Stick to the Truths
The winds have changed, but investment strategy is the same.

Mr. Glassman is editor of TechCentralStation.com.
November 6, 2001, 8:00 a.m.

atching the value of your portfolio decline can be excruciating, but the lesson of the past is that stocks always fall as economies slow, and when the recession (or the more modest slowdown) is reaching its depth, stocks tend to rise again. There have been nine recessions since World War II, and after each one the market rose to a level higher than when the recession began.

Similarly, a recent study by Ned Davis Associates looked at 28 major crises since the Nazis marched into Paris in 1940. Nearly every crisis produced the same powerful pattern: a sharp decline in stock prices followed by an impressive recovery to considerably higher levels. For example, stocks dropped 14% in the five months after the Japanese bombed Pearl Harbor on Dec. 7, 1941, but for the full year of 1942 the market rose 20%. In the next three years, stocks doubled. Shortly after the outbreak of the Persian Gulf War in the summer of 1990, stocks fell 14% as well, but for the full year of 1991 they were up 31%.

This does not mean that the future is entirely predictable from the past. After all, I am the co-author of a 1999 book called Dow 36,000, which made the claim that stocks were in a long-term period of revaluation that began in 1982 with the Dow at 777 and would continue until shares reached their "proper level" — a Dow of about 36,000. My co-author, economist Kevin Hassett, and I did not predict when this blessed event would occur, and we warned that outside events could send markets down in shocking ways.

"The era of Pax Americana could end tomorrow," we wrote, "and it is not hard to imagine investors becoming more nervous about their stocks, not to mention their survival."
The basic argument of Dow 36,000 was that Americans had come to understand that stocks were an exceptional investment — no more risky than bonds when held for long periods. So investors since the early 1980s were rationally bidding up the price of stocks and, we wrote, would continue to do so (with interruptions) until prices roughly quadrupled. Of course, if you call your book Dow 36,000, you set yourself up as a target. To many critics, our book was a manifestation of the Internet mania, of day trading and momentum investing — even though Kevin and I had a strong aversion to high-tech stocks, never made claims that we were in a "new economy," and preached a buy-and-hold creed. The list of 15 stocks we highlighted was dominated by boring companies such as Cintas, which rents work uniforms; Tootsie Roll, the century-old candy maker; and Johnson & Johnson. On the list were just two high-tech firms — Microsoft and Cisco, each with a strong history of profitability.

Still, it was an inflammatory title, and maybe we had it coming to us. Kevin joked that we should have called the book A Treatise on the Declining Equity Risk Premium. That was the guts of our theory: Investors were so scared of stocks that they demanded a premium — a much bigger return than bonds — to make up for the increased risk. But, we concluded, for long-term investors that increased risk was an illusion.

The theory was based on two big assumptions: first, that the economy would keep growing at the same rate it had since World War II, and second, that investors would not panic if the market turned down for an extended period. This is a time of severe testing, but, for now, the assumptions are holding. The consensus is that the economy will grow by about 3% annually over the next decade, and as for investors: In 2000, a terrible year for the market, they added $300 billion in net new money (after redemptions) to stock mutual funds. This year (through September), they added another $13 billion.

But the jury is still out. The attacks of Sept. 11 and their aftermath may yet change both the prospects for U.S. economic growth and the long-term confidence of investors. Right now, I believe the crisis is no more threatening than others this country has faced — from Pearl Harbor to the Kennedy assassination — and I think investors should proceed on that assumption. But it could be worse, and, if it is, then the old rules of investing may not hold. For now, however, those rules are more important than ever.

It is the very uncertainty of the markets and the world that require investors to go back to basics and to form a strategy to guide their investment decisions. In the late 1990s you could get away with bad habits. The wind was at your back and an infield pop-up would blow over the fence for a home run. Foolish maneuvers — like buying shares in companies that had never made a profit, concentrating your portfolio in a single sector, or jumping in and out of stocks on a whim — often paid off handsomely.

Those times are over. The wind has shifted. It's swirling all around the ballpark. This is a time to stay cool and keep disciplined.

1. Let me repeat, in condensed form, the "10 truths" from a column I wrote in 1999:
   
2. Before you invest a penny, know why you are putting money away: for retirement, to buy a house in a few years. Your answers determine how much you'll put into stocks, bonds, and cash. Those allocations serve as your guide; they can change over time, but only to meet changes in your plan.
3. Start early. The most critical element in investing success is time, not stock picking.
4. If you can't stay in stocks for at least seven years, then stay out. Stocks are very volatile in the short run, but in the long run the risk dissipates.
5. Don't try to "time" the market, or guess when it will rise or fall.
6. The best time to sell a stock is never. Yes, there are times to sell, but they involve the fundamentals of the company whose stock you own — not the stock's price or the state of the economy.
7. Diversification is essential.
8. Mutual funds are magnificent, democratic inventions, but they have deficiencies. Watch out for high expenses, tax surprises, high turnover, and managers who deviate from their stated goals.
9. Most investors can't do it themselves. They need professional help — not so much to pick stocks as to hold hands.
10. When it comes to bonds, the best deals are Treasury Inflation-Protection Securities (TIPS), which pay a flat "real" rate plus an inflation kicker.
11. On technology stocks: It's fine to own them, but don't get carried away. Tech should not represent more than one-fourth of your portfolio.

Following these guidelines would not have prevented losses over the past 2 1/2 years. (After all, another essential truth is that stocks never go straight up. The Standard & Poor's 500-stock index, a good proxy for the market, has produced negative returns, after inflation, in 21 of the past 75 years.) But diversification, for example, would have limited the decline in the value of your shares.

From the date of printing of my "10 truths" through Oct. 31, 2001, the tech-heavy Nasdaq composite index fell 34%, but if you had invested in Spiders — an exchange-traded fund that's the soul of diversification, behaving like the S&P itself — your loss would have been 18%. And if you had continued to buy stocks on a regular basis throughout the decline, you could have cut your losses to 15 percent or less.

This column originally appeared in the Washington Post.