How to Invest in Stocks for the Long Run
NEW YORK (TheStreet) -- There's a fine line between the optimist and the masochist. Individual investors may be forgiven for wondering on which side of the line they reside.
Being an optimist myself, I don't particularly like busting other people's bubbles -- we've had enough of those lately. Nonetheless, for my inaugural Long Run column, I have to begin on a negative note: Investing isn't going to be easy the next few years.
"For the long haul, we're going to be in for a period of fairly tough markets," says Ralph Wanger, manager of the (ACRNX)Liberty Acorn fund since 1970. "You're going to have to have substantial skill to prevail, because you can't wait for the markets to bail you out."
If you're still reading -- indeed, if you're still checking out TheStreet.com and other financial news publications -- then the bear market hasn't scared you away. That's wise, because stocks remain investors' best bet for the long haul. However, we are in a new era, only not the one people were touting a few years ago.From August 1982 to March 2000 -- the greatest bull market in history -- real returns averaged 15.6% a year, according to Jeremy Siegel in his book Stocks for the Long Run. That's more than double the historical rate of equity returns. Regression to the mean hasn't been fun. This doesn't mean that you can't make money. It simply means that the rules of the game have changed -- and some tried-and-true rules have returned with a vengeance. Investors who adapt to the changes will fare better than those who are still using the old playbook. The Long Run aims to help long-term investors succeed in this new era, whether the market goes up, down or sideways. In the coming weeks we'll discuss some smart investing ideas for the long run. But this week, let's start out by revisiting the Rules of the Game.
Know ThyselfThere are plenty of investing strategies out there -- buy and hold, deep value, active trading, index investing. The first real step investors should take is determining exactly what type of investor he is. "For a long-term investor, you have to know yourself," says Michael Mach, manager of (EHSTX)Eaton Vance Large-Cap Value. "The key is to pair your personality with a logical investing approach. If you apply it consistently, you'll prove successful." If you don't mind taking on a heaping portion of risk -- and don't lose your cool during periods of extreme volatility -- you can probably embrace a more risky strategy. Since most investors fall into the uncool camp (myself included), the Long Run will often focus on strategies that avoid undue risk and market-timing, favoring fundamental analysis and longer time horizons. Also, you have to be honest with yourself about how much time you will devote to tracking your investments. It's best not to take big stakes in a few companies in the rapidly evolving biotechnology industry, for example, if you don't plan to keep up with sector developments.
DiversifyDiversification is probably the simplest truth in all of investing -- and the most often misconstrued. In the 1990s, asset allocation for a lot of people meant 100% stocks, and about 90% of those stocks were large-cap growth. Virtually all investment vehicles have their ups and downs. However, too many individual portfolios consist of holdings that all move up at the same time and back down at the same time. "Investors need diversification, and by that I mean they need to diversify away from large-cap domestic equities," says Louis Stanasolovich, founder and chief executive of Legend Financial Advisors in Pittsburgh. "Buying three Fidelity funds, two Janus funds, American Funds Growth Fund of America and an S&P 500 index fund is not diversification." To achieve real diversification, investors need to build portfolios using investments with lower correlations to one another. For example, for your equity holdings, consider paring back your large-cap weighting and boosting exposure to emerging markets, international stocks, smaller-cap stocks and real estate investment trusts. (Using quantitative models, Stanasolovich has designed a well-diversified, "lower volatility portfolio" that returned 22.3% in 2000, a negative 2.2% in 2001 and negative 4.25% in 2002. In a forthcoming Long Run we'll discuss diversification with him at greater length.)
Reinventing Do-It-Yourself InvestingOne of the supposed hallmarks of the bull run of the 1990s was the rise of the do-it-yourself investor. The collapse of the stock-market bubble has led some pundits to declare the do-it-yourself movement dead. This is rich irony. One of the primary reasons why investors got so over their heads the past few years is that the notion of "do-it-yourself investing" was cast aside -- or at least poorly redefined. D-I-Y investing doesn't merely mean watching business news, reading The Wall Street Journal or TheStreet.com, listening to analysts or inside tips from your brokers; it means pulling up your shirtsleeves and doing your own additional research before making decisions. Doing it yourself isn't buying the stock that a professional or CEO just mentioned on CNBC. To redefine do-it-yourself investing, I'll defer to the original meaning of the phrase, succinctly put by Peter Lynch in One Up on Wall Street way back in 1989. "Stop listening to professionals! ... [Ignore] the hot tips, the recommendations of brokerage houses and the latest 'can't miss' suggestion from your favorite newsletter -- in favor of your own research." This isn't to suggest that you disavow all mutual fund managers, stock analysts, business news pundits and all other professionals. There are plenty of intelligent and trustworthy folks who can help you be a better investor -- and in the Internet age, you have plenty at your disposal. It simply means "trust, but verify." Use these resources to supplement your research, not replace it.
Be Passionate About Investing, Not Your InvestmentsBeing a successful do-it-yourself investor involves a lot of fundamental analysis, poring over company statements, analyst reports and online and offline research. You have to be passionate about it. You shouldn't, however, be overly passionate about the investments you make. "You have to be unemotional about the investments you hold," says Eaton Vance's Mach, who studied psychology at the University of Chicago and was a family therapist before managing money. "You don't want to be driven by emotions like fear and greed." This always holds true. But it becomes especially important to remember in a topsy-turvy market marked by lots of sudden moves but no sustainable upward trend. Investors need to stick to their guns and not blindly follow. "A lot of people wanted to sell everything in September  because they thought the world was ending, then in October they wanted to buy everything because we were going to the moon again," Wanger says. "Turns out, neither one was such a good idea."
The New EraTo get a sense of what the new era might look like, let's take a quick look past the market peak of 2000 to two previous stock market peaks: 1929 and 1966. Stocks didn't return to their previous heights until 1954 and 1982, respectively. When you adjust for inflation, make that 1955 and 1994, Wanger says. I'm not sure if it will take a quarter century to get back to March 2000 levels. But I do think investors need to realize that getting rich quick in this market isn't a recipe for success. I am also fairly confident that overweighting the previous decade's leaders -- technology -- isn't such a hot idea either. The 35-year chart below shows what happened to the energy sector after the energy bubble burst in 1980, and how technology has performed before and after its bubble.
|Tale of Two Bubbles
It was the best of times, then the worst of times for energy stocks. Technology stocks have suffered a similar fate and may keep sliding.
|Source: Credit Suisse, Standard & Poor's|
The 7% SolutionGiven the 18-year run of 15.6% returns, it's understandable that expectations got out of whack. But over the very long run -- 200 years, according to Siegel's research -- stocks return about 7% on average. Individuals -- and companies, in their overly optimistic projections for pension returns -- should expect the broader market to return the historical average over the course of their investing lifetime. "If you're expecting double-digit returns, you'll be disappointed," Stanasolovich says. Once you guide down your expectations, you realize 7% returns aren't so bad -- you'll double your money every 10 years. If you aim for a more realistic 7% annual return, you are less prone to deviate from the rules of the investing game. If you lower your expectations, it might be a lot easier to remain an optimist and not a masochist. Since I began this column on a negative note, I'll leave you with this piece of cockeyed optimism: The 2000s decade may equal the 1930s as the worst for investors. The decade from 1930-1939 marked the only decade in which the stock market averaged a loss -- notching a negative 0.05% average annual return, according to Ibbotson Associates. Why is this good news? Larry Sinsimer, managing director for managed accounts at Eaton Vance, points out that the average annual market return this decade has been negative 14.5%. "In order to equal the 1930s -- when we had Hoovervilles all over the country -- the stock market will have to return 5.6% a year on average." For the decade to have a flat return, the markets would have to return 6.5% a year.
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