DIY Investing (Part Two)

By Bob Wood, MMNS

Wow, so you’re really going to do it? You’re going to take matters into your own hands and manage your own investments? Well, good for you!

What the heck, right? How much worse will you do than most professional investors have done lately?

Now for the hard part: investing is difficult to do well, especially in terrible economic times, such as we’re seeing now. This appears to be the worst decade for investors since the 1930s, and none of the old rules for success are working well.

Of course, has successful investing in the markets ever been easy? I’ve mentioned in this column previously the research work of Dalbar, who has found that investors consistently do the wrong things. Even during the secular bull market in equities, which ended in 2000, the average investor in stocks would have fared better by staying with bond funds.

Most investors become overly active, making too many trades when simply sitting and waiting will provide the best course. And too many of us do the most obviously wrong things, namely, buying high amid the excitement of big, trailing performance and then selling in discouragement at what later proves to be the best time to buy.

Yet if you are among that big crowd nursing large losses incurred during the past few years, you’ve probably noticed that professional investors haven’t done much better. Most have trailed the passively-managed index funds again and again.

So if you’re ready to strap yourself into the big chair and do this yourself, look at it this way: you finally have your best interests aligned with those of your portfolio manager! And by now you’ve taken that short journey of discovery to learn all about asset allocation, diversification and Modern Portfolio Theory.

Great! Now for the next step: forget everything you learned about asset allocation, diversification and Modern Portfolio Theory! Do a complete brain dump, and get all that nonsense out of your head before you hurt yourself with it! Let’s face facts: if those theories were any good at all, everyone would have used them and achieved perfectly satisfactory results.

The amazing thing about those academic ideas is that everyone seems to use them, yet very few ever achieve expected results from them. That result, in itself, argues strongly against using the most widely accepted methods for building and managing your investments.

The only real reason for learning about academic theories on investing is knowing how they are meant to be useful. But in economic times like today, when all asset classes are falling in tandem, just what is the benefit of spreading your risks among several different types of investments? How much will this method smooth volatility while generating sufficient long-term returns?

During the bear cycle from 2000 to 2002, domestic large caps, mid caps, small caps, and international and emerging markets stocks all fell in unison. In a bull market, spreading your risks around makes sense, but, in a bear market, all bets are off.

So now that we have a good idea of what does not work with alarming regularity, what should we do instead? I believe your first step is most important. Simply ask yourself this: “Is now a good time to be adding risk to my portfolio?” Or should you be decreasing risk? Obviously, with the domestic market’s having careened through its worst calendar year since 1931 and with this new year’s suffering from a similar, bad beginning, shouldn’t we be seeking decreased amounts of risk?
With the S&P 500 now sitting about where it was 12 years ago, can there be any doubt that we are experiencing a secular, or long-running bear market for domestic stocks? I am convinced that there is no room whatsoever for domestic stocks in your portfolio. That’s right. I advocate, and have advocated for as long as I have been writing this column, that investors should allocate zero dollars to domestic stocks.

That guideline assumes that you will have your portfolio almost totally invested in overseas markets. And, you ask, haven’t those investments performed even worse than our home market since the start of last year? So answering that question brings me to the next useful suggestion for what to consider including in your portfolio: include shares of mutual funds that are designed to do well in down markets.

That seems rather obvious now, doesn’t it? And while such funds have been the big winners during this decade to date, they still have a place in your portfolio today. I use them liberally in my own managed accounts.

Some may think this a little late for those investing in those types of funds since the markets have already taken a pretty good beating over the past year and a half. That might sound right to you, but remember that 2008 was the worst year for the Nikkei 225 in Japan, and that bear market began almost 20 years ago!

Sure, the S&P 500 has fallen significantly in recent months, but so have earnings for companies that comprise that index. Actually, companies’ earnings have fallen faster than the index share price; specifically, even though the index has fallen so much, the average price-to-earnings ratio of index stocks has actually risen!

A recent Wall Street Journal article pointed out that, over the past four quarters, the combined earnings for the companies in the S&P 500 amounts to a paltry $28.75. Assigning an average P/E of 15 gives a level for that index that most would be mildly shocked at seeing.

One problem with today’s investing in international and emerging markets shares is that all asset classes seem to be strongly correlated. So when our domestic market drops, it tends to take down with it markets around the world.

At some point, I am sure that situation will change, and the decoupling I have been anticipating, which has been roundly called dead by almost everyone offering an opinion about it, will indeed be seen. In fact, decoupling has already begun; it’s just not so obvious to those who object, since they aren’t looking very hard.
All these points have been leading to some suggestions for building your own do-it-yourself portfolio. Again, let’s consider secular, long-term trends and how they make all the difference. While the domestic stock market has been a steady loser for this past decade, other markets and asset classes have done well.

Beginning with the international markets I have liked best, look at stock markets in Brazil, China and India, which are higher today than at the start of this decade. In addition, gold shares have done well, with the price of the metal, itself, much higher today than at the start of the year 2000. Given how these positions have generated positive gains for so long, they can be expected to regain investor favor before long. In fact, the Chinese market is showing a great start to 2009, and gold shares are moving higher, too.

My basic investment philosophy for the past few years remains intact today. I am adhering to a ‘’short here, long there’’ strategy, whereby I hold shares of bear market funds in domestic markets, offset by long-side allocations in international and emerging markets stocks and funds. But I strongly suggest that you buy mutual funds for your portfolio instead of the more volatile individual issues.

This type of allocation may well shock any traditional investor who looks at it, since it is so opposite to conventional investing wisdom. All I can say is that — as odd as it looks, perhaps even reckless to some professionals — it works! And, in the end, isn’t that the one thing that matters?

Take your time, allocate even more than you think right to cash for now, and build this kind of portfolio slowly, over the next few months. And as always, if it goes wrong in today’ non-conventional investment environment, don’t yell at me! If you’re losing money, so am I!

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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