The Best Investment Policy
Could it be that the most successful investment of the last 20 years will be the least successful for the next 20?
That is the burden of today’s letter: that a single decision made 20 years ago would have made you a very successful investor…and that a similar, but opposite, one today may produce comparable results in the future.
Like so many other things in life, a lot of sound and fury is expended in the investment world with no positive consequence.
My old friend Mark Hulbert has been tracking the progress of investment advisors for more than a quarter of a century. Recently he studied the relative importance of the three major investment variables: stock selection, market timing and what he calls “investment policy,” which might be better known as asset allocation.
Most investors work hard at stock selection. Many also worry about market timing. But few pay much attention to asset allocation. A young man assumes that he should have most of his money “in the market,” by which he means “in stocks.” An old man may want to take some of his money out of the market and spread it around a bit. The older man worries about the “volatility” of stocks – – preferring the stability of bonds and real estate. In any case, little thought or effort is typically given to the “investment policy” decision.
This, it turns out, is a mistake. By an overwhelming margin, it is the “investment policy” that matters. Stock selection and market timing contributed little to the performance of the advisors Mark tracked. But the basic choice — to be in stocks, bonds, commodities or cash — was decisive. A typical portfolio might have an annual return of, say, 12% based on its decision to be 50% in stocks and 50% in bonds, for example. Timing typically added less than 1% to the overall returns. And selecting stocks was nearly as likely to reduce the overall return as enhance it. That is, once an advisor made the decision to be “in stocks” — his stock selections were rarely better than the market averages.
I pointed out yesterday how a single simple decision back in 1978 — to get out of gold and into stocks — would have multiplied your wealth by a factor of 30. That is what you would have gotten had you simply put the money into a Dow index fund — or thrown darts at the Dow to make your selection. If you’d selected the Nasdaq, your wealth would have increased 90-fold.
Forget market timing. Forget stock selection. The key was merely to change the allocation from 100% gold to 100% stocks. Some investment geniuses did beat the averages, but most of the money was made simply by being in the right place at the right time and having the discipline to stay there.
All you had to do was to invest in the Nasdaq or the S&P 500 and you would have gotten spectacular returns for the last five years. The S&P 500 return for ’95 was 37.5%. It was 22.9% in ’96, 33.3% in 97, 28.5% in ’98 and 21% in ’99. Thus, an investment of $100,000 would have turned into $350,000 in short order.
According to a recent Gallup Poll, U.S. investors now expect to make about 20% per year for the next 10 years in stocks. On the evidence, this is a modest hope. The returns for the last five years were closer to 30%. In fact, the S&P has produced 20% average annual increases ever since 1982!
No wonder that investors are changing their investment policies in a big way to take advantage of this opportunity. The American Association of Individual Investors, which also published Mark’s findings, reports that U.S. investors allocated 43% of their money to stocks in 1990. By 1999, the portion in equities had risen to 75%.
This decision — to switch money from other investments into equities — will turn out to be the most important decision these investors make. But not only are people moving from bonds, cash and real estate into stocks…they are moving into the riskiest stocks they can find. During the month of November last year, for example, $19 billion was invested in equity mutual funds. Of that, $15.1 billion went into aggressive growth and technology sectors.
Investors withdrew $1.8 billion from more conservative stock and income funds…and another $7.25 billion from conservative bond funds. No wonder the Nasdaq rises while the rest of the market falters.
But while stock prices rose by 30% per year, earnings for the S&P 500 grew by only 8% per year. This disparity is unsustainable in the long run. Because, ultimately, the only reason to invest in public companies is for the profits they produce. Markets can soar on the hope of profits…they can glide on the memory of profits…but it is only upon real, actual profits that they can rest.
Competition keeps profits down. Always has, always will. But assuming corporate profits rose at the fantastic rate of 10% per year, it would still take 20 years for earnings to catch up with stock prices. That is the estimate, from Howard Bill, I reported yesterday. Stocks would have to return zero percent per year for two decades — while the economy turned in the strongest performance ever — in order to get the two back in sync.
Another way to look at this is to examine what the world would look like if investors’ expectations were realized. It would mean annual growth of stocks of 20% per year for another 10 years. Since competition keeps business earnings well below half that level, this would further separate the world of Wall Street and equity prices…from the world of Main Street and what is really happening in the business world. In fact, as reported in an earlier letter, it would mean that the stock market would grow to be worth more than four times total GDP by the end of the decade. Is this possible? Well, anything is possible, but it would be such an incredible distortion…I cannot even imagine what it would mean.
Your most important investment decision may be the one you’ve thought the least about. It is not which stocks to buy. Nor when to get into or out of any particular sector. Instead, the most important decision is whether to be “in the market” at all. The best thing you could have done over the last 20 years was simply to put your money into stocks and forget about it. But stocks were cheap 20 years ago. They are hardly cheap today. What’s more, they reacted to a sequence of events that pushed them up to extraordinary levels. I will describe those events tomorrow. You will see that they cannot be repeated. Regards,
Paris, France February 24, 2000
*** Well…just like that wily bear. Just when we think the Nasdaq has hit a top (last Thursday) the furry fiend fakes a fadeaway…fooling fellows who favor fictions and fantasies over finer and more formidable fortunes.
*** Whew! All the major stock market indices and sectors are in bear markets. But not the Nasdaq. Not yet.
*** The bear knows that as long as the Nasdaq is rising, he can continue his work undisturbed by the press. The Dow fell 97 points yesterday. And the A/D ratio — following the number of stocks that are going down on the NYSE as opposed to the number going up — fell too…as it has been doing ever since the April 4, 1998. There were 1,235 advancing issues as opposed to 1,756 declining ones.
*** Fourty-six stocks hit new highs. But 219 hit new lows.
*** But over in fantasyland, the incredible gap between the price of gold and the price of a Nasdaq share grew even wider yesterday. The Nasdaq went up 168 points. The Nasdaq 100 soared an incredible 200 points!
*** AOL is back up to $56. It’s a bear market bounce…most likely.
*** Gold, meanwhile, fell $5.30 to close at $302. And palladium, which I warned you not to trust, fell $96 [March contract].
*** When will the bear turn his attentions to the Nasdaq? Who knows, but he will.
*** If I were you, I wouldn’t trust the Nasdaq anymore than you trust the price of palladium. Both are aberrations…not genuine increases in value. Just look at the charts. They are like mountain peaks. Do the lines just keep going up forever? No, they turn down. Every mountain eventually reaches a peak. You know when you get there — because the only way from there is down.
*** Also, climbing mountains is dangerous. Oxygen gets thin at high altitudes. It affects the climbers’ judgment. They make mistakes and die. And it is more dangerous coming down than going up.
*** Ask the tech, Net and biotech bulls, of course, and you will get a completely different answer. They think a huge transfer of wealth is occurring — shifting money from the Old Economy to the new one. They see no reason why the Nasdaq Rocket Chips cannot continue to soar into space…even while most stocks slump.
*** “In this market, you can easily earn 20% per year,” said Miss May Mallouh to the reporter from the “Wall Street Journal.” “Even in a down market you can earn 8% — 10%.” Miss Mallouh was describing why she used her stock portfolio as collateral for a mortgage loan — rather than selling some shares to get the cash to pony up for a down payment.
*** Earn 8% to 10% in a down market? Miss Mallouh’s frame of reference must be a lot shorter than her stock positions. She has no idea what a down market is. Stocks fell 90% from ’29 to ’33.
*** But the height of the Internet frenzy was perhaps recorded on the other side of the planet yesterday. A company with $6.7 million in sales for last year…but with $10.3 million in losses…opened itself up to public investors. More than 1 million applications for the shares of the Hong Kong company were received. C.M. Law, perhaps a distant cousin of Miss Mallouh, was quoted as saying, “I don’t really know what kind of business they’re in. I know it’s some kind of technology company, like Amazon.com.”
*** Yes…Tom.com is a bit like Amazon.com. Both are Internet companies. Both lose money. And both have had investors lining up to buy them. In the case of the latter, the line was a figure of speech. But nearly 50,000 people stood in line to buy Tom.com. As the deadline approached, 100 police officers had to be called in to maintain order.
*** Even Tom.com will have to show a profit someday…somehow. This will mean, I am sorry to inform Ms. Law, that it will have to sell products to the real world, not just a good story to gullible investors.
*** Things get out of whack from time to time. But that’s what bear markets are for. That’s when, according to the old timers, “money goes back to its rightful owners.”
*** Meanwhile, the dollar has fallen below parity with the euro. This is worth watching. If the dollar falls — the whole thing takes a turn for the worse: stocks, bonds, inflation, interest rates, GDP. It would not be pretty.
*** In fact, Richard Russell thinks it’s already not very pretty — this is the “most grotesque stock market in Wall Street annals,” he says.
*** Russell refers to the way a handful of stocks continue to exceed all rational expectations, while the great majority are in bear trends. Not only that, but the financial news media seems unable to spot the underlying trend. No mention of a bear market — even now, with the Dow down 11% for the year.
*** I had dinner last night at the oldest restaurant in Paris, Le Procope on the rue de l’Ancienne Comedie. I was surprised that the place was so packed. It was turning away people. But it is a good restaurant and worth a visit the next time you are in town. Be sure to reserve a table.
*** “Pokemon Is Attacked!” is the Reuters headline. “Pokemon is not as innocent as some believe,” the Mexico City Archdiocese said Monday. It is said to incite violence among children. Apparently, there are even “sexual perversions” in the cartoon series. My two youngest boys are Pokemaniacs.
*** Oops… This letter should have been written on the train to London. But I got to the Gare du Nord this morning and discovered that I had forgotten my passport. Oh well, I’ll go next week.