The US Government passes a $700 billion bailout (or rescue) package, and the markets continue their spiral down. Financial advisors across the country are shouting, “Stay the course!” (Usually from under their desks.)
This crisis is unlike anything we’ve seen in recent history (and perhaps not-so-recent history); so, what should we do now?
First, Stocks Stink. Consider Buying Bonds.
One year ago (actually, on October 11, 2007) the S&P 500 topped out at 1,576.09. Today, it hit 1,007.97 – a 36% loss. From top to bottom, the Dow lost 32% over the past year. While the news is reporting that we closed at 2004 levels, I think a much more sobering reality needs to be addressed: Over the past ten years – from October 8, 1998 through today’s close – the Dow has grown just 2.6% on average for ten straight years.
Add in dividends, take out some management fees and commissions, and you’re lucky to have a 4% or so return for a decade.
(And I won’t say anything about how irresponsible, foolish, or downright fraudulent some of Wall Street’s finest were over those ten years. Remember Lucent? WorldCom? Enron? Merrill Lynch? Bear Stears? Really – I don’t want to beat a dead horse.)
(Morons.)
What can Joe and Jane American learn from all this volatility? First off, remember that stocks stink! A portfolio of solid bonds would have crushed the stock markets over the past ten years; and, while I don’t necessarily advocate 100% bonds for everyone, I do think that most people should own them.
Wall Street doesn’t talk about bonds except to the extent that they try to get you to buy bonds funds. Individual bonds are not very profitable to Wall Street; bond funds will pay your broker the quarterly kickbacks and allow you to be put on the back burner. (What adviser wants to track all those individual maturities or have to actually do some research?)
That leads me to my first point: Beware of bond funds.
The Danger of Bond Funds
Simply put, when you invest in a bond fund, you give the manager $x to purchase bonds. The manager then takes your cash, pools it with cash from other investors, and buys bonds of varying maturities.
Sounds pretty harmless.
The problem with bond funds is not in the buying, but in the selling. When investors sell their bond funds, the manager must generally sell bonds to pay the investors. The problem is that bond prices change; so, the manager might have to sell some bonds that you personally would have held to maturity.
How does this affect you? Consider this: You want to hold bonds for income and stability; but, in bond funds, your income and stability is directly affected by the actions of other investors. If a ton of people are buying into your bond fund today, your manager will be forced to buy bonds for you in a low interest environment. Then, when those same investors want to get out of that bond fund in five years – and if interest rates are higher – your manager might have to sell those low interest, now low priced bonds at a loss.
At the end of the day, you got a raw deal.
Instead, focus on buying individual bonds with the goal of holding them until maturity. If you buy a high quality bond offering a 5.5% yield until June of 2009, you know exactly what to expect – a 5.5% return for two years, and a definite dollar amount upon maturity, regardless of how happy or scared other investors are.
In short, don’t let the panic and fear of other investors determine your return if your goal is stability, income, and a defined return.
Second, Realize That Volatility Is Here To Stay.
I’ll admit – 6% or 8% daily swings in the markets are out of line. Still, volatility is here to stay. If you recall from this earlier post, the average number of daily transactions in the markets have grown 562% over the past ten years. Every day, 4.4 billion transactions occur, each moving a stock price in a certain direction.
Over the past two weeks, this number has grown to more than 8 billion transactions. If you are waiting for things to calm down, you’ll be waiting a long time. There is simply too much excited money floating around to ever return us to consistently small and “comfortable” movements.
If 36% losses make you sick to your stomach, it’s time for a reality check and a new strategy. Diversification (ie. holding a bunch of investments) is not the key – asset allocation is what will help you sleep at night.
When you are putting money to work in stocks, you must have a completely iron constitution. If watching your portfolio drop 50% will make you nervous, you shouldn’t be 100% invested in stocks. Nobody likes 50% drops and we’d love to avoid them whenever possible; but, if you’re 100% invested and prices drop quickly with no fundamental change in your businesses, you’ll suffer some big temporary losses in your portfolio.
Combating Volatility the Intelligent Way
Many advisors will tell you that “diversification” will help mitigate losses and maximize returns. Then, they sell you a mutual fund that holds hundreds or thousands of stocks.
It doesn’t make sense.
If the key to growing and preserving wealth (as Buffett has said) is putting your money into great investments and great prices, how can it make sense to buy a basket of great, mediocre, and bad companies at great, mediocre, and bad prices?
As of June 30, AllianceBernstein Holding LP; ClearBridge Advisors, a subsidiary of Legg Mason Inc.; Fidelity Management & Research LLC; Barclays PLC unit Barclays Global Investors NA; Wellington Management Co.; and State Street Global Advisors were the mutual-fund managers with the largest stakes in Lehman’s stock, according to FactSet.
So said the Wall Street Journal on September 16, 2008. While most of the funds did not comment, Vanguard’s Rebecca Cohen had this to say:
If you look at the absolute number of shares, we end up as one of the larger holders of Lehman…but on a relative basis, it’s a relatively small portion of our funds.
Oops. We lost hundreds of millions of dollars of your money; but hey, you were diversified. You only lost a little (even though you shouldn’t have lost anything in Lehman).
The intelligent way to combat volatility is to realize how much volatility you can handle, and then invest the rest in bonds. If you take a step back and realize that 50% losses are possible, then you have a base for building your portfolio.
Comfortable with a 10% drop, but not a 15% drop? Invest 20% in stocks and 80% in bonds and cash. Okay with a 25% drop but not a 30% drop? Put half of your money in stocks and half in bonds.
Focus on intelligently allocating your portfolio, not on broadly diversifying into more and more mediocre and bad investments. After all, those broadly diversified, armchair investor stock and index funds are down just as much – if not more – than the markets right now.
Don’t Change a Darn Thing in Your Approach
It is times like these that many investors panic and change their investment strategy in stocks. The fact that the markets are down does not change the fact that:
- stocks are pieces of businesses with intrinsic values;
- the value is the amount of cash that can be taken out of the business during its remaining life; and,
- price follows value, even if it takes a few years for that to occur.
When we bought Johnson & Johnson last year, we looked sheepish, as though JNJ was a boring buy at $62 or so. A few months later, we looked really smart as JNJ topped $72 a share. Today, it was down as much as 14% from its near-$73 high, and many people are kicking themselves thinking, “Boy, I wish I took my profits $10 ago.”
Why did we buy Johnson & Johnson at $62? Because we saw more than $62 – and more than $72 – of value. As the company’s value continues to grow, we have to sit back patiently until Mr. Market is ready to realize it.
It may take a few months; it may be years.
Finally, Realize That It Will Be Better In a Few Years
I wish the internet was around in the 1970s. From its peak on January 11, 1973, the Dow began a two year, 47% slide from 1,067 to its December 9, 1974 low of 570. With no internet or stock market channel, most people continued on saving and investing, cognizant of the losses but not completely panicked or terrified.
Today, the doomsday crowd is calling for the end of the world and a total and final financial collapse. If we were to drop 47% from our high, the Dow would be 2,300 points lower at 7,568. Possible? Absolutely. Anything is possible.
But, like we did after the Great Depression and the 47% drop in 1973 and 1974, and like after so many other times throughout history, we will get through this, great businesses will be more valuable five- and ten-years from now, and price will eventually follow value.
Believe me – there are some very attractive bargains developing in this market, and you should look for them the same way you looked for them when the Dow was at 14,000.
Filed under: Economics & History
Related Stocks: JNJ
I’ve had a large part of my portfolio in bonds for a long time, but I’ll be slowly moving to equities from here on out. Companies with little debt, good cash flows are the place to be, cash is not only king for investors, but for companies as well, as they can pick up cheap assets and avoid high interest financing. Also a good time for them to buy back their own stock. I also second the notion to stay away from banks, unless you really know that stuff, which I do not. I’m staying away from consumer discretionary as well. WB might be able to buy Goldman and BAC and Wells and GE, but I won’t. I’ve been wanting some GE, but every time I look at that 500B debt I get vertigo.
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well said…
I think that something people are missing is just how bad it is that there is an amount of money that will probably never circulate again. When sub prime mortgages were floating around, there wasn’t anybody without a pulse that couldn’t get a home loan. This, coupled with a lot of mortgages that are simply not being originated for the time being (personally, as a landlord, it is HARD for me to get money… and I won’t buy any house unless I get margins of at least 40%) means that revenue and profits will be significantly less than they were in the past.
With this doomsday/chicken little-esque quip, you are right that there are a ton of bargains out there… I am shocked to see so many companies trade at levels that more or less value their earnings and growth at next to nothing. Yesterday, I bought shares in DRAM-which were trading for about 70% of their cash!
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Joe, I havent read all your post yet, something just POPS OUT:
DO you mean, it is better to be invested in BONDS, as a desirable % of portfolio, EVEN IF
you had the chance to invest on an INDEX FUND(whole stock market) at today’s prices?
It would seem like a good strategy as long as you believed the economy would recover. For example:
if you can buy the Economy’s Output at 2006-2007 levels, you would probably ENJOY a 30% gain in advance of FUTURE economic developments.
I think this CONTRADICTS your strategy somewhat but is worth to be scrutinized as I may be missing out on the bigger picture.
Say the economy recovers and grows after 5 years of low economic output; in other words, the Index fund could recapture 30% in 5 years = 6% per year.
On top of it all, you haven’t factored in “the INCREASE In the value of the future cash the businesses generate”; thus, you will likely NOT sell that index fund and you will get greater gains IN THE LONG-TERM.
I’ll post another premise for readers to share their opinions in a few days!(im busy trying to FIND the right professor to teach me Financial theories LOL)
..GREAT POST JOE, your DA MAN I’ll be trying hard to answer any questions that I can for you from our newest members.
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haha Renee… I feeel you on that GE pick! Its hard to accept a 3-4% CROIC but management is VERY DECENT compared to these other cronies running Lehman brothers lol
perhaps joe would LIKE to interpret this for our entertainment purposes of course!
(never take Joe’s advice to the letter. You should make OWN decisions and take RESPONSIBILITY is key here)
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Just to let you guys know HOW it “feels”
Im in for the long-term on MHP! I got in at 35$ just to see it drop days later to 25$.
It doesn’t hurt me one bit, I’m only interested in finding out if the business can deal and survive in the long-term given its duopolist nature of the debt rating industry.
FYI: Moody’s is more efficient(margins as a whole because it only serves financial segment) and has much lower Capex which makes for good investment. Only difference with MHP is that it has a 5-8% margin that contributes to diversifying its cashflows through its Dominant position as an educational platform(books/online courses) for MANY states and provincs(in Canada).
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This is a great site – I have learned a lot here. Thank you for sharing your insight, Joe.
The main question I have is: is it wise to buy American for the long term? A lot of the minimal growth of the S&P500 over the last ten years can be attributed to Sarbanes-Oxley, and with the increasing amount of make-it-up-as-we-go legislation, can’t we expect our economy to suffer more? Already our country is saddled with a lot of debt, and we can probably expect American companies to suffer for it via taxes. We also have the devaluation of the dollar to consider, which has been losing value for several decades now as opposed to other currencies.
With the bailout, the Iraq War, the future unfunded liabilities of Social Security, and the national debt, should we follow the advice of someone like Peter Schiff and move our investments overseas for the next few decades? Not just China, but Australia, New Zealand, India, and the like?
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tjv: I agree, but that’s advice for all markets. Stick with companies that don’t have to rely on debt or additional financing (ie., companies that can generate excess cash) and companies you can understand. If one can’t understand banks, one can’t tell whether or not they are down or cheap and have no business speculating in banks!
J: Ben Graham talked about the irresponsibility of Wall Street that led to the Great Crash and I always said he could have been writing those lines in 2002. I guess he could have written it in 2008 as well!
cg: I definitely see more potential downside than upside on a broad level. We are not headed for rapid growth in the next year or two — give or take a few months or years. At any given time, individual companies and their stocks can grow regardless of the direction of the overall markets; but, I wouldn’t be in any broad-based mutual funds or index funds right now.
If you have to try and time the markets — like in a 401k with no outside brokerage or separate account option and just a bunch of crappy mutual funds — I’d wait for more certainty and predictability (like in all investing). I can’t tell you that this certainty and predictability will come at Dow 10,000 or Dow 5,000 — you just have to wait and see how it plays out, and sock away as much cash as possible.
That said, I put orders in for an individual stock just this morning.
Amit D.: For most people, it’s not a matter of timing your investment in bonds versus index funds, it’s a matter of an overall strategy of bonds instead of index funds (or a combination of the two). My point is: Most people should be in bonds, in whole or in part, regardless of how attractively priced the markets or a particular stock might be.
Think about this: A nervous 45-year-old investor wants growth and safety, and can’t stomach the markets. Where should (s)he invest? No doubt, this investor has lots of options:
- stocks
- bonds
- real estate
- mutual funds
- options
- commodities
- futures
- precious metals
- currencies
- life insurance policies
- annuities
- private businesses
The list goes on and on. Most people immediately think stocks and bonds for growth and safety. Why? Because that is what Wall Street has hammered down peoples’ throats. Stocks and bonds, and preferably through mutual funds.
For decades before Wall Street really gained popularity with Jane and Joe American, bonds were the investment of choice for most people. Stocks were risky, misunderstood, or reserved for a very small portion of Jane and Joe American’s portfolio. Some things never change.
It’s time for Jane and Joe American to go back to the intelligent investing of the 1950s, and realize that a portfolio entirely or mostly in bonds is not bad or too scared considering that most people do not have the stomach or strategy for investing in stocks.
One last point on this: If someone told me a very compelling argument why the price of nickel will triple in the next year, it wouldn’t change the fact that my tolerance and expertise is not in nickel. Thus, I would not invest in nickel. Instead, I’d focus on my core competency and look for underpriced businesses, no matter how attractive the nickel potential was. That’s the kind of “intelligent investing” I think people need to make with their own money and strategies.
If stocks dumbfound Joe and Jane American the way that nickel escapes me, they shouldn’t be in stocks and I shouldn’t be in nickel.
Bill: I think investors can find opportunities in their home markets no matter where they are, unless their country is truly going to hell (eg. Zimbabwe — and we’re not there yet). The American economy needs to do some unwinding, and that can be a long, painful process. The Dow won’t be at 15,000 next October, and if it is — run! Still, opportunities will exist in American companies.
I’m all about investment freedom. (That’s why I hate what Wall Street has done to most 401k plans — setting restrictions on mutual funds, no separate accounts for a lot of companies, etc.) I don’t think you should ever narrow your scope down to one country (US or not). If you are comfortable looking at foreign companies, you should.
Other than the restrictions I impose on my own investing — restrictions that were set not by me, but by my sphere of confidence and competence — I would never say, “Don’t look at XYZ” or “Stay away from China” just because.
From a macro perspective, things are ugly the world over and other countries may offer more growth (and perhaps safety) on a broad index level — a serious consideration for mutual fund investors. Still, I wouldn’t worry about that if focusing on individual companies.
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Has anyone read Security Analysis and understand the entire book ? I bought the new edition and although it includes commantaries from leading value investors I still find this book difficult to read, specially the parts about bonds and fixed income investments. So I’m skipping those parts for now and reading the parts on stock investment. I don’t have a degree in Finance but I’ve taken a Financial Accounting class at community college. So if anyone has any advice on what I need to do to prepare myself so I can understand the concepts in this book I will be very grateful.
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I saw a stat on Bloomberg that said this decade starting with the year 2000 has been the worst so far for equity investors, even worse than 1930s. The stock returns since 2000 are -22 percent while bonds have return 86 percent for the period! I also recently heard an interview with Buffett where he said besides owning BRK, he has the rest of his personal portfolio in US Treasuries!
I’m also putting more buy orders in with this recent downturn.
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One trouble with investing in foreign companies is America is relatively low on the corruption and regulation scale (even after Sarbox, believe it or not!), which provides a lot of security and is good for business in general. Graft, bribery, patronage, access to markets, and so on eats away at profits and can cause some strange things in foreign markets. Europe and Japan are ok, but most other places have a lot of trouble with this phenomenon, and investors should be wary of the changing fortunes of foreign companies which may or may not be the result of being a well-run company.
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Amen, Joe. Now is the time to buy. It is no coincidence that Warren B is investing a lot of money right now. If folks are really afraid, they can invest in companies with no debt (that don’t care about the availability of credit, yeah?). …and stay away from banks right now.
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