The Market Made New Highs; What Did You Do?

Posted: May 08, 2013 12:01 AM

With stocks making record highs, it’s time to look at the management of your portfolio. While individual stock investors have largely been stuck on the sidelines, the stock market has made a lot of money for institutional investors.

When I was a broker this phenomena was explained thusly: Individual investors don’t make money in the market, they just borrow it from the institutional investors for a while.   

“Although individuals have added almost $20 billion to U.S. stock funds so far this year,” reports Investment, “the amount is just 3.5% of the withdrawals since 2007 and compares with $44 billion placed with fixed-income managers in 2013, according to the Investment Company Institute.”

When is “no“ risk too risky? Perhaps right now.

(Note: Readers of Townhall Finance should always shoot me an email if they have questions about money and markets.)

One of my favorite illustrations about risk comes from the ancient period. In those days parables were often used to illustrate complex points. Our parable has to do with a master who, going on a trip, leaves a sum of money –in those days called talents- to three servants in proportion to each servant’s supposed ability to manage the sum left to them. To the best servant he gives five talents, to the next best two talents and to the last, one talent. The one with five talents went away and through shrewd trading made five more talents for his master. The one with two talents also went away a traded well and made two more talents for is master. But the third servant was afraid of losing the money of his master so he dug a hole in the ground and hid it. After a period of time the master returned and summoned each servant in order to settle the accounts. The best servant produced the ten talents for his master and was rewarded by being put in charge of many more things. Likewise the servant charged with two talents produced four for his master and was rewarded with more responsibility. But the last servant said to his master “I know that you are a hard man who gathers where he does not scatter seed. I was afraid of thieves and cheats, so I dug a hole in the ground and hid your money. See, here it is. You may have back what is yours.” The master exploded in rage saying: “You wicked, lazy servant. You ought to have put the money in the bank if you were frightened of thieves and cheats. Had you done so, I would have gained interest plus my original money.” The talent was then taken from the servant and he was cast out into the darkness.

Don’t be cast out into the darkness. Here are some ways to give you a reality-check on risk and return:

#1- Check your assumptions: sometimes taking no risk is riskier than you think.         

Although none of us would think of digging hole in the ground to hide our money, perhaps in effort to avoid risk we have unwittingly opened ourselves up to unaccounted risks of a different sort, like missing substantial returns.

According to $10 trillion in new wealth has been added to the market since the market reached a bottom in 2009.  How much of that is yours?

#2- Know your strategy. Don’t speculate on it.

The truth is that a diversified portfolio across all the equity classes- value, growth, small cap, and international stocks- increases portfolio returns substantially. It also has less risk than the market generally, as represented by the S&P 500.

“There are two times in a man's life when he should not speculate: when he can't afford it and when he can.” -Mark Twain

While Mark Twain was undeniably one of the great American social thinkers and authors, he was also a notoriously poor businessman. He lost fabulous sums of money speculating on mostly private inventions during the muscular phase of the U.S. industrial revolution after the Civil War. After over-extending himself in these speculative ventures, and finally going into bankruptcy, he became soured on Wall Street, although there is no evidence that he lost money in the stock market per se. 

Unfortunately his above quoted maxims have stuck in the American consciousness contributing to the idea that investment in the stock market is the same thing as speculation.

It shouldn’t be.      

“Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble... to give way to hope, fear and greed.”- Benjamin Graham, Investor/Author

Benjamin Graham has been widely credited with inventing the methodologies behind value investing. His influential books “Securities Analysis” and “The Intelligent Investor” are considered classics in investing. These works introduced the concept of crunching numbers in order to make investment decisions to a whole generation of investors. His most famous pupil is noted value investor Warren Buffet.

But as Graham suggests, you should be buying when prices are low.

Like right now.      

#3- Don’t chase returns   

As time passes and your requirements change due to life events, small calibrations of your portfolio are going to be in order. But your portfolio should change to reflect changing circumstances in your life, not changing circumstances in the market.

“Before this century is over, the Dow Jones Industrial Average will probably be over 1,000,000 versus around 10,000 now. So for the long-term, the outlook is tremendously bullish if you buy stocks blindly to keep for a century.”- Sir John Templeton, mutual fund pioneer

#5- Expect losses, but enjoy your returns

While it is impossible to know the returns of the next 36 years, yet alone the next 86 years it is likely we can count on periods of losses.  That doesn't imply we won't have larger losses than we have experienced in the past. After all, the world is getting more connected and developing countries will add some volatility.  But keep in mind that the period from 1970-2005 included a few very bad bear markets. And yet people were still able to retire if they planned sensibly.

(Note: Readers of Townhall Finance should always shoot me an email if they have questions about money and markets.)

Please also note my daily radio feature, Stocks in the News, which is reprinted right here the next day. And listen to Ransom Notes Radio, from politics to portfolios, I have the answers for you.