Investing: Squeamish shareholders can create winning portfolios
Admit it: You're a coward. When you look danger in the eye, it's from the lens of a telescope. But that's not necessarily a bad thing when it comes to investing. And if you're tempted by this stock market — but too scared to do anything — you should create a cowardly portfolio.
A truly terrified investor doesn't ask what he will gain from an investment, but what he stands to lose. As investors learned last year, the answer to this question is important. If you lose 50 percent of your money, you'll need to earn 100 percent to break even.
Only 148 stock funds out of 5,554 distinct portfolios tracked by Lipper have recouped their losses since the bear market started on Oct. 9, 2007. And 2,085 are still down 25 percent or more since the market's 2007 peak. No wonder you're terrified.
Nevertheless, stocks are your best bet for gains over long periods of time. If you have a long-term goal, such as retirement, you need to tiptoe back into the stock market, if only to get returns somewhere above "pathetic."
Your best bet is a tame mix of stock funds, bond funds and money market funds. We first proposed the Cowardly Portfolio back in October 1998. It has gained about 58 percent since then, vs. 9.8 percent for the Standard & Poor's 500-stock index.
Before you get too excited, the Cowardly Portfolio's gains translate into a 4.4 percent average annual return over 11 years. But it has fared well precisely because it was born to be mild. The portfolio has:
20 percent in money funds. Money market mutual funds are the traditional haven for the craven. But the average money fund now yields just 0.04 percent, according to iMoneyNet, which tracks the funds. At that rate, you'll double your money in 18,000 years.
On the other hand, you won't lose anything. In fact, a money fund is probably the only fund around whose returns are likely to be higher in five years than they are today. And if you get a bit of courage, you can use the money in your money fund to buy something else.
We use Fidelity's money fund for the sake of example, but any money fund from a large fund company will do just fine.
30 percent bond funds. Bonds are another favorite of the fainthearted, because they're usually less volatile than stocks -- and because they make regular interest payments, which cushion any price decreases. Furthermore, if you hold your bond to maturity, you'll get the bond's full face value, plus interest.
That's assuming the issuer survives. A terrified investor will stick with Treasury securities. Here again, however, you won't get much payback for your prudence. A 10-year T-note yields just 3.34 percent.
We're using bond funds because their prices tend to rise when stocks fall, and vice versa. But here's a caveat: In the next few years, most bond funds are likely to be disappointments. Long-term interest rates are more likely to rise than fall in the next five years or so. Pimco Total Return is a fine fund, but if you're worried about high rates or inflation, you might consider a fund that invests in Treasury Inflation-Protected Securities, or TIPS. Pimco Real Return (ticker: PRTNX) is one obvious choice; Vanguard Inflation-Adjusted Securities (VIPSX) is another.
50 percent stock funds. All three funds are run by cautious, value-oriented managers.
The managers of Vanguard Windsor II, for example, look for beaten-up stocks with decent growth prospects. Selected American Shares, run by the management team of Chris Davis and Ken Feinberg, looks for stocks of growing companies selling for reasonable prices. And T. Rowe Price Equity Income is a large-company fund with a long-term record of keeping risks low.
This doesn't mean they won't get hit by losses: Vanguard Windsor II lost nearly 45 percent in the 12 months ended February 2009. In general, however, these funds hold up well in a bear market and rebound decently in a bull market.
If you want, you can ameliorate risk a bit more by investing in a low-cost exchange traded fund that mirrors the broad market. Then put a stop-loss order on your fund, which requires the broker to sell your fund if it falls below a certain price — say, 10 percent. The only drawback: If the market starts to climb again, you'll have to work up the nerve to get back in. And that could take years.