Part 5 (2/2)

But there are also times when growth stocks demonstrate their own peculiar risks. As we'll see in the next chapter, from time to time, the public becomes overly enthusiastic about the prospects for companies at the leading edge of the era's technology. These growth stocks can appreciate beyond reason-as happened in the late 1990s in the technology and Internet areas. When the bubble deflates, however, large sums can be lost. On the other hand, we usually don't have to worry about a bubble in bank, auto, or steel stocks.

There can be no question that small stocks are riskier than large stocks. Small companies tend to be insubstantial and fragile. More importantly, they are thinly traded-relatively few shares change hands during an average day, and in a general downturn, a few motivated sellers can dramatically lower prices. From 1929 to 1932, small stocks lost 85% of their value, and from 1973 to 1974, a 58% loss was incurred. Why invest in small stocks at all? Because over the very long haul, they do offer higher returns; this is particularly true for small value stocks, as we saw in Figure 1-18 Figure 1-18.

How much of your portfolio should be held in small and value stocks? Again, it depends on the amount of tracking error you can tolerate. Small stocks and value stocks can underperform the broad market indexes for very long periods of time-in excess of a decade, as occurred in the 1990s. To demonstrate this, I've plotted the returns of the market, small stocks, large-value stocks, and small-value stocks for the past three decades in Figure 4-10 Figure 4-10. From 1970 to 1999, small-value stocks had the highest return (16.74% annualized), followed by large-value stocks (15.55%), the S&P 500 (13.73%), and small stocks (11.80%).

But Figure 4-10 Figure 4-10 also shows that during the last ten years of the period, this pattern was virtually reversed, with the S&P 500 being the best-performing a.s.set, and small value stocks, the worst. So, again, it comes down to tracking error: how long are you willing to watch your portfolio underperform the market before it (hopefully) turns around and pays off? If you cannot tolerate playing second fiddle to your more conventionally invested neighbors at c.o.c.ktail parties, then small stocks and value stocks are not for you. also shows that during the last ten years of the period, this pattern was virtually reversed, with the S&P 500 being the best-performing a.s.set, and small value stocks, the worst. So, again, it comes down to tracking error: how long are you willing to watch your portfolio underperform the market before it (hopefully) turns around and pays off? If you cannot tolerate playing second fiddle to your more conventionally invested neighbors at c.o.c.ktail parties, then small stocks and value stocks are not for you.

What is the maximum you should allot to small stocks and value stocks? This is a tremendously complex subject that we'll tackle in some detail in Chapter 12 Chapter 12. In general, you should own more large-cap stocks than small-cap stocks. In the large-cap arena, you should have a reasonable balance of value and growth stocks. Small-growth stocks have relatively low returns and high risks, so your allocation to small value should be much larger than to small growth. But realize that the more you stray from the S&P 500, the more often your portfolio will dance to its own drummer. This will distress investors who do not like to temporarily underperform the market.

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Figure 4-10. S&P 500, small, large value, and small value, by decade. ( S&P 500, small, large value, and small value, by decade. (Source: Dimensional Fund Advisors, Morningstar Inc.) Dimensional Fund Advisors, Morningstar Inc.) Step Four: Sectors What about industry sectors: tech, autos, banks, airlines, and the like? They are hardly worth the trouble; once you're exposed to the whole market via an index fund, you already own them. The only way you can improve on the market return by using sectors is by picking the areas with the future highest returns. And, as we've already seen in the preceding chapter, lots of luck.

There's another reason why it's generally a bad idea to focus on sectors: they can virtually disappear. For example, at the turn of the last century, railroad companies const.i.tuted most of the U.S. market's total value. But by 1950, they had been devastated by the automobile and the aircraft. In 1980, the market was dominated by oil stocks, but within a decade, they had shrunk to one-quarter of their former share of market capitalization. The real risk in the sector game is that you may wind up owning the next generation's buggy whip and leather industries.

But with some trepidation, I think that there are two sectors worth considering: REITs (real estate investment trusts) and precious metals stocks. Of the two, a much stronger case can be made for REITs. Their historical returns, as well as their expected future returns, are probably comparable to the market's. And, as we saw a few pages ago, they can do quite well when everything else has gone down the tubes. Unfortunately, the same table showed that the opposite is also true: they can do poorly when the rest of the market is going great guns. (Or, as Dan Wheeler of Dimensional Fund Advisors puts it, the problem with diversification is that it works, whether or not we want it to.) Again, it all comes down to tracking error: how much does it bother you when an a.s.set grossly underperforms the rest of the market? Because of the high volatility and tracking error of REITs, the maximum exposure you should allow for this a.s.set cla.s.s is 15% of your stock component.

Precious metals stocks-companies that mine gold, silver, and platinum-historically have had extremely low returns, perhaps a few percent above inflation. Not only that, they tend to have very poor returns for very long periods of time and are extremely volatile. Why expose yourself to this a.s.set cla.s.s? For three reasons.

First, precious metals stock returns are almost perfectly uncorrelated with most of the world's other financial markets. During a global market meltdown, they are liable to do quite well. For example, from 1973 to 1974, gold stocks gained 28%. We don't have exact returns for gold stocks from 1929 to 1932, but anecdotally, they seemed to have done quite well at that time as well, when everything else was getting hammered.

Second, precious metals stocks will be profitable if inflation ever again rears its ugly head. During such periods, ”hard a.s.sets” such as precious metals, real estate, and ”collectibles” (e.g., art, rare coins, etc.) tend to do very well.

And third, this a.s.set's random volatility will work in your favor via the rebalancing mechanism. If you can hold precious metals stocks in a retirement account and trade them without tax consequences, the natural buy-low/sell-high discipline of the rebalancing process should earn 3% to 5% per year in excess of the low baseline return for this a.s.set. Be forewarned that this process takes discipline, because you will be continually moving against the crowd's sentiment. While you are selling, you will be reading and hearing some very compelling reasons to buy, and when you are buying, you will find that others consider it an act of lunacy.

This brings up a very interesting point about a.s.set cla.s.ses in general. Some bring a bit more to the portfolio than their historical rates of return would suggest. The benefit occurs when an a.s.set is extremely volatile and does not move in synch with the rest of the market. Gold stocks are the epitome of this behavior. REITs, emerging markets stocks, and small international stocks also do this. In general, this kind of behavior can only be taken advantage of in sheltered accounts or in accounts that have high inflows of funds, as it is dependent on the rebalancing technique discussed above.

That said, precious metals are strictly optional. If gold stocks make you queasy, don't buy them. But if you do buy this a.s.set cla.s.s, it should be no more than a few percent of your portfolio.

Some Working Ill.u.s.trations It's time to show you what the overall process looks like with a few examples. First of all, to reiterate: there will be an optimal allocation among different kinds of stocks over the next 10, 20, or 30 years. Unfortunately, there is no way of knowing in advance what it will be. there is no way of knowing in advance what it will be. (Over the shorter periods, it will likely consist of a 100% allocation to the best-performing a.s.set, and over longer periods, to a mixture of two or three of them.) The important thing, then, is that your a.s.set allocation be properly diversified and behave tolerably well under most circ.u.mstances. (Over the shorter periods, it will likely consist of a 100% allocation to the best-performing a.s.set, and over longer periods, to a mixture of two or three of them.) The important thing, then, is that your a.s.set allocation be properly diversified and behave tolerably well under most circ.u.mstances.

Let's start with a theoretical fellow named Charlie Cringe. Charlie hates investing and wants to keep it as simple as possible. Further, it drives him nuts when his neighbor, Harry Hubris, brags about how well his blue chips are doing. Charlie's no spring chicken: he'll be retiring in a few years and has lived through a few bear markets. He knows that he can't sleep at night owning more than 50% stocks. Here's a reasonable allocation for Charlie: * 35% U.S. stock market (the ”total market,” not just the S&P 500)* 10% Foreign stocks* 5% REITs* 50% Short-term bonds The performance of the equity portion of Charlie's portfolio will never stray too far from that of the overall market, making c.o.c.ktail hour with Harry much less stressful. Best of all, he should only have to spend a few hours per year following and rebalancing his portfolio.

On the other hand, consider Wendy Wonk, who runs the computer network in the accounting department of a large company. She's 28 years old, and numbers don't scare her one bit. Not only that, but she inherited her father's love of investing and is something of a risk taker. Here's what Wendy might do: * 10% S&P 500* 10% U.S. large-value stocks* 5% U.S. small stocks* 7.5% U.S. small-value stocks* 7.5% REITs* 2.5% Precious metals stocks* 10% European stocks* 7.5% j.a.panese and Pacific Rim stocks* 7.5% Emerging markets stocks* 7.5% International value stocks* 25% Short-term bonds First, note that she's at 75/25 stocks/bonds. This is about as much equity exposure as anyone should have, given the expected returns of stocks and bonds. Next, notice that nearly half of her stock exposure is foreign, and that only a small corner of it owns the S&P 500.

The next cubicle happens to be occupied by an unpleasant creature named Bonnie Bore, who's forever going on about her Microsoft options. But Wendy knows that Bonnie couldn't invest her way out of the lady's room, and on days when the big blue chips soar above all other a.s.set cla.s.ses (and Wendy's portfolio), she couldn't care less.

Finally, this is not a simple portfolio: Wendy owns no less than ten different stock a.s.set cla.s.ses; she tells me that she's thinking of adding in some junk and international bonds, and I can't come up with good reasons not to.

Wendy will probably do better than Charlie. Not only does she have a higher stock exposure, but she's also much more exposed to value and small stocks, which should earn higher returns. Of course, we can't be sure-in finance, nothing's for certain. But even if we knew positively that she would have better returns than Charlie, he's still better off sticking with his less efficient portfolio. He'll be able to manage it without exhausting his limited patience for finance and stay the course when the chips are down.

Charlie and Wendy are only two extreme ill.u.s.trations. For example, a case mid-way between the two might look like this: * 25% U.S. total stock market* 10% U.S. large-value stocks* 10% U.S. small-value stocks* 5% REITS* 10% Foreign stocks* 40% Short-term bonds Your a.s.set allocation may need to be radically different from the above examples based on your own circ.u.mstances, the most critical being your tax structure. (That is, how much of your a.s.sets are held in ordinary taxable accounts, and how much in sheltered retirement and annuity accounts.) We'll explore this in much greater detail in Chapter 12 Chapter 12.

The comparison between Charlie and Wendy highlights the tradeoff between the benefits of diversification and the pain of tracking error. The superior expected return and risk of a highly diversified portfolio come at the price of tracking error-the risk that your portfolio will significantly lag the S&P 500, and thus the portfolios of your friends and neighbors-for years at a time, as happened during the late 1990s.

CHAPTER 4 SUMMARY.

1. Past portfolio performance is only weakly predictive of future portfolio behavior. It is a mistake to design your portfolio on the basis of the past decade or two.2. Your exact a.s.set allocation is a function of your tolerance for risk, complexity, and tracking error.3. The most important a.s.set allocation decision revolves around the overall split between risky a.s.sets (stocks) and riskless a.s.sets (short-term bonds, bills, CDs, and money market funds).4. The primary diversifying stock a.s.sets are foreign equity and REITs. The former should be less than 40% of your stock holdings, the latter less than 15%.5. Exposure to small stocks, value stocks, and precious metals stocks is worthwhile, but not essential.

PILLAR TWO.

The History of Investing.

When Markets Go Berserk.

About once every generation, the markets go barking mad. When this happens, most investors sustain serious damage, many are totally ruined. Unless you have been living at the bottom of a well these past several years, you are keenly aware that we are in the midst of such a period.

Markets can crash, but it is less well known that markets can also become depressed for decades at a time. The following two chapters will deal with the periods of euphoria and depression that occur on a fairly regular basis. The average investor lives through at least a few markets of both types.

Even with an appreciation of their behavior, dealing with both buoyant and morose markets is difficult. Sometimes even the best-prepared can fail. But if you are unprepared, you are sure sure to fail. to fail.

5.

Tops: A History of Manias Progress, far from consisting in change, depends on retentiveness. Those who cannot remember the past are condemned to repeat it.

George Santayana There is nothing new-only the history you haven't read.

Larry Swedroe Men of business have keen sensations but short memories.

Walter Bagehot To many readers, this section on booms and busts will seem out of place. After all, this book is a humble how-to tome; it has no pretension of being a doc.u.mentary work. But of the four key areas of investment knowledge-theory, history, psychology, and investment industry practices-the lack of historical knowledge is the one that causes the most damage. Consider, for example, the princ.i.p.als of Long Term Capital Management, whose ignorance of the vagaries of financial history almost single-handedly brought the Western financial system to its knees in 1998.

A knowledge of history is not essential in many fields. You can be a superb physician, accountant, or engineer and not know a thing about the origins and development of your craft. There are also professions where it is essential, like diplomacy, law, and military service. But in no field is a grasp of the past as fundamental to success as in finance.

Academics love to argue whether the primary historical driving forces over the ages are repet.i.tive and cyclical or non-repet.i.tive and progressive. But in finance, there is no controversy: the same speculative follies play out with almost clock-like regularity about once a generation. The aftermaths of these binges are a bit less uniform, but just as worthy of study.

I'm writing this chapter with great trepidation, because as my keyboard clacks, we are likely just past the cusp of one of the greatest speculative bubbles of all time. For this generation, the horses are already out of the barn, and it may be another 30 years-the typical interval between such episodes-until the warning implicit in this story is again fully useful.

I do not know if this time we will see the usual sequel that issues from periods of speculation, in which prices plummet as investors flee all except the safest securities, having previously embraced the riskiest. Although this chapter has just lost much of its timeliness, it is still the most important one in the book. For even if you can master the theory, psychology, and business of investing, your efforts will still come to naught if you cannot keep your head when everyone around you has lost his.

General Considerations Manifestly, technological progress drives economic progress, which in turn drives stock prices. Should some malign force suddenly stop all scientific and technological innovation, then our standard of living would remain frozen at the present level; corporate profits would remain stationary, and stock prices, although fluctuating as they always have, would not experience any long-term rise. This point cannot be made forcefully enough: the great engine of stock returns is the rate rate of technological progress, not its absolute level. of technological progress, not its absolute level.

I recently spoke at an investment conference at which a member of the audience, knowing that I was a physician, asked how the great strides in biotechnology were revolutionizing my medical practice. My reply was that these advances-gene therapy, DNA-based diagnostic testing, the flow of new surgical and angiography tools-had brought only marginal improvements on a day-to-day basis.

In fact, the greatest single advance in medicine occurred more than six decades ago, with the invention of sulfa drugs and penicillin. At a stroke, literally millions of lives, which had been previously lost to diseases such as bacterial pneumonia and meningitis, could now be saved. Not only that, those saved were predominantly the young. In contrast, today's advances disproportionately benefit the elderly. I do not think it likely that we shall again see the kind of medical progress experienced at the dawn of the antibiotic era.

We tend to think of technological progress as an ever-accelerating affair, but it just isn't so. Technological innovation comes in intense spurts. And the most impressive blooms were not at all recent. If you want to see the full force of scientific progress on human affairs, you have to go back almost two centuries. The technological explosion that occurred from 1820 to 1850 was undoubtedly the most deep and far reaching in human history, profoundly affecting the lives of those from the top to the bottom of the social fabric, in ways that can hardly be imagined today. Within a brief period, the speed of transportation increased tenfold, and communications became almost instantaneous.

For example, as late as the early 1800s, it took Jefferson ten days to travel from Monticello to Philadelphia, with considerable attendant expense, physical pain, and peril. By 1850, the steam engine made the same journey possible in one day, and at a tiny fraction of its former price, discomfort, and risk. Consider this pa.s.sage from Stephen Ambrose's Undaunted Courage: Undaunted Courage: A critical fact in the world of 1801 was that nothing moved faster than the speed of a horse. No human being, no manufactured item, no bushel of wheat, no side of beef, no letter, no information, no idea, order or instruction of any kind moved faster. Nothing had moved any faster, and, as far as Jefferson's contemporaries were able to tell, nothing ever would.

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