If your mother says she loves you …

Posted by on June 12, 2009 @ 9:03 am in Investing

I’ll admit it’s a stretch for investors to find something positive from the past 18 months or so. But perhaps one plus is that a number of investing beliefs are under examination, and that many of us are reconsidering our beliefs about the risks that are always present in investing. (Of course, there also are risks involved in NOT investing, but that’s a topic for another day.)

Young journalists are advised: “If your mother says she loves you, check it out.” A bit of investigation and a dash of skepticism are in order for investors too, whether applied to long-held tenets of investing or when seeking to debunk conventional wisdom. The important thing is to put some thought into your investment approach.

In a recent post, I wondered whether a three- to six-month emergency reserve—a very common rule of thumb—was sufficient, given data showing that the number of people unemployed for more than six months has been rising rapidly.

My colleague John Ameriks recently weighed in on the attacks made—often against crudely constructed straw men—against the idea of “buy and hold” investing. (FYI: We still think buy-and-hold, with periodic rebalancing, makes sense.)

And fellow blogger Steve Utkus wrote recently on how the negative returns from stocks over the past decade mean that many of us ought to relook at the math of retirement. (The implications of the math aren’t necessarily cheery.)

In the same questioning vein, Time magazine writer Justin Fox explored whether stocks could possibly be, as once widely believed, “the best long-run investment.” The article is worth a read, even though he says “the answer turns out to hinge on what you mean by best and what you mean by long-run.”

It’s pretty clear that some investors defined “long run” in terms of years, not decades. Otherwise, you wouldn’t have read about retirees who lost more than 50% of their retirement nest eggs during the market slide. A decline that substantial implies a portfolio invested either very heavily in stocks or in an undiversified or low-quality portfolio of bonds.

One common mistake, I suspect, is focusing too much on finding the best investment rather than “settling for” a less ambitious asset mix that is balanced across and diversified within asset classes (domestic and international stocks, bonds, and cash investments).

By definition, a balanced and diversified portfolio is simply never going to be the best investment in any particular period. And in a really nasty downturn like the one we’ve all just experienced, even “conservative” mixes of assets suffered declines that were unusually bad. But balance and diversification—boring old principles—still make sense. After all, the best investment isn’t necessarily the one that provides the highest return, it’s the investment that you can stick with and that you understand.

Consider the chart below. In 1999, when the stock market was booming, I didn’t conclude that my entire portfolio should be in stocks, even though they had produced an average annual return of 17.1% over the preceding 20 years, versus a 10.0% annual return for bonds. Likewise, this spring, I didn’t decide to leave stocks out of my portfolio, even though they’d been clobbered by bonds during the preceding 18 months. And take a look at the 20 years ended May 31, 2009: Stocks and bonds are a near toss-up, with a 7.7% annual average return for the stocks and a 7.2% average return for bonds. (In the chart, bonds are represented by the Barclays US Aggregate Bond Index, stocks by the Dow Jones U.S. Total Stock Market Index. For comparison, I’ve also included returns for a hypothetical stock/bond composite index.)

The question of whether stocks will outpace bonds over the next 20 years won’t be answered for, well, 20 years. But it brings to mind the old Damon Runyon line, with its twist on Ecclesiastes: “The race is not always to the swift nor the battle to the strong—but that’s the way to bet.”

Benchmark comparison

Source: Vanguard.

The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so that investors’ shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited.

Notes:

•  All investing is subject to risk. Investments in bonds are subject to interest rate, credit, and inflation risk.
•  The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
•  Past performance is not a guarantee of future results.
•  The link to Time.com will open in a new browser window. Vanguard accepts no responsibility for content on third-party websites.
•  We invite your comments on this Vanguard Blog entry. Comments will be monitored and published at Vanguard’s discretion. Comments received prior to July 7, 2009 will not be published.

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