by Steve Forbes
For investors this means: stay the course with your retirement money. With your other assets, proceed with caution.
The Importance of Taking the Long View
We can’t repeat it enough: your emotions are your enemy when it comes to investing your money.
A powerful real-life example of how emotions are misleading is the bear market that began in late 2007 and lasted for almost two years. In January 2009, while the financial panic had ended weeks before, stocks experienced the most dismal performance since January 1933 in the pit of the Great Depression. February 2009 was no better: it was the worst February for stocks since 1933.
The media abounded with speculation about the potential for a repeat of the Great Depression. Stocks, with few interruptions, kept sliding and sliding, almost to the point of oblivion. The Dow Jones Industrial Average, as we noted previously, fell 89% before the sickening slump ended. It was a virtual wipeout of equity value. We’ve had nothing even approaching this descent before or since. And yet today, not even counting reinvestment of dividends, the DJIA is 40 times higher than its pre-Depression high.
Nonetheless, many people, seeing their lifetime savings shrinking so rapidly in the violence of a bear market that seemed to have no end, decided to pull some money out of the market before it was all lost. Gallows humor about 401(k)s turning into 101(k)s couldn’t mask the psychological and financial devastation tens of millions of people experienced.
Then in March things suddenly turned around. Despite the policies of a new administration and the actions of the Federal Reserve, which gave the United States the weakest recovery from a sharp economic downturn in the country’s history, stocks more than doubled. By 2013, the major indexes were exceeding their precrisis high. Real estate investment trusts and banks went up several-fold.
How many individuals who fled the market with some or all of their money during its darkest days got back in for this totally unexpected bull market? All too few. Mutual fund industry numbers tell the sad tale: investors continued to pull money out of equity funds until late 2012. Most parked their cash in no-yield money market accounts or in bond funds, in which the Fed’s quantitative easing programs had created a bubble.
As the famous investor Sir John Templeton once put it: “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”
Daniel Kahneman, a noneconomist who won the Nobel Prize in Economics for behavioral finance, has noted the phenomenon of how when everyone is optimistic, when friends tell you how well they are doing, you tend to put money in the market. And when everyone is saying the sky is falling, you take your money out.
More Questions and Answers
Is the stock market today overvalued or undervalued?
In early 2014, stocks were fully priced. The price/earnings (P/E) ratio of the S&P 500 was at a healthy level. Having advanced so much, in order to advance further the market will want policy reinforcement such as a tax cut or simplification of the tax code, a progrowth budget deal, and/or a reform of the debt ceiling law that has incentives for spending restraint or regulatory moderation in antigrowth rules from the Obama administration. These are not likely. But barring a foreign crisis, earnings will grow and so will stocks, though at nothing like the pace of 2013.
Let us reiterate: don’t try to be a market timer. You have no way of knowing when a long-term bear market or bull market will turn. In 1996 Fed head Alan Greenspan gave a headline-making speech in which he warned about market “irrational exuberance.” The Dow was 6,437. Despite Greenspan’s jeremiad, it went on to reach new highs in 1997, 1998, and 1999.
What are some key indicators of the health of the stock market?
Corporate earnings, and the prospect of them, drive markets. But not all profits are the same. One very useful measure of corporate profits is the National Income and Product Accounts (NIPA) issued by the Commerce Department’s Bureau of Economic Analysis (BEA). It excludes nonoperating items such as dividend income, capital gains and losses, and deductions for bad debt. It is an excellent measure of companies’ operating profits, certainly better than reported earnings, when companies naturally try to put the best face on things.
In the late 1990s, for instance, profits looked robust. But by the BEA’s NIPA measure of earnings, profits peaked in 1997, not 2000. Reported profits were rising because of a surge in capital gains, not earnings from actual operations. This was a time of leveraged buyouts, divestitures, and IPOs. The wise investor would have sensed that the stock market was rising more than justified by the state of the economy.
Investors should also pay attention to the individual sectors of the market as broken out by Standard & Poor’s. Are all the gains taking place in only one sector? That could be the sign of a bubble, as opposed to healthy economic growth. Before the dot-com bust, the late 1990s bull market was becoming more and more narrowly based, involving primarily hightech companies. Much of the rest of the market was stalled or contracting.
Before the crash in 2008–2009, financial and housing stocks were on fire. The financial sector stocks were more than double what they were before the collapse of the Bretton Woods system. Although finance has been an innovative industry, nothing justified such a surge. It was clearly artificial, reflecting the increase in speculation and in the financial instruments that are a consequence of fiat money.
Austrian economist Joseph Schumpeter observed this during Austria’s post–World War I hyperinflation, which was every bit as bad as Germany’s. Vienna’s glorious coffeehouses, which were on every corner, were replaced by banks. When the inflation ended, the banks went away and the coffeehouses returned.
How important is the price/earnings ratio when choosing individual stocks?
When stocks in a bull market reach a P/E of 20 or more, beware. A sound ratio is 15 or so. P/E ratios, however, are generally a useless indicator of value in bear markets when many companies, including good ones, are experiencing losses.
Investing in International Stocks
Countries whose economies are growing faster than the U.S. economy can appear to offer investment opportunities. The downside is greater volatility and higher risk.
Take the example of China. That country with its seemingly unstoppable economy would appear to provide countless investing opportunities. But look at the real picture in this graph. No, that’s not a roller coaster but rather a chart of Chinese equities traded in Shanghai.
Potential investors awed by China’s spectacular growth are too often blinded to the economic problems causing such ups and downs. For instance, China’s still-communist government restricts where savers can park their money in addition to imposing various controls on foreign investing. Having an expanding economy doesn’t mean that every stock benefits.
In fact much of China’s growth comes from millions of small private companies that are essentially off the investment radar. Traditional banks often ignore them. These entrepreneurial enterprises get expensive financing from nontraditional sources such as street lenders. Listed equities do not include these small businesses.
To invest successfully in foreign equities one needs to understand a country’s political and regulatory environment. The experience of Japan underscores how treacherous investing can be. In the 1950s and 1960s, Japan pursued extraordinary growth policies that kept the yen stable and spending in check (no more than 20% of GDP). The government cut taxes every year. Stocks surged.
Then in 1989, after a traumatic real estate bubble, Japan’s government went off the rails. Savage tax increases were enacted. Spending went berserk. For several years the Bank of Japan adopted a deflationary monetary policy.
The country is still in a rut today. The Nikkei 225 peaked in 1989 at almost 40,000. A quarter of a century later, the Nikkei is at 15,000.
To minimize the risks of international investing, consider an index fund approach. Companies like Fidelity and Vanguard offer such vehicles for foreign stocks that include the entire world and the w
orld sans the United States.
How About Bonds?
The conventional wisdom has long been that bonds are safer than stocks. Because a bond is a debt that gets repaid, you’re less likely to lose your investment than with a stock, the value of which can sharply decline. The interest of bonds, unlike dividends, is guaranteed. There can be painful exceptions such as during periods of inflation, which knocks down the real value of both principal and interest. Political maneuvering can also affect bonds. For example, after the General Motors bankruptcy engineered by the Obama administration, bondholders were forced to lose far more than they would have in a normal, non-politicized restructuring; debt holders received a shellacking.
From the early 1980s until recently, bonds generally have had a great run upward, even outpacing stocks from time to time. But with the Federal Reserve winding down QE and its bond-buying binge, interest rates will be going up. Bond prices will be under pressure for the foreseeable future in this uncertain interest rate environment.
To guard against future inflation, put 5 to 10% of your money in inflation-indexed Treasury bonds. If you haven’t dumped your munis, good. The worries of two years ago were overdone; there was not a tsunami-like wave of city and state insolvencies. A word of advice if you want to buy bonds right now: stay short term. Don’t forget: interest rates will be moving up.
As with stocks, there are all kinds of debt issues from Treasuries to junk, from long to short durations. You now can get bonds from all over the world.
There are a handful of ways to deal with your urge to have bonds. One is to own a balanced fund like Vanguard’s Wellington Fund that mixes debt with dividend-paying stocks and has low management expenses. Again, watch those expenses; Vanguard’s expenses are usually among the lowest in the industry. Another option is to put money into a bond index fund that holds a wide range of debt. Depending on your age, you can go for funds that are short term, intermediate term, or long term. One exception is the present moment, as the Fed tries to wind down quantitative easing. Wait a year or two until the pricing in credit markets returns to normal.
Don’t try to guess classes of debt in which to put your retirement money. Since 2008 junk bonds have done far better than higher-rated debt issues as investors reach for yield in an era of zero-interest rates. But they also get slammed hard in recessions.
A warning light: junk bond issuances were at a record high in 2013. Emerging market government debt was popular for a time and has fallen into disfavor as investors anticipate higher interest rates in the United States. So don’t be a timer or sector picker. Go for a broad-range index fund.
Is Gold a Good Investment?
Gold is a great indicator of what’s going on in the economy. As we noted, gold can also act as portfolio insurance against the effects of monetary malfeasance by governments. But gold is not an investment unless you’re in the jewelry business. It is not similar to building a factory, opening a store, providing a new service, or creating a new product.
Most of the time, gold has been a loser compared to stocks. From August 1982 to February 2000 the Dow Jones Industrial Average increased 15-fold, a gain of 1,400%. Include dividends and the gain is even more impressive. Gold? It went nowhere. The same was true from the end of World War II until the Bretton Woods system was blown up in 1971.
From 2000 until the summer of 2011, gold went up sixfold. Since then, it tumbled over 35% while stocks went up 40%. The precious metal increases in its dollar price only when the United States is misbehaving monetarily.
Gold Mining Stocks
Gold mining stocks aren’t the answer either. Since 2011 these equities have been slaughtered, down more than 50%. The marginal price, including depreciation, of mining an ounce of gold is nearly $1,200. What about gold-based exchange-traded funds (ETFs)? Several have been launched that own gold and whose price mimics the gold market. No worry about gold mine managements or buying and storing the precious metal. And no worries about the dealer charges you pay when buying gold coins. Some people who purchased coins as a result of those once-nonstop TV ads found themselves paying outlandish commissions.
While a handy tool, metal-based ETFs have yet to prove themselves in a severe crisis or panic. They will probably pass with flying colors, but you should hedge your bets by having most of your holdings in the real stuff.
Other Investment Vehicles: Commodities and Currencies
Most people get interested in commodities and currencies when the dollar becomes very uncertain. Commodities and currencies can be bought on credit through your broker. You can lose a lot of money very quickly. Whatever a salesperson may tell you, surveys have found that most individual traders lose money in these markets. You are going up against people who make their living trading these things, which is stressful and fast-paced. Don’t kid yourself about your ability.
When money is stable, the volume of commodity trading is lower. Institutional money managers also wouldn’t treat commodities as an investment class, as they routinely do today.
Real Estate Investing
Housing took on the mantle of a great investment vehicle when the dollar went off the gold standard. Again, this flawed perception is a response to the instability of fiat currency. A house is a very expensive consumer item. It is a place in which to live, not a substitute for investing. An investment in a successful new venture grows in value because it creates a new product or service. The price of a house may rise because of increased demand. And it may become more valuable if you invest in improving it. When you have an unstable monetary environment, hard assets like houses can benefit, at least for a while. But a house does not offer the same kind of growth potential as investing in an Apple or a Google would.
We saw all too painfully during the subprime crisis that a house is no surefire way to make money. Having to maintain a home means that there are plenty of hidden costs you may not have counted on. And people can get into trouble overborrowing to buy a house—or find themselves strapped by rising mortgage and property tax payments.
Should you buy a house and then rent it out? Only if you treat such an act as going into a business. Tenants can make you pull your hair out; they can sue you. Going into the rental business is not like buying a stock.
A house can provide the emotional satisfaction of having a place of your own. But, like gold, it is more of an insurance policy than an investment that provides the kind of growth potential you need to beat inflation.
Life Insurance
Permanent life insurance, which is also called “whole life,” combines insurance with a savings vehicle. Unlike term life policies, this insurance does not expire; you have it for as long as you want right up until your death. And you can’t be dropped if you fall ill. The cash value of a permanent life policy always goes up each and every year. Moreover this cash buildup grows tax-free. If you let the policy lapse, you will owe no tax unless the cash exceeds the total premiums you paid for the policy.
With a mutual insurance company, the annual dividends can be used to reduce the premium. Within several years, the policy will become self-sustaining. That is, the premium effectively disappears because the annual dividend will exceed the premium. How many years depends on the company’s investment performance. You can borrow the cash portion at a specified rate of interest below what you would pay borrowing on your credit card, and usually below the margin rate that you would pay borrowing from your brokerage account.
Permanent life insurance is a great anchor in turbulent times—it’s nice to know that whatever is happening, one financial asset continues to grow.
Many advisors are negative on permanent life, saying the product is too expensive because of commissions paid to agents who sell the policy. Critics assert that you would do better to buy term insurance and invest the rest of the money yourself. We disagree. Most people won’t invest the alleged savings each year. Obviously not all companies are the same; you must examine credit ratings.
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This cha
pter has covered some basic ways to protect your money. There are of course plenty of other investment vehicles. They include, to name a few, annuities, private equity, and hedge funds. In the back of this book we list some books that can help you go further in evaluating the tools and strategies that best meet your objectives.
Most people don’t have the inclination or time to handle their investments on their own. They need a trusted advisor or advisors. Just as skilled athletes will use a coach, a trusted advisor can be helpful even for seasoned investors. John Schlifske, the CEO of Northwestern Mutual, likes to make that point this way:
My [exercise] coach doesn’t really tell me anything I don’t already know. But with a scheduled appointment, I will do what I should do but might not if I didn’t have to meet with that coach at a particular time. The same principle is true of a trusted advisor. He or she will help keep you on your program.
Schlifske’s advice is especially true in these times of turmoil. Everyone can use advice on the challenges and complexity of the myriad of financial questions raised by taxes, family, your business, and countless other topics.
There is no scientific formula for picking the right coach. You should do the obvious due diligence including researching fees, comments online and from friends, possible disciplinary actions, or promises that sound too good to be true. One axiom that famous money manager and Forbes columnist Ken Fisher emphatically emphasizes: make sure the custody of your securities is separate from your advisor. You want to know that what your statement shows is actually what you have.