Bold conviction, meet event risk. Oil above $60 a barrel, the specter of economic weakness and fears of inflation have combined to spook investors. Indeed, thanks to the recent stock-market slump, both the Dow Jones Industrial Average and the Standard & Poor’s 500-stock index are underwater for the year.
Yet such turmoil is par for the course. I got my first job in financial journalism 20 years ago, and I am still waiting for things to calm down. Consider what’s happened:
The Dow industrials plunged 22.6 percent on a single day in October 1987.
Japanese stocks peaked in 1989—and today are 65 percent lower.
Twice in a dozen years, stock investors were rattled when the U.S. went to war with Saddam Hussein.
The largest one-day point drop ever in the Dow industrials occurred when the market reopened after the Sept. 11, 2001, terrorist attacks.
The S&P 500 posted 20 percent-plus gains in five consecutive calendar years in the late 1990s—and then immediately got whacked with three consecutive losing years.
Yet, despite all this turmoil, many folks continue to insist that 10 percent is the typical annual return for stocks. Sure enough, the S&P 500 did indeed clock 10.9 percent in 2004.
But a “normal” year like 2004 is, in truth, far from normal. Over the past 20 calendar years, there have been just three years when the S&P 500’s annual return was above 6 percent but below 16 percent, according to Chicago’s Ibbotson Associates.
What about the other 17 years? Among them were nine years when the S&P 500 soared 20 percent or more and four years when it lost money.
Looking good. Thanks to this year’s lackluster market, stock valuations don’t look so terrible. The S&P 500 is at less than 19 times trailing 12-month reported earnings and the dividend yield now hovers around 2 percent. While that may be rich by historical standards, stocks look reasonable compared with 10-year Treasury notes, which yield less than two percentage points above the likely inflation rate.
That said, if we get a single scary headline, stocks could easily tumble 20 percent or more. Experts in behavioral finance have found that investors tend to be far too confident.
Real-estate investment trusts? Gold shares? Florida condos? Energy stocks? Overconfident speculators are convinced these highflying investments are a one-way ticket to wealth.
But a few years from now, we could be lamenting these investments the same way we now lament tech stocks bought in the 1990s. My advice: Never forget what happened to dotcom investors—and build your portfolio with well-informed trepidation.
Looking down. To that end, consider three key investment pitfalls: resurgent inflation, recession and sudden crises that shake investor confidence. In that last category, include the fallout from events like currency devaluations, political turmoil and terrorist attacks.
How would your investments perform in each scenario? In all three situations, money-market funds, Treasury bills and other “cash investments” would be the model of stability. But loading up on cash investments is no solution, because you won’t make money over the long run, once you figure in inflation and taxes.
Instead, to score decent gains, you’ve got to take more risk, and that means tapping into the stock and bond markets. But keep your overconfidence—and your portfolio’s risk level—in check.
Take bonds. You might spread your holdings across a mix of high-quality corporate and government bonds, inflation-indexed Treasurys, high-yield “junk” bonds and foreign bonds, knowing that only some of these sectors will do well at any one time.
For instance, if recession hits, junk bonds will get crushed as investors fear defaults. But your high-quality bonds should post gains, thanks to the likely fall in interest rates. Investors will also tend to flock to high-quality bonds, especially Treasurys, during crises of confidence.
On the other hand, conventional Treasurys would get pummeled by resurgent inflation. But in that environment, your inflation-indexed Treasurys should hold their own. And if the renewed inflation is sparked by an overheated economy, your junk bonds could notch impressive gains.
Foreign bonds, for their part, are a wild card, because currency moves are impossible to predict. That, however, is part of their allure.
When everything else fails, your foreign bonds may ride to the rescue, helping to prop up your portfolio’s performance. That will be especially true if the next crisis is triggered by worries over U.S. debt levels.
You can apply the same analysis to various classes of stocks, except the potential gains and losses are far larger. While an inflationary spike might dent stocks initially, shares should fare well longer term, as corporate earnings climb with inflation.
Recession would also cause short-term trouble for stocks. Meanwhile, it’s hard to know how shares will react to the next crisis. Given all that, you should spread your bets widely, always owning at least some bonds and allocating maybe 25 percent of your stock portfolio to foreign shares, 5 percent to real-estate investment trusts and 5 percent to gold stocks, commodities and other natural-resource plays.
REITs and natural resources should perform well if inflation picks up, and foreign stocks could save your portfolio if the dollar nose-dives. But who really knows? Investing is racked with uncertainty—and broad diversification is your best defense.