Your retirement nest egg might have lost 40% of its value since this summer and 10% the last 2 weeks. What should you do? Here’s the advice I’ve been giving to friends who ask, as well as what I’ve been doing with my own portfolio.
First, let me begin by stating that I make no claim whatever to be able to predict whether stock prices will go up or down over the near term or when the market bottom might be reached. In part that humility is inspired by a large academic literature demonstrating that it’s very hard to predict stock prices with formal statistical models.
I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds….
A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.
John Cochrane instead attributes the big swings in the historical P/E to changes over time in the compensation that investors require for risk. According to Cochrane’s view, people understood that they’d be getting less than a 6% expected real yield on stocks if they bought a few years ago, and that stocks purchased today offer you better than 6%. John summarizes his investment advice this way:
If you’re less leveraged, less affected by recessions, and have a longer horizon than the average, it makes sense to buy [now]. If you’re more leveraged, more affected by recession or have a shorter horizon, it might be the time to sell, even though you might be cashing out at the bottom.
As for which stocks to hold, one unquestionably sound investing principle is the benefit of diversification. But if you pay a big fee to somebody to manage your portfolio, you’re out that fee before you start, and the evidence is to me unpersuasive that high-priced fund managers can systematically outperform the market. So my advice for most people is to use broad funds that mindlessly, mechanically, and cheaply do something simple like try to hold a portfolio mimicking the S&P 500. Broader diversification into smaller companies and internationally is also an extremely good idea. My 403(b) invests 1/4 each in the following funds:
Yes, they’ve all tanked this year, but here’s the bright side– those monthly payments I’m still putting in are now more likely to get me something for my money!
We’ve also been saving some money beyond the 403(b) limits, and we’ve always just had this in T-bills. I felt pretty silly describing this part of my portfolio as a professional economist, but I was fearful of putting any more into stocks, given the graph above. Now I’m feeling pretty proud of myself for being so silly.
But my wife and I also feel that now is the time to move that money out of Treasuries and into the stock market. Outside of a 401(k) or 403(b), one disadvantage of stock index funds is that you’re taxed on realized capital gains as they arrive, whereas if you buy and hold individual stocks, you can postpone the capital gains tax. Because of compound interest, this can make a big difference. For example, if you face a 50% tax rate assessed every year on the gains from your 6% return, after tax you’re re-investing 3% for a 20-year cumulative return of [(1.03)^20 -1] or an 81% total return. On the other hand, if you can hold that 6% as unrealized capital gains and only pay the 50% tax when you sell, you’ve got 0.5[(1.06)^20 – 1] = 110% total return.
So we’ve been buying stocks over the last month, and greeted yesterday’s carnage as good news for us in that the downturn allowed us to execute two more of our outstanding limit buy orders. I didn’t do nearly enough research on individual stocks, but know the kind of equities I wanted– a P/E of maybe 11, dividend of at least 3%, long record of strong growth, a solid balance sheet, and a company that I knew at least something about personally. Here’s what we’ve bought (some of which meet those criteria better than others) along with some brief annotations on each:
- 3M COMPANY (MMM). Growth comes from continually developing new products– a lot more than Scotch tape.
- Apache Corp (APA). Yes, I know spot oil is below $60, but once the world recovers from this downturn, there’s room for quite a few more cars in China, and Apache should actually have some oil to sell.
- AT&T (T): I’m a sucker for the 6% dividend.
- Delhaize Group (DEG): Owns a number of grocery store chains; the ones I’ve used I like.
- Home Depot (HD): They should survive, and when growth resumes, they have a very successful strategy.
- Eli Lilly (LLY): Downside is likely legislation targeting drug company profits. But I like the long record of profitable R&D and 5.5% dividend.
- Walgreen (WAG): Drugstores too will survive.
- Johnson Controls (JCI): Downside: U.S. auto industry will be absolutely hammered. Upside: I don’t think Congress will allow domestic manufacturing to be completely eliminated, and JCI will be one of the survivors. Also may benefit from Obama’s green investments.
We plan on buying more next month. One thing that’s clearly underweighted in the little portfolio above is stocks in the financial sector. But in the brief time I’ve spent looking at a dozen or so of these, I didn’t find one that didn’t have some bad smell to it. What I’d really like is a regional bank that’s been run with a paleolithic conservatism during the go-go years. Any such entity would be in a good position to profit mightily from the current mess.
I look forward to hearing other suggestions or investment philosophy from our readers in the comment section below.