 irst,
a confession.
Nearly 20 years
ago, when I was in my mid-thirties, I got a chance for the first
time to manage my own tax-deferred retirement portfolio. I was confronted
with the same choices as the 42 million Americans who now have 401(k)
plans and the millions of others with federal Thrift Savings Plans.
I blew it. I put the whole thing into bonds — specifically
GICs, or fixed-rate "guaranteed investment contracts."
I figured that this was my nest egg, so I shouldn't fool around
with it — better to get a certain 6% than to risk the money
in the stock market.
I didn't know
much about investing at the time, but I learned — and I moved
from bonds to stocks. What I learned was this: If you can't touch
your money until you retire, 20 or 30 years from now, then you have
a spectacular opportunity. You can take advantage of the particular
quirk offered by the stock market. In the short run, stocks are
very, very risky. But over most long periods, history shows that
stocks have been no more risky than bonds — and they produce
average annual returns that are twice as high, 11% vs. 5.5%.
Americans are
at last absorbing this basic truth about investing. An extensive
study of the contents of 11.8 million 401(k) plans, released last
week, found that three-quarters of plan balances were invested directly
or indirectly in equity securities — mainly through stock mutual
funds. Researchers for the nonprofit Employee Benefit Research Institute
and the Investment Company Institute, the mutual fund trade association,
found that for the average 401(k), the proportion of total assets
invested in stocks rose by one-sixth between 1996 and 2000. At the
same time, the proportion invested in GICs dropped by two-thirds,
in conventional bonds by one-quarter, and in money-market funds
by one-fifth.
This is very
good news because throughout the 1980s and much of the 1990s, most
people had far too much money in bonds and cash and not enough in
stocks. The study also found that investors in their twenties and
thirties had one-third more of their assets in stocks than investors
in their fifties and sixties. That makes sense, too. When you are
close to retirement, a sharp stock-market decline can be devastating
since you don't have the time to recoup the loss before you need
to withdraw your money.
The process
of dividing investments into categories — mainly, stocks, bonds
and cash — is called "asset allocation." Academic
studies show that the proportion that you assign to each category
is far more important than the particular stocks and bonds and mutual
funds you pick within the category. But — face it — allocating
assets is nowhere near as much fun as picking stocks.
The basic rule
is simple: The younger you are, the more stocks you should own.
Unless you can't sleep at night, a retirement portfolio that's composed
entirely of stocks may be appropriate for investors in their twenties
and thirties, but a 50-50 or 60-40 split between stocks and bonds
(with a little cash on the side) is better for the average 60-year-old.
Some portfolio
analysts, however, believe that even young investors should own
bonds. Bernstein Investment Research and Management in New York
is probably the most articulate advocate of this approach. In a
recent study, Bernstein argued that all portfolios should balance
risk and reward, and the best way to do it is by owning asset categories
that have a "low correlation" to each other — that
is, when one category goes down, the other tends to go up.
Stocks and
bonds are wildly uncorrelated. "In 10 of the 11 years since
1950 in which U.S. stocks declined, the bond market made money,"
says the Bernstein study. "In the eight bear stock markets
of the past 30 years, bonds always made money, and sometimes lots
of it." For example, between March 2000 and June 2001, the
Standard & Poor's 500-stock index, the equity benchmark, dropped
9%, but five-year U.S. Treasury bonds returned 15.4%, counting both
interest and price increases (when rates fall, bond prices rise).
Bernstein has
concocted what it calls a "fully diversified portfolio,"
or FDP — 55% conventional stocks; 10% REITs (real estate investment
trusts, which are shares that represent ownership in diversified
properties, usually within a theme, from hospitals to outlet malls
to resort hotels); and 35 % medium-term bonds (generally maturing
in two to six years). The conventional stocks are divided up this
way: 19% growth stocks (companies with fast-rising earnings but
also relatively high prices), 19% value stocks (overlooked companies
that appear to be bargains), 14% stocks of major foreign companies,
and 3% stocks of companies in emerging markets. In my opinion, the
particulars of diversification within that category aren't very
critical, though you should have a mix of growth and value, large
and small, choosing from the best countries around the world, wherever
they are.
Between 1981
and 2000, this FDP asset allocation produced average annual returns
of 13.7%, compared with 15.7% for an all-stock portfolio (represented
by the S&P). But the FDP cut volatility by one-third. That's
very impressive.
"For many
people," says the Bernstein report, "that smoother ride
means greater peace of mind, and a greater likelihood you'll have
the money when you need it." And the FDP made a lot of money:
an investment of $10,000 grew to $130,000.
But is the
trade-off — two points of annual growth for a lot less risk
— worth it? Not for investors who can ignore the short-term
ups and downs of their 401(k) balances and who absolutely don't
need the money for a long time. But for investors who are more anxious
and have a shorter horizon — yes, absolutely. Investors who,
like most of us, fall between these two poles can modify the Bernstein
formula.
Still, never
underestimate the fear factor. Volatility is frightening. It may
force you into bad mistakes, like bailing out of stocks entirely,
at just the wrong time. And the fully diversified portfolio does
prevent bad things from happening to good investors. For example,
Bernstein measured the FDP's results against the S&P as a whole
during several rocky periods. Between September and November 1987,
the S&P dropped a scary 30%, but the FDP lost only about half
that: 16%. More recently, from April to December 2000, the S&P
fell 11%, but the FDP actually rose 4%.
One of the
keys to the FDP's success is that dose of REITs, which, like bonds,
have very little correlation to stocks. For the 20 years ending
in 2000, the REIT index returned 12.4%, but volatility was strikingly
low. Tax law requires REITs to pay out nearly all their earnings
to shareholders in dividends, and that flow of cash adds stability
to a portfolio. For example, Archstone Communities Trust, a Denver-based
REIT that specializes in garden apartments, recently merged with
Charles E. Smith Residential Realty, a large Washington-area firm,
to form Archstone-Smith Trust. Based on the expected payout this
year, the REIT has a dividend yield of 6.4%, compared with 4.9%
for 10-year Treasury bonds. While the dividend itself is not guaranteed,
the way bond interest is, Archstone has been remarkably consistent.
The lowest yield in the past 10 years was 4.4%, but in eight of
those 10 years it has been at least 5.7%.
Cohen &
Steers Realty Shares, the top pick of the No-Load Fund Investor
newsletter, is probably the class of the REIT mutual-fund field.
Top holdings include some of the largest firms, including Equity
Office Properties Trust, with a 6% yield; Simon Property Group (shopping
centers), 7.3%; and Health Care Property Investors, 8.4%. Through
Wednesday, the Cohen & Steers fund was up 3% for the year including
dividends (compared with a loss of 13% for the S&P). Its 10-year
record is almost precisely the same as the equity benchmark: 12.7%
average annual return.
Another fund
with a superior track record is Fidelity Real Estate Investment,
up 15% over the past 12 months. The fund's top holdings include
Apartment Investment & Management (currently yielding 7%); Equity
Residential Properties Trust, run by legendary bargain hunter Sam
Zell (6.2%); and Crescent Real Estate Equities, whose CEO, Richard
Rainwater, won fame as manager of the Bass family fortune (8.6%).
But Robert
Mitkowski Jr., analyst for the Value Line Investment Survey, warns
of Crescent: "We'd avoid these untimely shares." He's
worried about the collapse of the high-end Arizona housing market,
and he notes that Crescent recently cut its dividend to $1.50 a
year. That's still a hefty number for a stock trading at $17.42,
but dividend-cutting is a bad sign. No one ever said that REITs
carry no risk.
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