Back in June I argued investors should create their own conglomerate by assembling a diversified portfolio of high quality companies.\u00a0 Michael Crook of UBS provides a potent factoid validating this strategy. He calculates:<\/p>\n
\u201cAfter accounting for inflation, $100 invested in US equities, US corporate bonds, US Treasury bonds, and US Treasury bills in 1932 would now be worth $30,790, $1,252, $810, and $156, respectively. That is equivalent to excess performance for equities of over 2000% over eight decades.\u201d<\/p>\n
Roll that around in your brain for a moment: $30,790 versus $156 – $1,252.<\/p>\n
Bottom line: Over time you can become wealthy investing in stocks, but not in bonds or cash.\u00a0 Very long term, it really is that simple.<\/b>\u00a0 Naturally, there are short-term exceptions.\u00a0 Equities perform poorly in certain decades (1930s, 1940s, 1970s).\u00a0 And bonds are a great investment occasionally, such as the early 1980s when nominal yields were sky-high (15-20%!) and inflation was about to plummet.<\/p>\n
Timing Is Not That Important . . . <\/b><\/p>\n
. . . if\u00a0you are saving for retirement out of income, because you can invest regularly without making bets\u00a0on when the market will rise and fall.\u00a0 And if you accumulate significant savings by the time you retire, you can raise some cash and\u2014to the extent you need to dip into capital rather than live off dividends and Social Security\u2014sell stock in years when the market is strong, and use cash in years when stocks are weak.<\/p>\n
. . . . But the Cult of Over-Diversification Makes This a Fairly Good Time to Buy Stocks<\/b><\/p>\n
Yes, it would have been better to plunge into stocks four years ago.\u00a0 But now is still a decent time because investors remain skeptical about stocks, leading to excessive diversification.\u00a0 At the end of long bull markets, you get a cult of equities.\u00a0 At the end of the 30-year bull market in bonds we got a cult of bonds, with PIMCO\u2019s Bill Gross arguing bonds would continue to outperform stocks, which were a \u201cPonzi scheme.\u201d\u00a0 (Stocks are up 27% since Bill shared his insight with the world.)\u00a0 Now we have a cult of over-diversification<\/b>:<\/p>\n Five years from now, much higher allocations to equities will be conventional wisdom\u2014which will be a bearish sign.\u00a0 But as institutions raise equity allocations over the next few years it will be positive for stocks.<\/p>\n How to Assemble your own Conglomerate<\/b><\/p>\n This advice is more radical than it sounds . . . <\/b><\/p>\n No trading.\u00a0 No market timing.\u00a0 No allocation across stocks, bonds, cash, gold, industrial commodities, private equity, hedge funds, real estate, art, rare baseball cards, etc.\u00a0 \u201cRisk\u201d is not defined as short-term price volatility but permanent loss of capacity to generate free cash flow.\u00a0 (According to Wall Street\u2019s conventional definition of \u201crisk\u201d as \u201cBeta\u201d — or stock price volatility relative to the market — General Motors and Citigroup were \u201cless risky\u201d in 2007 than Nike or Starbucks.\u00a0 Oops.)\u00a0 You have to accept that occasionally the quoted value of your portfolio will go down a lot. \u00a0But this doesn\u2019t matter unless you need to sell stock (which is why you should keep enough cash to weather bear markets, both financially and psychologically).<\/p>\n Don\u2019t Buy High-yield Stocks Because \u201cI need the income.\u201d<\/b><\/p>\n In an interesting Barron\u2019s<\/b> interview, American Funds\u2019 James Rothenberg was asked whether and why he owned too many bank stocks before the financial crisis.\u00a0 His answer:<\/p>\n Yes, we did.\u00a0 We have a lot of funds for which current yield was, and is, a very important part of the objective<\/b>.\u00a0 And there were only a few places where you could get significant yield.\u00a0 One was financials, one was oil, one was utilities, and there was a smattering of other things.\u00a0 So we were naturally drawn to the financials because on earnings they looked cheap, relatively speaking.\u00a0 The problem was that t heir earnings weren\u2019t real, as we now know. (emphasis mine)<\/p>\n I am not second-guessing Mr. Rothenberg; I, too, got burned badly in certain financial names in 2008.\u00a0 But, what is flawed here is the thought process of investors thinking, \u201cWell, I need income.\u00a0 I only want stocks with high yields.\u201d\u00a0 That logic dramatically narrows your choice of stocks. You are likely to end up in companies with high dividend payout ratios, mediocre growth, and perhaps high financial risk.\u00a0 (Which describes many utilities these days.)<\/p>\n Even if you value income, you want to own\u00a0growing businesses.\u00a0 You should evaluate stocks not just on dividend yield but also EPS growth<\/b>, using the \u201cPETR Principle\u201d described in my April 30, 2013 post.\u00a0 It simply involves dividing the PE ratio by an estimate of total return, defined as (dividend yield + long-term EPS growth).\u00a0 Doing this properly requires an understanding of the business and its future growth, which is why you may need an investment advisor.<\/p>\n Copyright Thomas Doerflinger 2013.\u00a0 All Rights Reserved.<\/p>\n","protected":false},"excerpt":{"rendered":" Back in June I argued investors should create their own conglomerate by assembling a diversified portfolio of high quality companies.\u00a0 Michael Crook of UBS provides a potent factoid validating this strategy. He calculates: \u201cAfter accounting for inflation, $100 invested in … Continue reading \n
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