, patriotic investors were left holding the bag when the market resumed its correction in 2002.
Buying on Margin Buying on margin simply means buying with money loaned by your broker. Currently, the Federal Reserve allows you to borrow up to 50 percent of the amount you wish to invest; your broker will be happy to loan you that 50 percent at an interest rate that was recently averaging about 5 percent. The stock that you buy with the borrowed money is your collateral against the loan. The problem with buying on margin is that if the price of your investment goes down, you will get a margin call requiring you to add cash to your account. For example, let’s say you want to buy $20,000 worth of stock but only want to use $10,000 of your own money. So you borrow the other $10,000 on margin from your broker. But if the value of the stock you bought falls to $10,000, then what you owe to the broker equals the value of your investment. This means you have no stake (equity) left in the account. When you borrowed on margin, the broker will have required that you maintain some minimum equity—perhaps $3,000. Because the equity has been eliminated by the decline in the value of the stocks, you will receive a margin call asking you to put $3,000 into your account. If you don’t have the cash, you’ll be forced to sell some of your stock to raise the money. And if you don’t sell, your broker will sell it for you regardless of price.
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This vicious cycle of falling stock prices, margin calls, and forced selling that causes stock prices to fall farther was one of the main causes of the Great Crash of ’29 and a lesser factor in the 2000–2002 correction. But in 2003, with the stock market showing signs of recovery, folks were again buying on margin. In fact, by July 2003 the value of margin loans to brokers affiliated with the National Association of Securities Dealers was greater than what it was in March 2000. Even if you are absolutely 100 percent convinced that a stock is going up, I don’t recommend buying on margin. For one thing, the only way you could be sure you were right is if you had inside information. For example, while working in the mailroom at troubled Podunk Manufacturing, your cousin thinks he sees evidence of a deal to sell the company at double its current price. In that case, buying the company’s stock would be illegal, because trading based on such inside information is illegal. For another thing, you could lose the full value of your investment and be obligated to pay off the margin loan if your cousin isn’t good at putting two and two together, and instead of the company being sold, its share price continues to plunge.
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C H A P T E R
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It’s Never Too Early to Save for Retirement
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p until now, I’ve focused on general principles of stock investing. This chapter zeros in on retirement planning, dealing with questions such as how much money is enough for retirement and how do I get there?
How Much Money Will I Need to Retire? I’ve seen advice that says you should shoot for at least 60 percent of your working income to ensure a satisfactory lifestyle after retirement. But everyone’s wants and needs are different. And the higher your working salary, the smaller percentage of that salary you will need to live in comfort. For example, Jennifer Lopez or Michael Jordan could probably live quite well on 1 percent of their current income after they retire, but someone who is struggling to make ends meet now will need more than 60 percent of their current income for a comfortable retirement. There’s no magic formula for deciding how much you will need. Instead you need to decide how much you are willing to sacrifice now for a more affluent lifestyle after retirement. I think that my parents’ generation (for most of you in your twenties through forties, this would be your grandparents’ generation) saved too much, probably because of fear owing to lingering memories of the Great Depression. They avoided risk, putting much of their money in bank CDs. They deferred
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vacations and kept careful watch over their household budgets. And for many, when they reached retirement age, they had more money than they knew what to do with. I think that Generation X is in danger of making the opposite mistake—going for the good life now without giving enough thought to retirement (though in some cases this is made possible by what their oversaving grandparents will leave them). In any event, it is up to each individual and family to decide for themselves what level of income they will need during retirement and how much they are willing to sacrifice to get there. The next step is to calculate how much wealth you will need in order to generate that level of income. For example, let’s say you decide you need $50,000 a year in today’s dollars before taxes to live comfortably in retirement. (I chose $50,000 only because it’s a nice round number.) First of all, figure how much you can expect from pensions and social security. As I discuss in the final section of this chapter, it’s a safe bet that social security will still be around after you retire. The uncertainty is what your benefits will be. The Social Security Administration (SSA) mails an annual report to persons older than twenty-five who pay social security taxes. The report shows your estimated monthly benefits upon retirement. (If you haven’t received it, you can request it from the SSA at www.socialsecurity.gov.) Let’s say that you and your spouse both receive statements and that they show you will receive an estimated $2,000 a month, or $24,000 a year, between you after retirement. Because of uncertainty, you might want to discount this figure. The further you are from retirement, the more uncertain this figure is. On the other hand, if you are far from retirement, your highest earning years should still be ahead of you, so the estimate from the SSA may actually be on the low side. Regardless, let’s say that you and your spouse want to err on the side of caution. Instead of $24,000, you count on social security providing only $12,000 between the two of you in today’s dollars. That leaves $38,000 in annual retirement income that you must save for. (We will also assume that you have no expectations of a pension, no rich aunt who plans to leave her estate to you, and no other expected source of retirement income.) The rest of your income will need to be generated by your savings. To calculate how much you need in savings at retirement to produce $38,000 in pretax income in today’s dollars, you need to make assump-
I t ’s N e v e r T o o E a r ly t o S av e f o r R e t i r e m e n t
tions about future returns on investment and life expectancy. The following is just one sample set of assumptions, but one that appears to be reasonably realistic. • Assumption 1: You will retire at age sixty-six. • Assumption 2: You will plan for a life expectancy of twenty-five more years, or until age ninety, for you and your spouse. • Assumption 3: You will continue to invest retirement savings based on this formula: percentage in stocks equals 100 percent minus age. This means that at retirement, 35 percent of savings will be in stocks and 65 percent in bonds. By the time you reach age ninety, the ratio will have shifted at a rate of 1 percent per year, to 10 percent stocks and 90 percent bonds. • Assumption 4: Stocks will outpace inflation by 7 percent a year; bonds will outpace inflation by 3 percent. • Assumption 5: All of your savings are in a tax-deferred plan, so taxes kick in only as you withdraw funds. Using these assumptions, to reach age ninety with savings unchanged in terms of purchasing power, you and your spouse would need to have saved twenty-five times your estimated annual pretax income need of $38,000 by age sixty-five. In other words, you would need to begin retirement with $950,000. If you did so, and all the assumptions proved correct, you would be able to leave $950,000 in today’s dollars to your children, grandchildren, nurse, or favorite charity when you departed this life at age ninety. And if you decided you wanted to stick around for a few more years, you would have almost a million dollars in today’s dollars to spend on whatever a ninety-year-old heart desires (a good bottle of bourbon, in the case of my father). Based on these assumptions, if you start out with more than $950,000, you’ll be richer at age ninety than at sixty-five because your investment income will grow faster than you spend it. But let’s say you and your spouse decide that you want to enjoy your working years by spending your children’s inheritance. In other words, you don’t want to save any more than you have to and you’re willing to die broke at age ninety. Well, the bad news is you would still need to save fifteen times your expected annual expenses of $38,000, or
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$570,000, by age sixty-five. And even if you saved that amount, you’re going to be in trouble if either of you decide to live past ninety. You’ll be flat broke until you get your next social security check. And your kids, who may by then be in their sixties, may be less than thrilled to have you move in. It’s interesting how, based on these assumptions, the amount of savings on the date of your retirement makes a big difference. If you have less than fifteen times your required annual spending in retirement, you run out of money before the age of ninety. For example, if you only saved ten times your expected pretax income requirement, you would run out of money at age seventy-eight. On the other hand, if you save more than twenty-five times, you reach ninety richer than you were at sixty-five. There’s no magic about where the multiple of twenty-five comes from. In the assumptions that I used, the average annual inflation-adjusted total return on investments during retirement was about 4 percent, or 1/25th of your investments. So for every dollar of income needed, you need $25 of assets—assuming you want to maintain your wealth in terms of purchasing power. And even if you’re not concerned about maintaining your wealth, it’s not a bad idea to shoot for a multiple of twenty-five times your expected pretax retirement requirement because the 4 percent return assumption might prove too optimistic. If the actual real return is 3 percent, you would need to save thirty-three times your spending needs. And 2 percent would require a multiple of fifty to maintain your real wealth. Also, you might well find yourself alive, well, and ready to spend money well past age ninety. These examples are intended only to get you thinking about retirement and to give you a ballpark sense of how much you might need to save. If you change the assumptions about income requirements, life expectancy, investment mix, or return on investment, you could get drastically different results. Many 401(k) and IRA sponsors offer retirement planning calculators on their websites so that you can plug in your own assumptions to see how much you need to save for retirement. The basic formula, assuming you want to maintain your real net worth in retirement, is as follows: required savings at retirement equals required annual pretax income during retirement divided by expected real annual total return on investment during retirement. Or, from the preceding example, $950,000 ⫽ $38,000 ⫼ 0.04.
I t ’s N e v e r T o o E a r ly t o S av e f o r R e t i r e m e n t
How Am I Doing? Based on the experience of the 1990s bull market, many investment advisers wrote that the long-term expected return from stocks is some percentage in the teens—and never mind about inflation. But the correction of 2000–2002 has brought such forecasts back down to earth. As I stated in Chapter 1, based on data going back to 1871, the longterm inflation-adjusted total return from stocks is probably no better than 7 percent a year. And there’s no solid evidence that you can improve this return by investing in more volatile types of stocks, such as small-cap or emerging market stocks. Small-cap funds or emerging market stock funds may help to diversify your portfolio, but there’s no certainty that they will push your long-term return above 7 percent. And while bonds had a great run in the 1980s and ’90s as inflation declined, there’s no reason to expect them to do better than their historical 3 percent long-term total return. So the reality is that if you have a typical portfolio of 60 percent stocks and 40 percent bonds, your expected long-term total return is probably no better than 5.4 percent a year—to be conservative, let’s say 5 percent. Now before you throw this book away and go out and buy a book titled How I Made Zillions in Real Estate with No Money Down, consider first why someone who made zillions is so intent on giving away his secrets. And then consider that 5 percent a year above inflation is not a bad deal. If you let your money work for you in a tax-deferred account, it will grow in value by 63 percent over the course of a decade and triple in value in just over twenty-three years while you simply watch and occasionally make adjustments to the asset mix. The problem is that most folks don’t have enough in their long-term savings accounts. The average 401(k) account has $36,000 worth of assets. If we assume that historical rates of return will prevail in the future and that your stock/bond mix is a conservative 100 percent minus your age, it would require an annual contribution of $3,809 a year starting at age twenty-five to reach a goal of $500,000 in savings on your sixty-sixth birthday. To reach $1 million would require an annual contribution of double that amount, or $7,618 a year. Table 10.1 shows where you should be at each birthday based on your retirement savings goal. As you can see, if you have a typical $36,000 saved up, you are
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behind target if your goal is $1 million and you are past your thirtieth birthday, or if your goal is $500,000 and you’ve already turned thirtythree. Table 10.2 shows how much you can expect to have on your sixtysixth birthday based on different assumptions about when you started contributing to a retirement account and how much you put in each year. Four important points need to be made about Tables 10.1 and 10.2: 1. These tables have not been adjusted for inflation. Most likely there will be continued inflation between now and the time you reach retirement age. This means that your actual savings will likely be greater than what is shown in these tables, but the cost of living will be higher by an equal percentage. Because no one, not even Alan Greenspan, knows how much inflation there will be, there is no right way to adjust these figures for inflation. If prices double between now and your retirement date, your $1 million in savings will actually be $2 million, but it will only buy what $1 million would buy today. Inflation also means that to reach an inflationadjusted goal, you would need to increase your contribution at the same rate that inflation increases each year. 2. No one expects to contribute the same amount each year, even after taking inflation into account. Life circumstances change. If you are single and have a good job, you may be in a position to put the maximum into your 401(k) plan and some more into an IRA to boot. Then if you marry and have a big mortgage and several kids who want to go to college, you may have to cut back your contribution. And when the kids are done with college, and you’ve changed the locks on your door to keep them from coming back, you may be able to max out again on your contribution. But remember that because of the principle of compounding, contributions made early in life are more valuable than catch-up contributions made later. As you can see from Table 10.2, someone who starts at age twenty-five will have 3.72 times as much savings at age sixty-six compared with someone who starts at forty-five—even though they have contributed only about two times as much. 3. These tables make the assumption that you are a conservative investor, using the rule of thumb that the stock portion of your port-
Table 10.1 Amount You Should Have Saved at Each Birthday, If Your Goal Is . . . Birthday
Goal of $500,000.00
Goal of $1,000,000.00
25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66
$— $3,923.27 $8,079.61 $12,479.66 $17,134.45 $22,055.33 $27,254.00 $32,742.53 $38,533.34 $44,639.21 $51,073.27 $57,849.03 $64,980.32 $72,481.36 $80,366.71 $88,651.26 $97,350.28 $106,479.33 $116,054.35 $126,091.58 $136,607.57 $147,619.20 $159,143.62 $171,198.29 $183,800.91 $196,969.46 $210,722.16 $225,077.44 $240,053.95 $255,670.53 $271,946.16 $288,899.99 $306,551.28 $324,919.40 $344,023.75 $363,883.83 $384,519.09 $405,949.00 $428,192.98 $451,270.35 $475,200.31 $500,000.00
$— $7,846.54 $16,159.21 $24,959.33 $34,268.91 $44,110.66 $54,508.00 $65,485.05 $77,066.67 $89,278.41 $102,146.54 $115,698.05 $129,960.65 $144,962.73 $160,733.42 $177,302.53 $194,700.55 $212,958.66 $232,108.70 $252,183.16 $273,215.15 $295,238.40 $318,287.25 $342,396.58 $367,601.82 $393,938.92 $421,444.32 $450,154.89 $480,107.91 $511,341.05 $543,892.32 $577,799.98 $613,102.57 $649,838.79 $688,047.51 $727,767.65 $769,038.18 $811,898.01 $856,385.97 $902,540.70 $950,400.63 $1,000,000.00
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Table 10.2 Expected Savings at Age 66 Starting Age 25 30 35 40 45 50 55 60
Annual Contribution of $5,000
Annual Contribution of $10,000
$656,342.77 $482,863.29 $352,154.25 $252,734.11 $176,392.34 $117,212.08 $70,896.57 $34,301.83
$1,312,685.55 $965,726.57 $704,308.50 $505,468.22 $352,784.69 $234,424.15 $141,793.13 $68,603.67
folio should be limited to 100 percent minus your age. If you want to take a bit more risk and use a formula of 105 percent or 110 percent minus your age, your expected return should be higher—but with a greater degree of uncertainty. As well, if you use the rules in Chapter 6 to increase your exposure to stocks when they are cheap and to avoid them when they are expensive, that should also help you to do better. 4. Finally, and perhaps most importantly, past performance is no guarantee of future performance—even using 130 years of past performance in coming up with these estimates of normal inflation-adjusted total return from stocks and bonds. Your actual results will vary. Maybe you’ll do better, maybe worse. But these figures do show how a tax-deferred account will compound over time, assuming that the next forty years are not all that different from the past 130.
Will Social Security Still Be Around When I Retire? The short answer is that of course it will be. Senior citizens, unlike teens and twentysomethings, vote. And they consistently vote against anything that would interfere with the transfer of wealth from wage earners to retirees through the social security program. That said, it’s true that the program is currently underfunded to meet its long-term needs. The 2003 annual statement from the Social Security Administration
I t ’s N e v e r T o o E a r ly t o S av e f o r R e t i r e m e n t
that is sent to all future beneficiaries over the age of twenty-five warns that: Unless action is taken soon to strengthen Social Security, in just 15 years we will begin paying more in benefits than we collect in taxes. Without changes, by 2042 the Social Security Trust Fund will be exhausted. By then, the number of Americans 65 or older is expected to have doubled. There won’t be enough younger people working to pay all of the benefits owed to those who are retiring. But that doesn’t mean that starting in 2042, retirees will receive nothing. The statement goes on to say that in that year there will still be enough to pay 73¢ on the dollar toward scheduled benefits. What’s more, the date at which the Social Security Trust Fund runs out of money keeps being pushed back. In 1999 the trustees of the fund forecast that it would run out of money in 2034. And between now and then, steps are likely to be taken involving some combination of the following: • Higher social security taxes • Later retirement ages before full benefits can be received • Lesser benefits after retirement (through smaller cost-of-living adjustments) • Allowing individuals to invest a part of their contribution as they see fit (sort of like a social security 401(k) program) • Allowing the fund’s trustees to invest a part of the fund in stocks and bonds • A means test, under which higher-income recipients would see their benefits reduced or eliminated None of these steps would be particularly good news. But at least we can be thankful that Congress didn’t go for the idea of investing part of the fund in stocks when this was being discussed around the height of the stock market bubble in 2000. In any event, some of these steps are likely to be taken to ensure that you will receive at least some reasonable level of social security benefits after you retire.
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The big questions are (1) how old you will have to be before you can retire and receive the full amount of benefits and (2) how much that full amount will be. People born in 1960 or later have already been told that they must wait until their sixty-seventh birthday if they want to receive the full amount. Congress may well push the normal retirement age further back for Generations X and Y. As for how much, in 2001 the average social security benefit for all retired workers was $10,140 a year, and for a retired couple it was $16,920. Social security accounted for 39 percent of the total annual income of all retirees, but for 65 percent of the over-sixty-five crowd social security provided more than half of their income. And for 20 percent of the population it was the only source of income. Clearly, if the amounts paid out are reduced, it will have a significant impact on the quality of life for retirees—at least those who do not save enough outside the social security program.
Epilogue Bringing It Together
T
he gist of this book can be summed up by four simple rules:
• Keep enough money to cover about six months of living expenses in a money market or another on-demand account. • Contribute as much as you can to a tax-deferred retirement account. • Keep the money in this tax-deferred retirement account in a mix of at least one stock fund that tracks a broad index (like the S&P 500) and at least one government or investment-grade corporate bond fund. • Don’t micromanage your portfolio. Keep a steady mix of stocks and bonds appropriate to your age, life situation, and risk tolerance. Adjust the mix based on market conditions only at times of unusual stock market over- or undervaluation based on the simple rules found in Chapter 6. Follow these four rules and though you may not have the dubious pleasure of dying rich, at least you’re not likely to die poor. Plus you’ll have the time to live your life instead of worrying about your finances.
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Appendix A Summary of 2003 Tax Law Changes
T
he following description of tax law changes has been provided by the Internal Revenue Service: Public Law 108-27, The Jobs and Growth Tax Relief Reconciliation Act of 2003, was signed by President Bush on May 28, 2003. Described in the following are the major changes made by the new law that affect tax years beginning in 2003. The 2003 Tax Rate Schedules have been revised to reflect the following changes: 1. The tax rate brackets of 27 percent, 30 percent, 35 percent, and 38.6 percent have been reduced to 25 percent, 28 percent, 33 percent, and 35 percent, respectively, and are shown in Table 1. 2. The 15 percent rate bracket for married taxpayers filing jointly and qualifying widow(er)s has been expanded to cover twice the income range as that of single filers. 3. The maximum taxable income subject to the 10 percent tax rate has increased to $7,000 for single taxpayers and married taxpayers filing separately ($14,000 for married taxpayers filing jointly and qualifying widow[er]s). The basic standard deduction for married taxpayers filing jointly and qualifying widow(er)s has increased to $9,500 (twice that of single filers). The standard deduction for married taxpayers filing separately has increased to $4,750 (the same as that of single taxpayers).
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appendix a
Table 1 2003 Tax Rate Schedules IF Taxable Income Is . . .
Over
But Not Over
THEN the Tax Is . . . This Amount
Plus This %
Of the Excess Over
Schedule X
Single
$0 $7,000 $28,400 $68,800 $143,500 $311,950
$7,000 $28,400 $68,800 $143,500 $311,950 —
$0 $700.00 $3,910.00 $14,010.00 $34,926.00 $90,514.50
10% 15% 25% 28% 33% 35%
$0 $7,000 $28,400 $68,800 $143,500 $311,950
$0 $14,000 $56,800 $114,650 $174,700 $311,950
$14,000 $56,800 $114,650 $174,700 $311,950 —
$0 $1,400.00 $7,820.00 $22,282.50 $39,096.50 $84,389.00
10% 15% 25% 28% 33% 35%
$0 $14,000 $56,800 $114,650 $174,700 $311,950
$0 $7,000 $28,400 $57,325 $87,350 $155,975
$7,000 $28,400 $57,325 $87,350 $155,975 —
$0 $700.00 $3,910.00 $11,141.25 $19,548.25 $42,194.50
10% 15% 25% 28% 33% 35%
$0 $7,000 $28,400 $57,325 $87,350 $155,975
$0 $10,000 $38,050 $98,250 $159,100 $311,950
$10,000 $38,050 $98,250 $159,100 $311,950 —
$0 $1,000.00 $5,207.50 $20,257.50 $37,295.50 $87,736.00
10% 15% 25% 28% 33% 35%
$0 $10,000 $38,050 $98,250 $159,100 $311,950
Schedule Y-1
Married Filing Jointly or Qualifying Widow(er)
Schedule Y-2
Married Filing Separately
Schedule Z
Head of Household
The maximum child tax credit has increased from $600 to $1,000 per child. The alternative minimum tax exemption amount has increased to $40,250 for single taxpayers and taxpayers filing as head of household; $58,000 for married taxpayers filing jointly and qualifying widow(er)s; and $29,000 for married taxpayers filing separately.
s u m m a r y o f 2 0 0 3 ta x l aw c h a n g e s
The maximum tax rate on net capital gain (i.e., net long-term capital gain reduced by any net short-term capital loss) has been reduced from 20 percent to 15 percent (and from 10 percent to 5 percent for taxpayers in the 10 percent and 15 percent tax rate brackets) for property sold or otherwise disposed of after May 5, 2003 (and installment sale payments received after that date). The reduced rate applies for both the regular tax and the alternative minimum tax. The higher rates that apply to unrecaptured section 1250 gain, collectibles gain, and section 1202 gain have not changed. The same 15 percent (or 5 percent) maximum tax rate that applies to net capital gain also applies to dividends paid by most domestic and foreign corporations after December 31, 2002. Certain dividends from regulated investment companies (such as mutual funds), real estate investment trusts, and certain foreign corporations do not qualify for the reduced rates. The 2003 Form 1099-DIV and 2003 Instructions for Form 1099-DIV will be reissued in June 2003 to add a box for the reporting of qualified dividends subject to the reduced rates.
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Appendix B Tax-Deferred Savings Plans
F
ollowing are what may be the four most frequently asked questions about the most important kinds of tax-deferred savings plans, 401(k) plans and IRAs.
Can I Contribute? For a 401(k), this is determined by your employer, but normally you can contribute after you have worked for a designated period of time. For a regular individual retirement account (IRA), anyone who has earned income (as opposed to income from investments) may contribute. This is also true for a Roth IRA, but individuals with incomes above $110,000 may not contribute, nor may married couples with incomes above $160,000.
How Much May I Contribute? The amount is also limited to the amount of your earned income, but in the case of an IRA, each partner in a married couple may contribute the maximum amount, provided the total contribution does not exceed the couple’s combined earned income. If you contribute to both a regular and Roth IRA, the total contribution to both IRAs may not exceed the maximum shown in Table 1.
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appendix B
Table 1 Maximum Annual Contributions to IRAs and 401(k) Plans IF You Are Under Age 50
IF You Are 50 or Older
Year
IRA
401(k)
IRA
401(k)
2003 2004 2005 2006 2007 2008
$3,000 $3,000 $4,000 $4,000 $4,000 $5,000
$12,000 $13,000 $14,000 $15,000 $15,000 $15,000
$3,500 $3,500 $4,500 $5,000 $6,000 $6,000
$14,000 $16,000 $18,000 $20,000 $20,000 $20,000
Based on data from the Internal Revenue Service.
Table 2 If You Are Covered by a Retirement Plan at Work, Use This Table AND Your Modified Adjusted Gross Income (Modified AGI)* Is . . .
THEN You Can Take . . .
Single or Head of Household
less than $34,000
a full deduction
at least $34,000 but less than $44,000 $44,000 or more
a partial deduction no deduction
Married Filing Jointly or Qualifying Widow(er)
less than $54,000 at least $54,000 but less than $64,000 $64,000 or more
a full deduction a partial deduction no deduction
Married Filing Separately
less than $10,000 $10,000 or more
a partial deduction no deduction
IF Your Filing Status Is . . .
*Modified Adjusted Gross Income is Adjusted Gross Income with certain deductions added. For details, see IRS Publication 590. Based on data from the Internal Revenue Service.
Is the Contribution Tax-Deductible? Tax-deductible means that when figuring your taxes, your taxable income is reduced by the amount of your contribution. In the case of a 401(k), the answer is yes, your contribution is taxdeductible. In the case of a Roth IRA, the answer is no, your contribution is not tax-deductible. In the case of a regular IRA, it depends: see Tables 2 and 3.
Ta x - D e f e r r e d S av i n g s P l a n s
Table 3 If You Are Not Covered by a Retirement Plan at Work, Use This Table AND Your Modified Adjusted Gross Income (Modified AGI)* Is . . .
THEN You Can Take . . .
Single, Head of Household, or Qualifying Widow(er)
any amount
a full deduction
Married, Filing Jointly or Separately with a Spouse Who Is Not Covered by a Plan at Work
any amount
a full deduction
less than $150,000
a full deduction
at least $150,000 but less than $160,000
a partial deduction
$160,000 or more
no deduction
less than $10,000
a partial deduction
$10,000 or more
no deduction
IF Your Filing Status Is . . .
Married, Filing Jointly with a Spouse Who Is Covered by a Plan at Work Married, Filing Separately with a Spouse Who Is Covered by a Plan at Work
*Modified Adjusted Gross Income is Adjusted Gross Income with certain deductions added. For details, see IRS Publication 590. Based on data from the Internal Revenue Service.
How Will Withdrawals Be Taxed? For a 401(k), withdrawals will normally be taxed as ordinary income at whatever rate applies to your income level. For regular IRAs, withdrawals will be taxed as ordinary income at whatever rate applies to your income level. Except if you have made nondeductible contributions, a percentage of the withdrawal will be taxfree. The tax-free percentage will be equal to the amount of your nondeductible contributions divided by the total value of your IRA. For Roth IRAs, withdrawals will be tax-free provided they are taken more than five years after you first contributed to the IRA and provided you are age fifty-nine and a half or older.
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Appendix C college savings plans
F • • • •
our major options for saving for a child’s college education are:
529 plan Coverdell Education Savings Account Uniform gift to minors custodial account Taxable account with a mutual fund or brokerage account
A 529 plan is a plan sponsored by a state or university to take advantage of the provisions of Section 529 of the Internal Revenue Code that set up the conditions for tax-deferred savings for a postsecondary education. The principal advantage of a 529 plan is similar to that of a 401(k) or an IRA: money in the plan can grow without being subject to federal (and in most cases, state) taxes. But it’s even better insofar as withdrawals are not subject to taxes provided that they are used for tuition or other qualified educational purposes. On the flip side, unlike a 401(k) plan, your contribution to the plan will not result in a federal tax deduction, though it can result in a state income tax deduction in some states. The biggest disadvantage of a 529 plan can be a high fee structure, but the structure varies from state to state. With most state plans, your money is invested in mutual funds, so you start out with the expense ratio of the funds themselves. Then there is a program management fee, and in some cases enrollment or administrative fees. And if you buy
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appendix C
the plan through a broker, instead of directly, there will be a sales charge as well. All told, you could easily be paying more than 1 percent in fees, which in most cases amounts to more than 10 percent of the expected return of your investment. But the good news is that many states offer their plans to nonresidents, so you can shop around to find the best plan. Another drawback of 529 plans is that the tax-deferred earnings of the plan are subject to federal income tax plus a 10 percent additional tax if the withdrawals are used for a purpose other than qualified educational expenses for the designated beneficiary. So you had better be sure that some form of higher education (many vocational programs are eligible) is right for Junior before setting up the plan. A Coverdell Education Savings Account, once known as an Education IRA, is an alternative to a 529 plan. The biggest drawback is that you can only contribute $2,000 per child per year. With a 529 plan you can contribute the maximum allowable $11,000 per year allowed by the federal gift tax, plus you can make a one-time gift of $55,000, provided you do so only once during a five-year period. The biggest advantages of a Coverdell are a lower fee structure and the ability to choose which financial institution will serve as custodian. This means you can select a mutual fund company that offers a wide range of low-expense, no-load funds and discount brokerage services, just as with an IRA. And because there is no state agency or university administering the plan, there are no big program management or administrative fees. If you invest through a no-load index fund, you can keep your expenses below 0.2 percent a year. And there is no law against supplementing a 529 plan with a Coverdell account. A third option is to make annual gifts of up to $11,000 a year to your child under your state’s uniform gift to minors act. This gives you the freedom to choose the financial institution that will hold the account, just as with a Coverdell. There are, however, two major disadvantages to this strategy. First, the investment is not tax-deferred, but rather is taxed at your child’s tax rate. In most cases, this is preferable to being taxed at your tax rate, but it isn’t nearly as good as being tax-free. The second disadvantage is that the money is your child’s—to do with as he or she pleases—upon reaching the age of majority. In those states where the age of majority is twenty-one, this is not a big problem, because it
C o l l e g e s av i n g s p l a n s
is easy to clean out the account with college expenses by then. But if you live in a state where legal adulthood starts at eighteen, your child gains control over the account on that birthday. He or she can then spend it on tuition . . . or something else. The fourth option is a taxable account in your own name. This may not seem like a good option if you are in a high tax bracket, but keep in mind that even in a taxable account, you can hold tax-exempt instruments, such as municipal bonds, and use them as the means to save for your child’s college education. Besides these four options, some advisers have recommended thinking outside the box by considering options such as paying down your home mortgage and then taking out a home equity loan to pay for college. Granted, this is an option, but it may be one inspired largely by today’s low interest rates. If rates are higher when Junior is ready to start college, you may wish you had saved in a more traditional manner. Some parents are reluctant to save for a child’s college education because they figure anything they save will just reduce their chances of qualifying for need-based financial aid. Depending on the method of saving that is chosen, this can be a valid concern. For example, in calculating eligibility for financial aid, colleges weigh the child’s assets more heavily than the parents’. Because money in a Coverdell or uniform gift to minors account is considered the child’s money, it can seriously reduce the chances of receiving financial aid. This is not a problem with a 529 plan, because the assets are considered to belong to the parents or whoever sets up and contributes to the plan. In calculating need, colleges assume that, at most, 5.65 percent of parents’ assets—and none of grandparents’—can be used to finance a college education. However, if a 529 plan is set up as a prepaid tuition plan rather than a savings plan, the prepaid tuition reduces the assumed cost of college attendance by the amount of the prepayment, thus reducing the assumed need for financial aid. As you can tell from the preceding, the rules governing college savings plans are complex and constantly changing. Moreover, they vary from state to state, and when it comes to eligibility for need-based financial aid, colleges—especially private colleges—may tinker with the standard federal guidelines.
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appendix C
A 529 plan in your home state might be the best choice in a state that allows you to deduct your contribution to the plan for state income tax purposes. A 529 plan from another state, or an alternative to a 529 plan, might be best if you live in a state that does not offer one of the better plans. In any event, analyzing all the available state plans is far beyond the scope of this book. An excellent resource on the subject is The Internet Guide to 529 Plans, found at savingforcollege.com. Also, you can check out the U.S. Department of Education’s Federal Student Aid website, studentaid.ed.gov.
Appendix D largest index funds and ETFs
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Type of Fund
S&P 500 Lehman Brothers Aggregate Bond Wilshire 5000 Total Market MSCI U.S. Prime Market Growth S&P 500 MSCI Europe MSCI U.S. Small Cap 1750 Schwab 1000 Total International Composite 60% Wilshire 5000; 40% Lehman Agg Bond
Benchmark Index
VFINX VBMFX VTSMX VIGRX FSMKX VEURX NAESX SNXFX VGTSX VBINX
Symbol
$3,000 $3,000 $3,000 $3,000 $10,000 $3,000 $3,000 $2,500 $3,000 $3,000
Minimum Investment
$1,000 $1,000 $1,000 $1,000 $2,500 $1,000 $1,000 $1,000 $1,000 $1,000
Minimum IRA Investment
*Redemption fee charged only if shares are not held for a specified minimum holding period, often two or three months.
Vanguard 500 Large-Cap Stock Vanguard Total Bond Bond Vanguard Total Stock Total U.S. Stock Market Vanguard Growth Large-Cap Growth Stock Fidelity Spartan Large-Cap Stock Vanguard Euro Stock European Stock Vanguard Small Cap Small-Cap Stock Schwab 1000 Investor Large-Cap Stock Vanguard Total International Stock International Stock Vanguard Balanced Balanced
Fund
Ten Largest Index Funds
0.18% 0.22% 0.20% 0.23% 0.19% 0.33% 0.27% 0.46% 0.37% 0.22%
Expense Ratio
0.00% 0.00% 0.00% 0.00% 0.50% 2.00% 0.00% 0.75% 2.00% 0.00%
Potential Redemption Fee*
vanguard.com vanguard.com vanguard.com vanguard.com fidelity.com vanguard.com vanguard.com schwab.com vanguard.com vanguard.com
Website
800-662-7447 800-662-7447 800-662-7447 800-662-7447 800-544-6666 800-662-7447 800-662-7447 800-435-4000 800-662-7447 800-662-7447
Telephone
Large-Cap Stock Tilted Toward Large-Cap Technology Stocks Large-Cap Stock Mid-Cap Stock Small-Cap Stock International Stock Corporate Bond Total U.S. Stock Market Japanese Stock Large-Cap Value Stock Large-Cap Stock Small-Cap Stock Biotechnology Stock Small-Cap Growth Stock Utilities Stock Large-Cap Value Stock Large-Cap Growth Stock Small-Cap Value Stock Mid-Cap Stock Technology Stock Total U.S. Stock Market Large-Cap Growth Stock Short-to-Medium Term Treasury Bond Semiconductor Stock
SPDR Trust Series 1 NASDAQ 100 Index Tracking Stock iShares S&P 500 Index Fund Midcap SPDR Trust Series 1 iShares Russell 2000 Index Fund iShares MSCI-EAFE Index Fund iShares GS$ InvesTop Corporate Bond Fund Vanguard Total Stock Market VIPERs iShares MSCI-Japan Index Fund iShares Russell 1000 Value Index Fund iShares Russell 1000 Index Fund iShares S&P SmallCap 600 Index Fund Biotech HOLDRS Trust iShares Russell 2000 Growth Index Fund Utilities Select Sector SPDR Fund iShares S&P 500/Barra Value Index Fund iShares Russell 1000 Growth Index Fund iShares Russell 2000 Value Index Fund iShares S&P MidCap 400 Index Fund SPDR Technology iShares Russell 3000 Index Fund iShares S&P 500/Barra Growth Index Fund iShares Lehman 1–3 Year Treasury Bond Fund HOLDRS Semiconductor S&P 500 NASDAQ 100 S&P 500 S&P MidCap 400 Russell 2000 MSCI Europe, Asia, Far East Index Goldman Sachs $ InvesTop Wilshire 5000 Total Market MSCI Japan Russell 1000 Value Russell 1000 S&P SmallCap 600 American Stock Exchange Biotech Russell 2000 Growth AmEx Utilities Select Sector S&P/Barra Value Index Russell 1000 Growth Russell 2000 Value S&P MidCap 400 AmEx Technology Select Sector Russell 3000 S&P/Barra Growth Index Lehman 1–3 Year Treasury Bond Index AmEx Semiconductor HOLDRS Index
Benchmark Index
*Quarterly custodial fee of 2¢ per share deducted from dividend. Expense ratio not stated in prospectus. Based on data from indexfunds.com and individual fund websites.
Type
Name
Twenty-Four Largest ETFs
SPY QQQ IVV MDY IWM EFA LQD VTI EWJ IWD IWB IJR BBH IWO XLU IVE IWF IWN IJH XLK IWV IVW SHY SMH
Ticker Symbol
0.11% 0.20% 0.09% 0.25% 0.20% 0.35% 0.15% 0.15% 0.84% 0.20% 0.15% 0.20% —* 0.25% 0.28% 0.18% 0.20% 0.25% 0.20% 0.28% 0.20% 0.18% 0.15% —*
Expense Ratio
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Glossary What Wall Street Really Means
T
he words used on Wall Street and in the financial press have many different meanings, depending on how they are used. Those meanings differ depending on whether the words are used in a general sense, in a financial sense, by Wall Street pros, or by accountants. The following definitions and explanations put these words into plain English, within the context used by stock market investors. Alpha: The Holy Grail of investing. The amount by which a portfolio beats its benchmark after adjusting for risk. American Depositary Receipt (ADR): A receipt for shares of a foreign company that are held by a U.S. custodian bank. ADRs are priced and pay dividends in U.S. dollars, so owning ADRs seems just like owning a U.S. stock. But don’t forget that when you own ADRs you actually own a stake in a foreign company, so its earnings and dividends in U.S. dollars will be affected by changes in currency exchange rates. Also, most foreign governments withhold taxes from your dividends, but you can file for a credit for these dividend withholdings when you file your federal income tax return. Amortization: The systematic reduction in the value of an asset over a set time period. For example, if a company buys a piece of equipment with an expected useful lifetime of ten years for $100,000, the company’s income statement would record a cost of $10,000 a year for ten years, rather than a cost of $100,000 in the first year. Analyst: See Securities Analyst.
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Annual Percentage Rate: Interest rate expressed as the amount of interest charged or received during a year, including the effects of compounding, as a percentage of the amount lent or borrowed. Annuity: A sequence of payments made over a fixed period of time. If the period is the lifetime of the recipient, an annuity can guarantee a steady stream of income no matter how long the recipient lives. In the case of a fixed annuity, the amount is fixed and will therefore decline in purchasing power at the rate of inflation. In the case of a variable annuity, the amount will vary depending on the growth in value of the investments underlying the annuity. Asset: On a balance sheet, anything of value that can be owned. Stocks, bonds, real estate, factories, patents, and artwork are all assets. Compare with Liability. Asset Allocation: The process of deciding how much of each asset class to own. Asset Class: A type of asset with characteristics that are distinctly different from those of other asset types. Stocks, bonds, cash, gold, commodities, collectibles, and real estate are all considered distinct asset classes because they have different characteristics in terms of expected return, risk, and reaction to different economic events. Balance Sheet: A financial statement showing the assets and liabilities of a corporation (or of a partnership, family, or individual). The amount by which the assets exceed the liabilities is the net worth of the corporation, partnership, family, or individual. Bear Market: An extended period of falling stock prices. By some measures, the major stock indexes must fall by 20 percent to qualify. Benchmark: A standard against which the performance of a portfolio or fund is compared. The standard may be a stock index or the average performance of a group of similar funds as measured by an evaluation service, such as Lipper or Morningstar. Beta: The volatility of a stock or portfolio of stocks relative to the volatility of its benchmark. Let’s say the benchmark is the S&P 500 Index. If the S&P 500 Index goes up 100 percent and a stock goes up 150 percent, its beta is 1.5 (150 percent ⫼ 100 percent). But beta is not necessarily a good thing. A beta of 1.5 also means that a stock will go down 50 percent more than the benchmark when the benchmark goes down.
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Bid-Ask Spread: The difference between what a buyer bids for a stock and what a seller offers. Usually, the difference is a few pennies, but when there are few buyers and sellers it can be significant. Big Board: The New York Stock Exchange. Blend: As a description of a stock fund, blend means the fund is neither a growth fund nor a value fund, but a blend of the two. Board of Directors: The people elected by a company’s shareholders to hire corporate managers and to oversee how they are running the company. In practice, many boards have given up their authority to management. Bond: A certificate of indebtedness issued by a corporation or government guaranteeing payment of the original amount of debt, plus interest, by a specified future date. In other words, a bond is an interest-paying IOU. Book Value: The value of the shareholders’ stake in a company, meaning the value of the firm’s assets minus its liabilities. Also known as net worth or shareholders’ equity. Bubble: An out-of-control bull market, characterized by irrational exuberance and the triumph of greed. The result is that buyers pay far more for stocks than their earning power justifies—until the bubble bursts and prices tumble as fear replaces greed. Bull Market: An extended period of stock market advances. By some measures, the major stock indexes must rise by 20 percent to qualify. Buy-Side Analyst: An analyst who works for a mutual fund company, a pension fund, or an independent publisher. His or her job is to advise a fund, or the readers of a publication, which stocks to buy or sell. Capital: The economic definition of capital is wealth used to produce more wealth. The accounting definition is net worth of a business, meaning the value of the business’s assets minus the value of its liabilities. Capital Gain or Capital Loss: The difference between the amount you receive when you sell a security and what you paid for it. Capital Growth: As a fund objective, this means that growth in the value of the fund’s assets is a more important goal than income from those assets. Also known as capital appreciation.
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Capital Preservation: As a fund objective, the primary goal is to avoid a loss of value. A money market fund is the quintessential capital preservation fund, but bond funds, and stock funds with conservative management styles, may also state the goal of capital preservation. Capital Spending: Spending on long-lived assets that are expected to generate future profits. Buildings and equipment are examples of such assets. Spending on fuel and routine maintenance is not capital spending. In the WorldCom accounting scandal, company accountants booked routine costs as capital spending, thereby boosting reported profits. Cash: Literally coins and paper money, but in the language of asset allocation, it also includes money held in short-term interest-bearing accounts, such as checking, money market, and on-demand savings accounts, as well as Treasury bills. Cash-Balance Plan: A company retirement plan that credits workers with a percentage of their annual pay for each year that they work. At retirement, they can either take this sum as a lump sum or as an annuity. As such, it falls somewhere between a defined contribution plan and a defined benefit plan, though it’s probably closer to the former if you choose a lump sum on retirement and to the latter if you choose an annuity. In any event, companies have recently been hesitant to offer new cash-balance plans pending the outcome of a lawsuit against the IBM cash-balance plan. Cash Flow: The amount of cash—as opposed to accounting profit—generated or lost by a business. In the event of a loss, cash flow may be called cash burn. Central Bank: A bank controlled by a national or supernational government that issues money and determines monetary policy. The Federal Reserve Bank is the national bank of the United States. The European Central Bank is a supernational central bank, carrying out monetary policy for those nations that have adopted the euro as their currency. Charting: Another word for technical analysis. Chinese Wall: The legally required separation between analysts and investment bankers to ensure that analysts don’t acquire inside information about potential mergers and acquisitions. Commissions: Sales charges to buy or sell a stock, bond, or mutual fund. Common Stock: Shares in a company that denote ownership.
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Compounding: With respect to interest, compounding refers to the process whereby interest is earned, or charged, on interest. Consumer Price Index (CPI): A measure of the change in the cost of a basket of goods and services. It is based on the spending habits of a typical urban family of four and excludes the cost of purchased housing. As such, it is not a perfect indicator of inflation, but it is the most widely followed indicator. Contrarian: Someone who does the opposite of what most investors are doing. For example, someone who buys when most are selling. Convertible Debt: Corporate debt that is convertible into the common stock of the issuing company at a predetermined exchange ratio. Correction: A decline in stock prices after a period of gains. If a correction continues it may be called a bear market. Correlation: If two assets have a high correlation with one another it simply means that if one goes up in price, the other is also likely to go up in price. Likewise, if one goes down in price, the other is likely to go down, too. If you own two stocks with a high correlation and one goes down in price, you’re likely to lose money on the second one as well. Correlation is measured from ⫺1 to ⫹1. A correlation of ⫹1 means that both assets have historically moved up and down in lockstep. A correlation of 0 means that there has been no relationship at all between the two. A correlation of ⫺1 means that whenever one has gone up, the other has gone down. Coverdell Account: A Coverdell Education Savings Account, formerly known as an Education IRA, is one method of tax-deferred savings for higher education. See Appendix C for details. Current Dollars: Dollars adjusted to factor in the effect of inflation. If prices doubled during the past ten years, then $1 ten years ago would be $2 in current dollar terms because it could buy the same amount of goods and services ten years ago as $2 can buy today. Day Trader: Someone who tries to make money from intraday price movements of stocks or other assets by buying low and selling high (or by short selling) within the course of a day. Defined Benefit Plan: A retirement plan in which the employer is responsible for paying out a defined amount in benefits during each month of an employee’s retirement years. Also known as a pension plan.
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Defined Contribution Plan: A retirement plan in which the employee contributes a defined amount each month, but in which the plan’s postretirement value is determined by gains and losses in the value of the assets in the plan. Derivatives: Any security whose value is derived from the value of another asset. For example, options and futures contracts are derivatives because they move up or down in price based on the price movement of the underlying stock or index. Diversification: Simply put, diversification means not putting all your eggs in one basket. In investment terms, it means investing in several different asset classes that have low correlations with one another, meaning that when part of your investment portfolio goes down in value, other parts are not likely to go down with it. Dividends: The portion of a company’s profits that are returned to the shareholders. Most U.S. companies pay dividends quarterly in cents per share. Most companies don’t pay a dividend during their early years because they are investing their profits to grow the company. As companies grow in size, opportunities for future growth become limited, so they start paying dividends. Or at least that’s the theory. Dollar Cost Averaging: A method of investment timing under which a fixed amount of dollars is invested at regular intervals, usually in stocks. The logic behind this method is that by investing an equal amount regardless of share price, you will buy more shares when a stock is cheap than when it is expensive. Also, spreading out the purchase reduces the risk of making a large investment in stocks at too high a price. This method makes sense if it involves putting a fixed amount from your paycheck into a stock fund each month. However, if you suddenly inherit a pile of cash, keeping most of it in a checking or money market account while only gradually investing it probably does not make a lot of sense unless the valuation methods in this book show that stocks are overvalued. Dow Jones Industrial Average (the Dow): The combined price of thirty stocks, which is a shorthand measure of the price of the overall stock market. See Chapter 6 for more information about this index. Earnings Estimate: An analyst’s estimate of how many cents per share a company will make (or lose) in a given quarter or year. Estimates are usually made based on information, and sometimes guidance, provided by company management. Good analysts do independent research as well.
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Earnings Surprise: The announcement of earnings that are well below or above the consensus estimate of analysts. A positive earnings surprise will cause a stock to jump in price when the earnings are announced; a negative surprise will cause it to plummet—usually more than a positive surprise of the same magnitude would cause it to rise. Employee Retirement Income Security Act (ERISA): A 1974 federal law administered by the U.S. Department of Labor that sets standards for corporate employee benefit plans. Originally aimed only at retirement plans, it now also addresses health plan issues. Equity: Another word for stock. Also, the book value of the shareholders’ stake in a company. Equity Income Fund: A fund that invests in stocks with high dividend yields, and perhaps in bonds as well. ERA (Earned Run Average): If you see this term, you’re no longer in the business section. Estimated P/E Ratio: A price/earnings ratio based on analysts’ consensus forecast of earnings, usually for a company’s current year. Sometimes called an expected P/E ratio. Estimates, Forecasts, and Projections: An estimate is an attempt to quantify something that has already occurred but which has not yet been officially measured. An estimate of last month’s unemployment rate before it has been announced by the Department of Commerce is an example. A forecast is a thoughtful attempt to predict the future based on combining insight with all available data. A projection is the mindless continuation of a trend line, presented as a forecast. Wall Street research usually uses the term estimate for forecast. And too often, forecasts are projections. Exchange Traded Fund (ETF): An index fund that can be bought and sold on a stock exchange. For more information, see Chapter 6. Expense Ratio: The percentage of assets of a mutual fund that go toward operating expenses, marketing expenses, and management fees. If two funds make identical investments that produce a return of 5 percent before expenses, but one has an expense ratio of 1 percent while the other has an expense ratio of only 0.25 percent, there would be a big difference in the return for the shareholder: 4 percent versus 4.75 percent.
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Federal Reserve Bank (the Fed): The central bank of the United States. Financial Accounting Standards Board (FASB): An independent board of certified public accountants that determines Generally Accepted Accounting Principles (GAAP). Financial Planner: Someone who advises clients about their financial affairs, including asset allocation, insurance, and tax issues. A financial planner who has passed examinations issued by the Institute of Certified Financial Planners is a Certified Financial Planner (CFP). Fiscal: Related to taxing, spending, and the budget. 529 Plan: A plan for tax-deferred saving for higher education. See Appendix C for details. Fixed-Income Security: Any security that pays a fixed amount of interest—as opposed to a dividend that may be increased, decreased, or omitted. Bonds, notes, and bills are the principal forms of fixed-income securities. 401(k) Plan: An employer-sponsored, tax-deferred retirement savings plan in which the employee defines how much to contribute (although the employer may choose to match part or all of the contribution) and the market determines the amount of assets that will be available for retirement. Free Cash Flow: The amount of cash a company generates or loses, after subtracting the amount that needs to be reinvested in the business in the form of capital spending. Fundamental Analysis: The in-depth study of a company, including its products, its competitive position in its industry, its strategy, the quality of its management, and so on—all in an effort to predict its future earnings and thus determine at what price it should be bought or sold. Fund Manager: The person who makes the asset allocation and security selection decisions for a fund. Can also refer to the institution that person works for. Futures Contract: A contract to buy or sell something at a future date at a set price. Unlike an option, a futures contract must be fulfilled even if it involves buying or selling at a loss. In practice, money is normally exchanged to compensate for the gain or loss rather than the sale actu-
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ally taking place. For example, say you have $100,000 invested in an S&P 500 Index fund but are worried that the market is overvalued. You can agree to sell S&P 500 Index contracts for delivery next month. Normally, such futures contracts trade at a slightly higher price than the current level. If the index goes down, you make the difference between the agreed-on price and the actual price of the index. But if it goes up, you pay the difference. If you buy enough contracts, you can totally hedge your investment, meaning you break even whether the index goes up or down because what you make or lose on your investment in the S&P 500 Index fund is matched by what you make or lose on the futures contract. Generally Accepted Accounting Principles (GA AP): The rules companies are supposed to use in preparing financial statements to ensure consistency from one company to another. Global Fund: A fund that invests in both domestic and foreign securities. Goodwill: The difference between the market value of an asset and its book value. For example, the value of the Coca-Cola and PepsiCo companies is far greater than the value of their physical assets. The difference, which lies in the value of the brand name, is their goodwill. Gross Domestic Product (GDP): The U.S. Department of Commerce, which calculates GDP, defines it as the market value of goods and services produced by labor and property in the United States. As such, it includes the value of goods that are produced in the United States and exported, and subtracts the value of imports. Because imports have exceeded exports in recent years, we have been enjoying a higher standard of living than the GDP data would suggest—but at the cost of becoming a debtor nation to China and other countries with which we have big trade deficits. Growth at Reasonable Price (GARP): Many growth investors claim to be GARP investors, meaning that they seek growth at a reasonable price. Duh! How many fund managers are going to say they will pay any price for growth? Note: John Irving’s The World According to Garp is not a book about growth stock investing. Growth Stock: The stock of a company that is expected to have rapid growth of revenues and earnings. These stocks are bought in the hope of capital gains, not for the assurance of current dividends. Guidance: A forecast of future revenue or earnings made by a corporation’s management rather than by analysts.
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Hedge: As a verb, to hedge means the same thing in financial lingo as in plain English: to take steps, such as using futures or options contracts, to reduce the risk of loss. Hedge Fund: A hedge fund is not what it sounds like. It is a fund that usually takes on above-average risk in the hope of high returns. Hedge funds are open only to high net worth individuals (Wall Street’s term for rich folks) and are not as strictly regulated as are mutual funds that are open to anyone. Income: In investment terms, this usually refers to the income produced by an asset. For a stock, it means the dividend. For a bond, it means the interest. When a fund prospectus states a goal of income (or current income), it means that the fund intends to invest largely in bonds or in stocks that pay out a high percentage of their earnings as dividends. Income Statement: A statement of how much money a company takes in as revenue and pays out as costs. The bottom line is its net income. Individual Retirement Account (IRA): An account for tax-deferred savings for retirement. Refer to Chapter 6 and Appendix B for more information. Inflation: The increase in the cost of living. The most common measure is the consumer price index (CPI). Initial Public Offering (IPO): An opportunity for the original investors in a company to sell their stake in the company to the public. After an IPO, the stock can be bought and sold on a stock exchange. Insider Trading: The buying or selling of securities based on information that is available to company insiders but unavailable to the general public. Insider trading is illegal. For example, if the chief financial officer of a company knows he is going to report disappointing earnings, it would be illegal for him to sell shares in the company before the announcement. Interest: The reward for lending money, or the cost of borrowing money, usually expressed as a percentage of the amount lent or borrowed. Interest Rate: Interest as a percentage of the amount of money lent or borrowed. International Fund: A fund that invests in foreign securities. Investing: Expending money in the hope of making a profit. Examples include buying a stake in a business in the expectation of participating in
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its profits (this is what you are doing when you buy stocks), or loaning money to a business or government in return for interest on the money. Investment Bank: A company that raises money for businesses by helping them to sell stocks or bonds. Most stock brokerage firms are also investment banks. Investment-Grade Bond: A bond that is considered a safe investment, as indicated by its high grade from the bond-rating agencies. Issuer: A company that raises money by borrowing (issuing debt) or selling a stake in itself (issuing stock). Large-Cap Stock: The stock of a large corporation. Currently, defined by Lipper as one with a market capitalization of at least $8.5 billion. Liability: On a balance sheet, any debt or potential debt. Loose Monetary Policy: A central bank policy that encourages growth in the money supply through low interest rates in the hope of stimulating economic growth—even at the cost of higher inflation. Lump Sum Distribution (or Payout): The receiving of all the assets of a retirement plan as a single payment. A lump sum payout can have negative tax implications. Margin Account: A brokerage account that allows the customer to borrow money from the broker to buy securities. The securities in the account are the collateral against any borrowings. If the value of the securities goes down, the customer may receive a margin call telling him or her to add additional cash or securities to the account. If the customer fails to do so, the broker may sell securities from the account. Market Capitalization: What it would cost to buy 100 percent of a company. The price of a share of stock in the company times the number of shares. Market Timing: The tactic of frequently increasing and decreasing stock ownership based on beliefs about the near-term direction of stocks. Also, a good way to decrease your net worth. May or Could: These are the verbs used by Wall Street analysts, company spokespeople, the financial press, and just about everyone else these days to say what they expect to happen, when they don’t want to take the risk of being wrong. For example, if an analyst says, “Podunk Manufacturing stock may rise to $90 in the next six months,” it means the analyst
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is hopeful that the shares will reach $90. Of course, Podunk stock may actually reach $90—if either enough investors buy the stock or they discover oil in the company parking lot. But remember that Podunk shares may also reach $1 in the next six months. May and could are safe verbs to use because anything may or could happen. For a great real-world example, I need look no further than today’s business section headline from Reuters: “Wall Street Week Ahead: Market May Cool.” C’mon, guys! Tell us something we don’t already know. Mid-Cap Stock: The stock of a midsize company. Currently defined by Lipper as one with a market capitalization between $2 billion and $8.5 billion. Money Market Fund: A mutual fund that invests in short-term debt securities, such as Treasury bills, commercial paper, and negotiable certificates of deposit. As a result, the return on a money market fund is similar to the return on such instruments and has historically been less than 1 percent above the rate of inflation. Money market funds normally maintain a fixed price of $1 per share, and income earned by the fund is paid to shareholders in the form of additional shares. Money market funds have expenses like any other mutual fund, and the expense ratio can be a big factor in determining the relative performance of money market funds, especially when interest rates are low. Municipal Bond (or Muni): A bond issued by a state or local government agency that is exempt from federal tax and usually exempt from state tax in the state in which the issuer is located. Mutual Fund: A fund that pools the assets of many individual shareholders and invests those assets in accordance with the investment objectives of the fund. An open-end mutual fund (the most common variety) continually offers to buy and sell shares from the public. A closed-end mutual fund does not issue new shares but maintains a constant number of shares that are bought and sold on a stock exchange. NASDAQ (National Association of Securities Dealers Automated Quotation System): An electronic stock exchange where shares of many of the United States’ largest companies, including Microsoft, Dell Computer, and Amgen, are traded. NASDAQ Composite Index: An index of the price of all stocks traded on the NASDAQ stock exchange.
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Net Asset Value (NAV) per Share: The value of a share of a fund. Normally, it is calculated at the closing time of the New York Stock Exchange (4 p.m. Eastern Time) on each day that the stock exchange is open. First, all the fund’s assets are valued and totaled and the value of the fund’s liabilities are subtracted. The result is net asset value. Then net asset value is divided by the number of shares outstanding to obtain net asset value per share. This is the price that will be published in newspapers the next day, as well as on the mutual fund company’s website. It is also the price you would pay (receive) if your order to buy (sell) was accepted before 4 p.m. ET that day. Net Income: The amount of money a company earns, net of taxes, as determined by Generally Accepted Accounting Principles (GAAP). No-Load Fund: A mutual fund that has no sales charges on purchases or sales of shares in the fund. Nominal: Not adjusted for inflation. Compare with Real. Offering Statement: See Prospectus. Operating Net Income: The amount of money a company earns after taxes, as determined by Generally Accepted Accounting Principles (GAAP), but adjusted to exclude items such as unusual and nonrecurring gains or losses and the cost of amortizing goodwill. Also called pro forma, or non-GAAP, net income. Option: The right to buy or sell an asset at or up to some specified future date, at a specified price. The right to buy is a call option; the right to sell is a put option. Options can be used to hedge (reduce) risk or to speculate. See the “Limit Orders and Options” sidebar in Chapter 7 for more information. Pension Plan: See Defined Benefit Plan. Portfolio Manager: Anyone who manages assets and makes investment decisions on behalf of another person. See also Fund Manager. Preferred Stock: Shares in a company that differ from common shares in three ways. First, preferred shares pay a dividend that is fixed at the time the shares are issued. Second, the dividend on preferred shares must be paid before the company may pay a dividend on common stock. Third, in the event of bankruptcy, preferred shares give their holder priority in
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claims against the assets of the company compared with common shares (but debt holders have priority over preferred shareholders). Price/Earnings (P/E) Ratio: The price of a share of stock in a company, divided by the earnings attributable to that share. Unless otherwise noted, it is usually based on earnings during the latest twelve months for which earnings have been reported. See also Estimated P/E Ratio. Price-to-Book Ratio: The ratio between the market value of a company and its book value. It is calculated by dividing the price of a share of stock by the company’s book value per share. As a general rule, growth companies will have a high price-to-book ratio because investors are willing to pay for the potential future growth. Pro Forma: Also known as non-GAAP, pro forma income statements are adjusted in an attempt to give a truer picture of a company’s operations than income statements based on GAAP. They do this by excluding extraordinary and nonrecurring gains and losses, the amortization of goodwill, and the results of discontinued operations. Done evenhandedly, this can give a better picture of how a company is doing than GAAP earnings. However, some company managements, especially during the bubble years of the late 1990s, used pro forma earnings to inflate earnings by excluding losses that were recurring, while neglecting to exclude nonrecurring gains. Prospectus: A document that must be approved by the Securities and Exchange Commission before a company can sell stock or issue debt. The prospectus provides information about the nature of the business, including risks and competitors, financial statements, and a list of officers, directors, and shareholders, among other details. Public Company: A company whose shares are traded on a stock exchange and owned by the general public. Quantitative Analysis: The comparative analysis of financial and stock market data from many corporations using mathematical models and done by a computer in an attempt to create a portfolio of stocks that can outperform a benchmark portfolio. As such, it is an alternative to fundamental and technical analysis. Real: Adjusted for inflation. Rebalancing: Rebalancing a portfolio means adjusting its holdings to get it back into agreement with its objectives.
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Reported Earnings: Earnings as reported by a company—normally in accordance with GAAP principles, as opposed to pro forma earnings. Research: The work of fundamental analysts. Return on Investment (ROI): The profits generated by an investment divided by the cost of the investment. The riskier the investment, the higher the ROI should be. Risk: Risk is often defined as volatility, meaning the tendency for a security’s price to make large moves, both up and down. Perhaps a better definition of risk is the odds that the security will lose value. Risk-Adjusted: When comparing the performance of investments, riskier investments are expected to produce higher returns to compensate for the higher risk. Roth IRA: A type of individual retirement account that allows for taxfree withdrawals. See Chapter 6 and Appendix B for more details. Sarbanes-Oxley Act: A bill that President George W. Bush signed into law on July 30, 2002. Its purpose is to toughen financial reporting standards of public corporations by requiring that top management certify the validity of financial reports and disclose important transactions and liabilities that are not on the balance sheet. Secondary Offering: Sale of additional shares of stock by a company or its major shareholders after its initial public offering. Also known as an additional offering. Securities Analyst: A person whose job is to analyze the fundamentals of a company for the purpose of recommending whether the company’s stock (or bonds) should be bought, sold, or held. This is done by reviewing the company’s financial statements, interviewing company officials, talking with suppliers and customers, and doing other kinds of research. A sell-side analyst works for a brokerage firm and provides research results to the firm’s clients in exchange for brokerage business. A buy-side analyst provides the research to portfolio managers in a money management firm or to subscribers to an investment advisory publication, such as The Value Line Investment Survey. A Chartered Financial Analyst (CFA) is an analyst who has passed three years of examinations in economics, financial accounting, portfolio management, securities analysis, and professional standards of conduct given by the Association for Investment Management and Research.
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Securities and Exchange Commission (SEC): The federal agency created by the Securities Act of 1934 to administer securities laws. Security: A document indicating ownership of property (e.g., a stock certificate) or creditor status (e.g., a bond). Sell-Side Analyst: An analyst who works for a brokerage firm. His or her job is to produce research to help sell stocks. Share: Any of the equal parts into which the stock of a company is divided. If a company has one million shares of stock outstanding and you own one share, you own one one-millionth of the company. Share Repurchase (Buyback): The buying back of shares by a company from its shareholders. In theory, this increases the value of the remaining shares because they now represent a greater percentage ownership of the company. Short Selling: The selling of borrowed shares in the expectation that they can be bought back at a lower price at a later date. Small-Cap Stock: Stock in a company with a small market capitalization. The cutoff keeps rising. It had been $1 billion, but now some fund evaluation services consider any company with a market capitalization below $2 billion to be a small-cap company. Speculation: The meaning of this term has changed over time, but generally it means investing with the goal of making a quick profit. Standard & Poor’s 500 (S&P 500) Index: An index of five hundred stocks that measures the price of the overall U.S. stock market. For more detail, see Chapter 6. Stock: See Common Stock and Preferred Stock. Stock Option: The right to buy a share of stock at a set price until a set date. Much of the compensation of many corporate officers is in the form of stock options. The proper way to account for the cost of these options recently has been a contentious topic in the accounting community. Stock Split: The split of each share of stock in a company into a greater number of shares. For example, if you owned one hundred shares of Global Gizmos and the stock had a two-for-one split, you would now own two hundred shares. But because every other owner also doubled his or her
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stake, your ownership percentage in the company would be unchanged, and your two hundred shares should be worth the same as your one hundred shares had been. A share price in the range of $30 to $40 is generally considered the ideal price for a stock. It allows small investors to buy a round lot of one hundred shares at a reasonable price of $3,000 to $4,000. Thus when a stock reaches $60 or more, a company’s directors may declare a stock split to bring the share price back down to about $30. Investment theory teaches that a stock split is meaningless because the value of your holdings is the same before and after the split. Nonetheless, splits may be a positive signal because they show that management is confident about the future of the company. After all, if they thought the value of the stock was going down, there would be no point in reducing the share price by doubling the number of shares. Street, The: London’s financial community refers to the center of financial activity as The City. Tokyo’s center of financial activity is Kabutocho because that is the district of Tokyo where the stock exchange is located. New York’s center of financial activity is Wall Street, or simply The Street. Strong Dollar and Weak Dollar: A strong dollar is one that can be exchanged for more and more euros, Japanese yen, British pounds, and other currencies. That means a dollar can buy more French wine, Japanese automobiles, or Scotch whiskey. (It could also buy more Japanese wine and French automobiles, but what would be the point?) That’s why a strong dollar is good for U.S. consumers and Americans who vacation abroad. But a strong dollar is bad for U.S. manufacturers who must compete with foreign goods. On the flip side, when the dollar is weak it takes more and more dollars to buy foreign currencies and foreign products. This is bad for consumers but good for manufacturers. In an ideal world the dollar is neither strong nor weak. That way industries in one country don’t gain an unfair advantage from a weak currency and start flooding the world with inferior products just because they can be made cheaply there. Technical Analysis: The attempt to predict the future direction of a stock, or the stock market, based on its past trading patterns. Cynics would say technical analysis is like trying to predict where a car is going from a road map showing the route it has already taken or (less kindly) that it has as much predictive value as reading sheep entrails. Still, if enough investors actually buy and sell based on these patterns, it might have some validity in the short term.
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Ticker Symbol: The one to five digits used as shorthand for the name of a stock. Stocks that trade on the New York or American Stock Exchange have one, two, or three letters. Those that trade on NASDAQ have four. Five letters signal some irregularity, such as bankruptcy or failure to file financial statements with the Securities and Exchange Commission. Hence, Bethlehem Steel, which once had the unfortunate ticker of BS, now must go by BHMSQ as a result of filing for bankruptcy. Ticker symbols are issued on a first-come, first-served basis. Thus, established companies such as Ford (F) get to have one-letter symbols. Citigroup was able to become “C” only after Chrysler was bought by Daimler-Benz. Some companies have shown some imagination in their choice of ticker symbols. For example, WOOF is the ticker symbol for a chain of veterinary hospitals. Wall Street traders usually refer to companies by pronouncing the ticker as a word. Thus the oil field services company Schlumberger is universally called “slob” for its ticker SLB. Tight Money Policy: A central bank policy of discouraging growth of the money supply through high interest rates for the purpose of controlling inflation—even at the cost of slowing economic growth. Total Real Return: Total return minus the increase in prices. If your total return is 15 percent and inflation is 10 percent, your total real return is 5 percent. (Actually, it’s 4.55 percent because the correct way of doing this calculation is to divide total return plus one by inflation plus one, and then subtract one from the result. But the important thing to remember is that the total real return is the total return adjusted for inflation.) Total Return: The change in the value of an investment plus any interest or dividends, including additional interest earned from reinvesting the interest or dividends, divided by the value of the investment at the beginning of the period. For example, let’s say you owned $100 worth of stock on December 31, 2003. On December 31, 2004, it’s worth $110. During 2004 it paid $4 in dividends, on which you earned $1 in interest. Your total return would be 15 percent: $10 in gain in value, $4 in dividends, and $1 in interest on those dividends, for a total of $15, divided by your original $100 in value. Trading Costs: The total cost of buying or selling a security, including the sales charges and the bid-ask spread. Treasury Bill: A short-term IOU from Uncle Sam. Treasury bills are normally paid back after periods of thirteen, twenty-six, or fifty-two weeks and are sold in minimum amounts of $10,000. The bills are auc-
glossary
tioned off at a discount to their face value. Thus if you pay $9,500 for a $10,000 fifty-two-week T-bill, you would earn $500 on an investment of $9,500, for a yield of 5.26 percent. Treasury Bond: A long-term IOU from Uncle Sam. Treasury bonds pay a fixed amount of interest every six months. The annual amount of interest divided by the purchase price determines your interest rate, or yield. Treasury Note: A medium-term IOU from Uncle Sam. A note is for one to ten years, with the two-, five-, and ten-year notes being among the most popular, although the ten-year is often referred to as a bond. Interest payments are as described for Treasury Bonds. 12b-1 Fee: A fee charged by a mutual fund to cover the costs of distributing the fund. Not all mutual funds charge this fee, which is permitted by SEC rule 12b-1. Underwriter: The investment banking firm that ensures the success of a sale of stock or debt by buying it from the issuing firm and reselling it to the public. Value Stock, Value Fund, and Value Investor: A value stock is one that offers good value, as indicated by a low P/E multiple, a high dividend yield, or some other such indication of value. (Note that a low price alone is not a good indicator of value. A stock that is cheap is often cheap for a good reason.) A value fund or value investor is a fund or investor that owns mostly value stocks. Volatility: The relative degree to which the price of a security, a fund, or an index moves up and down. For example, if the shares of Dullsville Gas & Electric move up or down 1 percent in a typical week, while the shares of Cutting Edge Biotech move up or down 10 percent, then Cutting Edge has ten times the volatility of Dullsville. This means that Cutting Edge gives you ten times the upside potential of Dullsville, while also giving you ten times the risk of losing money. (Note to geeks: volatility is actually calculated based on the standard deviation of the daily or weekly movement in the price, but the preceding example gives you the general meaning of the term.) Wall Street: Used to refer to the brokerage business, and in particular to the sell side. The New York Stock Exchange is at the corner of Wall Street and Broad Street, with its front entrance on Broad. Because Trinity Church (with its cemetery) stands at the west end of Wall Street, many wags have referred to Wall Street as the path from a river to a graveyard.
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In fact, it is the sanctuary of the church rather than its graveyard that looks down on the stock exchange, a short block away. On many days Wall Street has been a path from the sublime to the ridiculous. Weak Dollar: See Strong Dollar and Weak Dollar. Whisper Number: The earnings that analysts actually expect a company to achieve immediately before earnings are announced. This will often differ from the consensus estimate. Thus if a company reports results that are not as good as the whisper number, the stock is likely to go down even if the results are better than the published consensus. Yield: The percentage return on an investment. Yield can be calculated in different ways. The most important measure is the annual yield, meaning simply the amount of interest or dividends paid in a year, divided by the principal at the beginning of the year. If the interest or dividend is reinvested, the interest on the reinvestment should also be included in calculating the yield.
Index
Actively managed funds, versus index funds, 107–11 Adelphia Communications, 65 Alexander, Michael, 3–4 Allen, Frederick Lewis, 154 Amazon.com, 22, 24 America Online, 22 Annuities, tax-deferred variable, 82 Asset allocation funds, 134–35, 145 Asset mix, determining bonds versus cash, 92–94 for investment plans, 79–80, 88–94 stocks versus bonds or cash, 88–92 AT&T, 65 Bad news, reaction of stock market to, 53 Balanced funds, 131, 144, 145 Behavioral financial, 48 Bernstein, Richard, 147 Bezos, Jeff, 24 Bogle, John C., 97 Bond funds, 142 international, 159–60
Bonds. See also Treasury bonds cash versus, 92–94 corporate, 86 municipal, 87 as safe investment, 157–60 treasury, 83–84 Bottoms. See Stock market bottoms Bubbles, 11–12 collapse of emerging markets in nineties, 16–20 Florida real estate in 1920s, 154 Internet, 22–24 Japan stock market in late eighties, 14–16, 155 psychology of, 25–28 trajectories of, 28 United States in late nineties, 20–25 Buffett, Warren E., 32 Buying on margin, 170–71 Calvin, John, 19 Capitalism, Calvinism and, 19 Case, Steve, 22 Cash, 86 bonds versus, 92–94 Cash flow, 63–64 Charting, 165
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Cisco Systems, 56–60 Colamosca, Anna, 43 Common Stocks as Long-Term Investments (Smith), 13 Compounding, 7 Corporate bonds, 86 Cubes, 102. See also Exchange traded funds (ETFs) Day trading, 165–66 Defined benefit plans, traditional, 81 Diamonds, 102. See also Exchange traded funds (ETFs) Dividends, 7, 66 Do-it-yourself index funds. See Exchange traded funds (ETFs); Index funds Domini Social Index 400, 129 Earnings operating, 68 reported, 68–71 Efficient Market Theory, 45–47, 162 fallacy of, 58 Emerging market funds, 121–24, 142 Emerging markets, 16–20 Equity income funds, 112–14, 144 ETFs. See Exchange traded funds (ETFs) Exchange traded funds (ETFs), 101–2. See also Index funds advantages of, 102–3 disadvantages of, 103–4 Fear, rational stock market behavior and, 48–49 Fed model, 71–73 Filo, David, 24 Fisher, Irving, 14
Fooled by Randomness (Talem), 51 Four best months fallacy, 91–92 401(k) plans, 80–81 options for, 139–45 overdiversification and, 169 Fundamentalism, 163–64 Funds actively managed, 107–11 asset allocation, 134–35, 145 balanced, 131, 144, 145 bond, 142 convertible, 135 emerging market, 121–24, 142 equity income, 112–114, 144 exchange traded, 101–4 gold, 136 growth, 111–12, 144 high-yield bond, 128, 144 index, 97–111 international, 143–44 international bond, 159–60 life cycle, 134, 145 mid-cap, 126–27, 142–43 money market, 86–87, 145 sector, 114–17 small-cap, 124–26, 142–43 socially responsible, 128–30 technology, 143 value, 111–12 Gates, Bill, 32 GICs. See Guaranteed investment contracts (GICs) Gold funds, 136–38 Graham, Benjamin, 64–65 Grasso, Richard, 44 Great Depression, 26, 29–31 Great Florida Real Estate Bubble, 154, 155 Great 401(k) Hoax (Wolman and Colamosca), 43–44
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Greed, rational stock market behavior and, 48–49 Greenspan, Alan, 21, 22, 71–73, 96, 157 Greenspan model, 71–73 Growth funds, 111–12, 144 Guaranteed investment contracts (GICs), 85–86 Hale, David, 35 Hawley-Smoot Tariff Act, 26 Herd instinct, rational stock market behavior and, 50–51 High-yield bond funds, 128, 144 Home prices, 152–54 Hong Kong stock market, 19–20 Human behaviors, that prevent rational stock market behavior, 48–54 Ibbotson Associates, 125 Index funds, 97–98. See also Exchange traded funds (ETFs) actively managed funds versus, 107–11 selecting, 98–101 Individual retirement accounts (IRAs), 81–82 Inflation, 7 interest rates and, 95–96 Initial public offerings (IPOs), 22, 167–68 Intelligent Investor, The (Graham), 64–65 Interest rates inflation and, 95–96 short-term versus long-term, 95–96 International bond funds, 159–60 International funds, 118–24, 143–44
Internet bubble, 22–24 Investing, patriotic, 169–70 Investment plans, types of, 80–83 Investment portfolios determining asset mix for, 79–80 monitoring, 104–6 reducing risk in, 138–39 IPOs. See Initial public offerings (IPOs) IRAs. See Individual retirement accounts (IRAs) Irrational exuberance, era of, 20–25, 71 Japan, 1980s stock market boom in, 14–16 Kahneman, Daniel, 48, 49 Kozlowski, Dennis, 65 Life cycle funds, 134, 145 Limit orders, 138 Loans, to top management, 65 Long-term interest rates, versus short-term, 95–96 Malkiel, Burton, 46 Management, loans to, 65 Margin, buying on, 170–71 Market bottoms. See Stock market bottoms Market timing, 161–62 Mexico, 16–18 Mid-cap funds, 126–27, 142–43 Money market funds, 86–87, 145 Municipal bonds (munis), 87 Murphy, R. Taggart, 35 Myopia, rational stock market behavior and, 52–54
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Myths, about stock market best to wait until investment outlook is clear, 148–51 bonds are safe, 157–60 real estate is always better than investment, 151–56 Wall Street strategists will tell you when to get back into market, 147–49 Netscape, 22 1929 stock market crash, 26 North American Free Trade Agreement (NAFTA), 16 Online trading, 165–66 Only Yesterday: An Informal History of the 1920s (Allen), 154 Operating earnings, 68 Options, 138–39 Overdiversification, 169 Patriotic investing, 169–70 Pattern recognition, rational stock market behavior and, 51 P/E ratios as predictor of future returns, 61–67 of S&P 500, 69–70 for valuing stock market, 59–67 Pets.com, 24 Portfolios. See Investment portfolios Prospectuses, reading, 131–34 Protestant ethic, 19 Random Walk Down Wall Street, A (Malkiel), 46 Rational stock market behavior, human traits preventing, 48–54 Real estate, as better investment than stocks, 151–56
Reported earnings, 68–71 Research, Wall Street, 162–63 Retirement adequacy of savings and, 177–80 calculating money required for, 173–76 four simple rules for, 183 Social Security and, 180–82 Rigas, John J., 65 Risk investing and, 55–56 reducing, in stock portfolios, 138–39 Roaring Twenties period, 12–14 Roth IRAs, 82 Rubin, Robert, 21 Sarbanes-Oxley Act, 66, 162 Savings, adequacy of, and retirement, 177–80 Schwed, Fred, Jr., 8–9 Sector funds, 114–17 Self-confidence, rational stock market behavior and, 49–50 Short-term interest rates, versus long-term, 95–96 Siegel, Jeremy, 22 Small-cap funds, 124–26, 142–43 Smith, B. Mark, 14 Smith, Edgar Lawrence, 13 Social Security, 180–82 Socially responsible funds (SRFs), 128–30 South Sea Bubble, 12 S&P 500 Index fund, 141–42, 145 S&P 500 P/E ratio, 69 locating, 70 Spiders, 102. See also Exchange traded funds (ETFs) Stock Cycles: Why Stocks Won’t Beat Money Markets Over the Next Twenty Years (Alexander), 3–4
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Stock market. See also Bubbles; Myths, about stock market distribution of annual returns for, 6 1929 crash of, 26 P/E ratio for valuing, 59–67 reaction of, to bad news, 53 war and, 39–40 Stock market behavior, human traits preventing rational, 48–54 Stock market bottoms August 2, 1990, 35–36 July 1932, 29–31 March 11, 2003, 38–40 October 3, 1974, 31–32 October 19, 1987, 33–35 psychology of, 40–41 recognizing, 42–44 September 11, 2001, 37–38 Stock market returns, P/E ratios as predictor of, 61–67 Stock options, 65 Stock portfolios. See Investment portfolios Stocks, 143 buying, 96–98 historical performance of, 4–6 reading prospectuses for, 131–34 Talem, Nassim Nicholas, 51 Tax-deferred variable annuities, 82 Technical analysis, 165 Technology funds, 143 Timing, market, 161–62 TIPS. See Treasury InflationProtected Securities (TIPS)
Traditional defined benefit plans, 81 Treasury bonds, 83–84 Treasury Inflation-Protected Securities (TIPS), 85 Tulip Mania, 12 Tversky, Amos, 49 Tyco International, 65 United States in late Nineties, 20–25 1929 stock market crash, 26–27 Roaring Twenties period of, 12–14 Value funds, 111–12 Value investing, 64–65 Vanity, rational stock market behavior and, 54 Variable annuities, tax-deferred, 82 Vignette Corporation, 164 Vipers, 102. See also Exchange traded funds (ETFs) Volcker, Paul, 42–43 Wall Street research, 162–63 Wars, stock market and, 39–40 Weber, Max, 19 Webvan, 24 Where Are the Customer’s Yachts? (Schwed, Jr.), 8 Wolman, William, 43 Yahoo!, 22, 24 Yang, Jerry, 24 Yield curve analysis, 73–75
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