Joining the Bandwagon? Don’t Lose Your Balance

This article from New york times

STOCKS are back. And that could be dangerous.

“This is one of those moments,”said Louis S. Harvey, the president of Dalbar, a research firm in Boston. “It’s one of those times we warn about year after year.”

Mr. Harvey has been documenting inconsistencies in investor behavior for more than two decades, and he was one of the first people I called last week for some expert perspective on the exuberant stock market.

The Dow Jones industrial average set a new closing record on Tuesday — and climbed even higher the next day, and the next day, and again the next. The Dow has risen nearly 10 percent in this young year alone. In the four years since stocks hit bottom in March 2009, their prices, on average, have more than doubled.

Already, fund flow data suggest that people who were frightened away from stocks after the catastrophe of 2008 have begun buying again this year. And no wonder. The stock market has been a marvel to behold.

What would Mr. Harvey tell someone who wants to start buying now, after sitting on the sidelines for the last four years?

“I’d say, if you can reliably predict where the market’s going, then jump in feet first — just buy, buy, buy,” he said. “But if you don’t know what the future will be,” he added, caution is the wiser course. Before plunging into the market, he said, “make sure that you select a reasonably defensive asset allocation strategy first.”

If stocks are irresistible to you, set up a balanced and diversified portfolio containing many different stocks and bonds, he continued. “The most important thing, once you have a strategy,” he said, “is to find a way to actually stick with it.”

He has seen soaring stock markets before, and, for the typical mutual fund investor, they have often gone badly. When the market is already high, Dalbar has found, many people start to buy. When it’s already fallen, they sell.

The dismal truth is that over the long run, the average person is a woeful investor, regularly losing money to more skillful traders. Dalbar performs an annual survey of actual investor returns in mutual funds, and compares them to the return of the overall market. He shared the latest, still unpublished figures with me. They tell a sorry story.

Over the last 20 years through December, the average return of all investors in United States stock mutual funds was 4.25 percent, annualized. Over the same period, the benchmark Standard & Poor’s 500-stock index returned an annualized 8.21 percent. That’s a huge gap — nearly four percentage points a year over two decades.

I ran the numbers. A $10,000 investment at 4.25 percent would be worth $22,989 in 20 years. An investment in the S.& P. 500, at 8.21 percent, would be worth $48,456. The difference is a sobering $25,467.

Why is the gap so wide? One reason is that after fees and expenses, the average mutual fund manager doesn’t beat the overall stock market, as many studies have shown. But that explains only part of the problem. The rest of it, Mr. Harvey said, is that investors themselves “move their money in and out of the market at the wrong times.”

“They get excited or they panic,” he added. “And they hurt themselves.”

It’s not that stocks are a bad idea in themselves. Holding a diversified group of stocks — along with a broad collection of bonds — has paid off for most long-term investors, Mr. Harvey and a large majority of strategists say. Stocks have outperformed bonds over the long term, while bonds have provided steady income and more reliable day-to-day returns.

Combining stocks and bonds, maybe with other assets, can create a less volatile portfolio, letting an investor sleep more peacefully. The question for most people isn’t whether to own stocks. It’s how to allocate them intelligently, as well as when to buy.

I asked Ed Yardeni, an independent economist and market strategist who has been bullish on stocks for four years, whether it makes sense to start buying now. “Obviously, it would’ve been better to buy them in March 2009,” he said. “But buying now still makes sense if you believe we’re in a secular bull market” — a market that will keep rising for a long time.

Mr. Yardeni assigned what he called “a subjective probability” of about 60 percent to that optimistic outcome. He said factors like growing energy independence in the United States and a “technological revolution that has never stopped” could help propel the domestic economy forward, bolstering corporate earnings growth and providing fundamental support for stocks. For the short term, he said, the expansive monetary policy of the Federal Reserve and other central banks is acting as a tonic for the stock market, and fear of disaster in Europe has abated. 

But there is still a sizable risk that the economy and the market could unravel, he said. “You want to be diversified,” he said. “You don’t want to just hold stocks. Even so, he said: “You do want to hold some stocks. You’re getting nothing for cash, and at some point bond yields will rise and there will be big losses in the bond market.”

Individual investors may be buying stocks, but they are generally not irrationally euphoric, said Omar Aguilar, chief investment officer for equities at Charles Schwab Investment Management. Schwab clients bailed out of stocks in such large numbers in the financial crisis, Mr. Aguilar said, that they still have “about a 5 or 10 percent lower allocation to stocks” now than they did in 2007, even though they have been net buyers since Jan. 1. New stock purchases have come from cash that was sitting idly, he said, not from bonds, implying that much more stock-buying may be ahead. While he urged caution, he said he remained bullish.

“There’s still room for more purchases, within a sensible allocation strategy,” he said.

AT Fidelity and Vanguard, the perspectives were quite similar.

Dirk Hofschire, senior vice president for asset allocation research at Fidelity Investments, says his firm believes that the economy is expanding and that stock returns over the next 5 to 20 years should be reasonably good. “I don’t want to give the impression that the market is off to the races,” he said. “But we think it makes sense to be holding stocks over the long term — as long as they are in a diversified portfolio.”

 

Joseph H. Davis, head of the investment strategy group at Vanguard, said that “chasing stock returns when the market is setting records is obviously not a smart strategy.” He would urge anyone tempted to do that “to consider what their risk tolerance really is — and how they’d feel about their portfolio if we have another year like 2008 — because even if it won’t be exactly the same, something like it will eventually happen again.”

Mr. Harvey of Dalbar also suggested that investors try to keep the bad years in mind before committing heavily to stocks. “It’s easy to feel euphoric about new records,” he said, “but you don’t want the regret of getting into the market at a time that appears to be less than optimal.” 

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