The 7% bet ... is it prudent now?

Investing has always been a trade-off. Making choices with your money involves weighing the potential risk and rewards to determine the best course of action to achieve your desired goal. So, in a way, investing is akin to odds-making. In America, this is called fixed odds betting; wagering where you know the odds at the time of the placement of the wager. This is fairly easy to determine in the stock market since reliable statistics and performance are readily available for past sessions going back at least to before the Great Depression, or about 1925.

I thought it timely to undertake this market study now, as the stock market has fallen about 30% since it's high last October. I'm using the 7% figure to compare stock price performance vs. a hypothetical 7% rate of return, such as a deferred index annuity. The answer sought: is it generally better to accept the market risk of stocks (gaining above in any one year, and also losing money in any year), or to bet with the a less risky 7% annual return with no risk of loss when the stock market is down for any year.

To get started, I took the annual Standard & Poor’s 500 Index and compared this with a fixed index annuity that would credit you interest annually based on the performance of the S&P 500 Index with a cap of 7%. The cap is the maximum you could earn in any year, with a floor of zero in down years. You would never have a down year with your principal. Dividends were not considered for ease of calculations.

Seven decades of data were used, starting in 1930, and ending in 2007. This covered all of my available data, and represented co-incidentally about the lifetime of an investor, 78 years.The data presents itself as follows:

1930’s Stock market lost 41%, the 7% strategy gained 31%
1940’s Stock market gained 34%, the 7% strategy gained 40%
1950’s Stock market gained 257%, the 7% strategy gained 65%
1960’s Stock market gained 53%, the 7% strategy gained 50%
1970’s Stock market gained 17%, the 7% strategy gained 49%
1980’s Stock market gained 227%, the 7% strategy gained 66%
1990’s Stock market gained 315%, the 7% strategy gained 68%
2000-2007 Stock market lost 1%, the 7% strategy gained 31%

Well, the tally is pretty easy to figure: being a long term investor in the stock market paid off more than the 7% rule, but you needed a strong stomach to stay in during all the bad markets (24 years were down years). Using the 7% maximum gain in any one year, and all down years counted as zeros, you would have beaten the buy and hold market 50%, or one-half the time – ‘30’s, ‘40’s, ‘70’s, and so far the current decade. The other 4 decades your stock portfolio would have bested the 7% strategy. Taken all together, you earned about twice the amount by following the market.

You may say, “that’s all history now, what do I do today?” My reply; if you are more than 15 years to retirement, keep ¾ of your money in the market, and ¼ in the 7% plan. If you are younger, keep less; if older, keep more in the safer plan. With the recent stock and credit market turmoil, you should look at your allocations to determine your risks. If you can't eat or sleep well, you probably need to consider changes. Call me and I can help you with that.

Diversification - Your Free Lunch

Investment diversification has been called the "Free Lunch of Investing". Rightly so, Wall Street can serve up some nasty surprises with your money, but diversifying your portfolio against risk is entirely within your control.

Jim Cramer of the "Mad Money" television program on CNBC moderates a segment of his show titled, "Am I Diversified?" In it, his viewers call in and deliver their 5 largest stocks in their portfolio. Jim then decides yes or no if they are diversified or not. I like this, because it is helpful to all the viewers, no matter what your situation, and it works for both investors and traders alike.

To get started understanding diversification, the stock market can be broken down into sectors, represented as such:
CONSUMER DURABLES
CONSUMER STAPLES
ENERGY
FINANCIALS
HEALTHCARE
INDUSTRIALS
SERVICES
RETAIL
TECHNOLOGY
UTILITIES

These are fairly broad categories, as there are about 5,000 stocks traded on the three major stock exchanges. Next, place your stock into these 10 slots to determine your diversification. Go to finance.yahoo.com, enter your stock symbol, and then click profile to view your stock's sector. If you own 10 stocks, and more than 2 are in the same sector, you probably are not properly diversified.

There are those who disagree with this lesson, stating that they may choose not to invest in certain sectors based on their research. That is okay, but that increases your portfolio risk when you stray off target. For the average investor that doesn't manage money full time, my strategy is advisable as it lessens your risk of owning too much in any one sector or industry. It does not require you to cover all the sectors; just don't place too much in any one sector - say 15% maximum. Why? If that sector performs horribly (financial stocks, for example), it won't crater your portfolio. The same holds true for mutual funds held in your retirement accounts. Do they own the same sectors of stocks in more than one fund? What is the sector breakdown between your retirement account mutual funds and your other funds and stocks? If you own mutual funds in your retirement account, the quarterly reports would contain the sectors invested in; or call the fund company and ask them. Or, call me and I'll arrange a consultation to run the numbers for you.

In reviewing portfolios of stocks and mutual funds, I continue to see diversification violations big time. Hewitt Associates' recent research showed 21% of the respondent's 401K plan balances held company stock shares, and fewer than 1 in 5 make any transfers in their investment choices in a given year. What that shows me is that they are not "watching the pot" of money very closely.

While reviewing a 401(k) statement from a prospective client I advised in 2001, I noted that 75% of her portfolio was invested in her employers stock, which happened to be a major regional bank you'll see on the corners of Fort Lauderdale. We'll, maybe she made some changes the past few years, maybe not. The bank's stock declined 20 points over 8 years, or 30%, while the general market has been up since 2001. Lastly, a close family friend also owned a banking stock which represented 40% of their portfolio back in early 2006. Long story short, even though some shares were sold along the way, the result thus far has been more than a $1 million decline. These are tough lessons to learn from.
If you are not quite sure of your financial future, seek a professionals advice. I've been managing money and risk for folks since 1982. Be careful out there.

Summer Doldrums May Spell Profits Ahead

The financial markets have improved since my last blog at the end of June.

By most measures, stock prices are higher; Dow Industrials, +4%, Nasdaq Composite, +5%, and S&P 500, +1%. Some areas groups are lower, such as utility, energy and commodity-based stocks. The same groups that outperformed prior. The range of prices, spelled volatility, has been rising, which I think indicates the start of standoff between buyers and sellers. I'm not certain of this, but if the lows of mid-July can hold, we may not get another chance to buy at ‘sale’ prices this year. If the “worst case” is a 30% bear market, then we’ve seen two-thirds of that pain already by mid-July. A run to the former Dow high of 14,200 from here would be a 20% gain, so it would be worth the wait, even if it took 2 years to get back there. Look forward, not back, and you’ll no doubt enjoy the ride with less stress.

Still not comfortable with stocks? Try to dip your toe in gradually, adding to your retirement account or mutual fund account with any idle cash or money from your tax rebate (if you got one). In a falling market, you will lose less if you spread out your investing. For example, investing equal amounts at months end from Dec. 2007 through July, 2008 would have lost you 6.5% vs. -13.7% if you lumped it all in year-end 2007. Now it's easier to be made whole again.

Financial Media Reporting Alert

I enjoy reading, especially anything financial, and turn to both on-line and hard copy newspapers and periodicals. Including Barron's, The Wall Street Journal, Investor's Business Daily, USA Today, and the local Fort Lauderdale News / Sun-Sentinel. But...let's get the facts straight, reporters, TV and radio hosts! I see more sloppy reporting and errors in the daily media with stock prices, financial calculations, interest rates, etc. In the past few months, radio hosts have scared the bejesus out of my morning commute by reporting on the prior day's crashing stock prices, only to find out that the program was a replay of a show the prior week. Or the numerous mis-prints in the local paper; gaining stocks with minuses before their prices, down and up arrows mixed up. USA Today columnist John Waggoner's Friday column reported that "A 10-year Treasury note, for example, now yields 3.93% ... your $100,000 bond investment would pay you about $393 a month". Oh yeah, John - my calculator shows $3,930 a year in interest would be $327.50 per month, about $65 per month less. (Hint, use 12 months in the year, not 10). If you're bought some Treasury bonds today, you're getting 17% less income based on his calculations. Buyer beware.

Generally, the financial-only based news sites and weekly papers are very much more accurate thant the dailies. Maybe they are less-stressed with their deadlines. Bottom line, media - when dealing with markets, finances and lots of numbers, get a good proof-reader or better calculator before you go to press to millions of your readers. Bottom line, read your financial news with a skeptical eye.

Next blog: Wall Street’s Free Lunch - Diversification