Starting Over: The Investing Portfolio that Will Preserve Your Wealth and Your Sanity

This chapter is from the book

Never Buy Another Stock Again: The Investing Portfolio that Will Preserve Your Wealth and Your Sanity

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This chapter is from the book

This chapter is from the book 

Never Buy Another Stock Again: The Investing Portfolio that Will Preserve Your Wealth and Your Sanity

Learn More Buy

Deprogramming

Part of what caused this amazing run in the equity market was an unprecedented period of relatively stable economic growth. After the harsh recession of the early 1980s, the economy suffered just one contraction between 1982 and 2001, in the early 1990s. Fed chairman Greenspan sometimes talked of the "Great Moderation," the period of time when economic cycles became less volatile and less disruptive, and certainly this period, encompassing nearly two decades, qualifies.

During this period, several significant developments occurred that facilitated the greater involvement of investors in the equity market. For one, interest rates declined from double-digit rates as part of Fed chairman Paul Volcker's effort to choke off inflation. Lower rates supported borrowing, which supported the equity market.

Second, the creation of the 401(k) plan, the 403(b) retirement vehicle, along with the individual retirement account and specifically designed accounts for individuals to sock money away for education for children, piqued interest in equity investments. "There were all of these plans to save for retirement that hadn't been there before, and suddenly America had a way to invest in the stock market in a tax advantaged way," said Kevin Flynn, head of Avalon Asset Management, an investment advisory in Massachusetts. "There was a wonderful excitement in the investment world for years."²

The spirit of this feeling was captured in a commercial for discount brokerage Charles Schwab in the late 1990s. Olympic skier Picabo Street is shown in a weight room talking about an unspecified "crash." Since she had broken her leg in an awful wipe-out the year before, the natural assumption was that she was discussing skiing. She then makes it clear that she isn't speaking about skiing at all—she's referencing the one-day, 22 percent decline in stocks in 1987, which she concludes was a buying opportunity, and not a crash.

With that in mind, the massive explosion in interest in the stock market rewarded investors with staggering outperformance. The Dow industrials put together a streak of nine consecutive years of positive returns, and between 1996 and 1999, the Dow industrials returned more than 22 percent in four of five years (the straggler was a still-terrific 16 percent gain in 1998). It's no wonder that the three-year bear market lasting from 2000 to 2002 did not dissuade investors from the by-now accepted behavior that buying again was the most prudent course of action.

The hangover from those gains was easy for investors to dismiss. Plenty of people simply brushed off those losses, rationalizing the 2000-2002 period as a consequence of overly optimistic buying of Internet companies that did not make money. (The 9/11 attacks also hastened the decline in equities.) Investors went back to their old ways, buying heavily in stocks—and as we shall see, real estate—but this time, doing it by borrowing lots of money, using their houses as a casino with home equity loans. And what was merely risky—putting all of one's eggs in one basket, that basket being the stock market—became downright foolish when they were somebody else's eggs.

It's been a tough lesson to learn. Since 2003 investors have found that the old saw about stocks being the best investment for long periods of time has not held up. Since 2000, the Dow has finished higher in four years, and finished lower in five years, including the devastating 34 percent decline in 2008.

But even after such a lackluster period of performance—what is already being referred to as America's "lost decade" in equities—learned behavior is hard to change. There's an odd paradox at work here: Investors are told to avoid selling stocks in response to a sharp decline, because that's considered "panicking." But frenzied upward moves in equities are not met with the same cautious advice—investors are instead told they'd better act lest they "miss the rally." Either way the prevailing advice defaults in favor of buying more stocks, and also happens to be the one guaranteed to cause the average investor the most stress—you're either sweating out sharp declines in stocks while doing nothing, or instructed to dive right in again after losing lots of dough. This is a particularly curious set of rules to follow, because long-run statistics show that most major markets, at one time or another in their history, have lost about 75 percent of their value. This tends to happen when the greatest number of people have convinced themselves of the market's value and are most leveraged to continued success in the market.

Even after the horrific bear market that commenced in late 2007 and saw stocks fall to 12-year lows in March 2009, investor behavior has still been slow to change. Between March 2009 and late August 2009, the stock market rallied by 50 percent, and the investor populace, forever convinced of the stock market's superiority, rushed headlong back into the equity market. In January 2009, assets in money market funds, a safe, cashlike investment, hit a peak at $3.92 trillion. By the end of August, more than $300 billion in that capital shifted out of those money market funds and back into stocks, according to Mizuho Securities.³

Confidence among investors, while not shattered, has been eroded. After the sharp move back into the market among mom-and-pop investors in the summer of 2009, money market fund assets remained at a stable level as the market continued to rally, suggesting investors had become a bit more gun-shy, and equity inflows, according to the Investment Company Institute, trailed inflows into fixed income funds, suggesting that the overall appetite for risk has shifted away from stocks. But it's hard to say whether hope springs eternal here—in 2010, data on flows into equity funds started to show, once again, that investors were getting back into stocks, after a gain of more than 60 percent, the biggest 12-month rally in the history of the Standard & Poor's 500 stock index. Once again, individuals are showing their shortcomings, and they appear, once again, all-too-willing to forgive and forget, and go back to what's familiar. Are you one of those investors? Did you stay away for 2009 and then jump back into the market in 2010 after a spectacular rally that had already concluded? You're not alone—and your sudden enthusiasm comes just as institutions, which have made hay off the 2009 gains, are finding the environment a little more circumspect.

Investor tolerance for risk has been at least somewhat altered, though—a report from consultancy Spectrem Group published in October 2009 noted that newly conservative investors with assets of $100,000 to $1 million were unlikely to change those behaviors in the long term, citing the sharp decline in their portfolios. Cash had become king, and bond market investments looked better as well. They were also monitoring their investments more closely, as 55 percent of the nearly 2,000 surveyed said their losses had "seriously impacted" their long-term financial plans.⁴

The greater attention to detail is a positive development, as is a newfound realization that the market would not provide rich gains for year after year. In a sense, this is the new version of the Great Moderation—the moderation in investment behavior that deals with the reality of gyrations in financial assets and attempts to insulate against it, rather than simply assuming all goes for the best. Time will tell, however, whether this recent streak of cautiousness we've all adopted goes by the wayside if stocks continue to perform well, or whether behavior has been changed irrevocably. The way things usually go is that people swing from one extreme to another—the average American remained deathly afraid of the stock market for years after the Great Depression. Once the love affair with equities was rekindled in the mid-1980s, though, it was impossible to give up for so many. Margin borrowing rose, people borrowed on home equity to finance purchases in the stock market, and America made unlikely celebrities of Fed chairman Alan Greenspan, CNBC anchor Maria Bartiromo, and Jim Cramer of TheStreet.com.

Now, after an ugly two-year recession that has left the economy overleveraged and on shaky footing, Wall Street doesn't have a lot of friends. Data on mutual fund inflows suggests that the ingrained mistrust of brokerages, which remained at a simmer when things were going well, is red hot. You're looking to preserve your capital, and right now the government seems like a better place than anywhere else.

But that would be a fool-hardy approach, because the government bond market is likely to provide very limited returns.

We'll get to the specifics of what to do there in a bit. The first task, however, is deprogramming: It's retraining your mind to understand that the reflexive advice you've been hearing for the last decade-and-a-half (in the face of all evidence pointing the other direction) should be largely ignored. There are a number of good lessons in the long-run historic data in the stock market, which we'll look at shortly, but few seem to acknowledge that simply repeating mantras about staying in the market at all times is not the path to success. Mutual fund data, for now, seems to suggest that investors may have finally gotten the idea when it comes to this—and it only took a couple of really, really hard blows to the head to figure it out. If the definition of insanity is doing the same thing time and again while expecting a different result, well, the bulk of stock pundits would have been put in a white room with padded walls a long time ago.

Those of you looking for easy answers will not find any such comfort here, and you should be wary of anyone who gives you the impression that this—managing your money—is an easy task. It is not. It will frequently be stressful, and it is naturally going to be emotionally taxing at times. Yes, it can be fun—particularly when things are going well. But they're not going to always go well. And the complex nature of it is part of the reason why I am advising, in general, to avoid complicating already tough decisions with individual stock investments. Your time is better spent elsewhere. In these pages we will go through the various basics for getting your portfolio set up, so your assets can be in sound shape for what is likely to be several more years of tumult.

But the first lessons are going to be in psychology and in nerves. Those who stay alert and skeptical tend to fare better, even if for a few years they were considered stodgy because they refused to go all-in and bet on the most aggressive investment that was being proffered by talking heads and Wall Street brokerages. I've also been investing for years—making plenty of mistakes along the way—and have come to realize that those who don't have the time to try to outperform markets should look to work with their money as best as they can through keeping their costs low and their losses at a minimum. It's simple advice, as much of the advice in this market tends to be, but it's not well-followed, as the historic performance of the individual will show you. Learning that there are limitations does not mean you can't put together a portfolio that will stay relatively strong during tough periods—you have to accept some losses, after all—and do well during the good times.

With that, it's time for a few aphorisms that could come from the mind of Al Franken's Stuart Smalley character from "Saturday Night Live," the relentlessly optimistic self-help counselor. Consider them ways to keep yourself humble and in a cautious frame of mind when the market gets out of control. Here are Gaffen's four rules for investing:

1. You don't know everything. This is okay.
2. You're not missing something by not buying _____.
3. It's okay to move money from one asset to another.
4. It's okay if you lose money. Accept this as part of investing.

Much of the conventional wisdom the market belches out revolves either around the notion that you can do this better than anyone, so go for it!, or that you should give your money to someone who presumably does know everything. It's the nature of this market that we will continue to strive for that ideal, that market-beating mechanism that will work for infinity, and not just a lucky streak of six years or something, which we'll talk about at length in the coming pages. But admitting you don't have all of the information is merely prudent. Recognizing your own limitations as an investor is crucial; it's one reason why you picked up this book! This will also allow you to keep your objectives clear and your philosophy simple: that low-cost investments, keeping yourself away from big losses in your portfolio, taking advantage of opportunities that will keep taxes low, and strategic shifting of your money and proper diversification, should keep you in reasonably solid shape for the bulk of your investing life.

The second point—that you're not missing something by skipping on the fad of the week—is key. It's one we'll discuss at great length, as many people have convinced themselves of the better mousetrap, only to lose everything. This is fine if you have a million dollars lying around to play with. (I still don't recommend it, but knock yourself out.) But your nest egg is not for playtime. If the industry or stock in question becomes successful, buying large, total market indexes will eventually see the fruits of this, and if it doesn't, well, you haven't lost much. This goes for new products or different asset classes that somehow are advertised as insurance against any and all pitfalls (Gold! Commodities! Hedge funds! Alternative Assets!). But with the exception of a government debt instrument that's rolled over consistently from now until you eventually die and leave your assets to your children, there are almost no guarantees in terms of getting your money back. Annuities have such guarantees, true, but there are costs to be considered as well. Pensions have a defined guarantee, although with so many big municipalities and states in trouble around the U.S., who knows how that'll turn out. But for self-directed investments, other than government debt, the guarantees are few. And government debt is not going to get you the kind of asset appreciation that will fund your retirement, not if you live for 30 years after you finally turn in your keys at the office for the last time. This is the reason why other riskier assets are the ones people lean on in their portfolios.

The third point—that it's okay to move money around—is one that's been lost for decades amid the ridiculous rise in the equity market. It took mutual fund investors a while after the gut-wrenching losses of 2008 and early 2009, but mutual fund data shows investors getting back to the stock market in 2010—after they'd already missed what is likely to be the best rally of their lifetime. And it's a sign of the reflexive belief in the stock market's role as savior of all that is good and holy. But you're allowed to sell your equity holdings if they are moving against you; simply leaving them alone does not make you prudent or heroic. With the proliferation of exchange-traded funds and mutual funds that invest in currencies, commodities, real estate, corporate debt, and hard assets, you're not forced to stick with a mundane stocks/bonds split.

The last point is perhaps the most important. Many people open individual retirement accounts and 401(k) accounts and overweight in stocks, particularly if there are hot funds available looking to capture strong performance in bank stocks, small-caps, technology, emerging markets, or corporate debt. But suddenly, things aren't going well, and now that fund in question is down substantially from where you purchased it. Well, the historical data is not going to help you. The fund is up 30 percent in the last two years? That's great, but for someone else—you weren't there for it. So take a deep breath and repeat after me: I'm allowed to sell this. You've got a lousy fund that's not getting anywhere? I'm not talking about a fund that's only up a few percentage points while everything else runs to the moon—that's perfectly acceptable. I'm talking about a dog, something that's getting killed, down 15 percent while the rest of your assets go nowhere. If it worries you that much, get rid of it—you've lost 15 percent on it but you won't lose any more.

If you do sell certain investments, you're going to risk the possibility that they come back in a big way. This has to be accepted. You're going to risk also that cash does nothing (as it tends to do). But small losses help you prevent big losses. Funds can be repurchased, and if you're so enamored of this one investment, keep it on your radar screen and perhaps get it back later when it has stabilized. Everyone makes mistakes when they invest—I left my money in the stock market much longer than I should have amid the meltdown in 2008—but keeping those mistakes small will preserve your capital.

First, though, we have to start with the deprogramming. In the 1960s Timothy Leary exhorted a generation to "Turn On, Tune In, Drop Out." I'm not suggesting anything so drastic as to remove yourself from the market entirely. But there's a lot of noise that can be filtered from your daily diet, and it starts with most forms of media, but particularly the television. So we're going to drop out. That means it's time to turn off the racket that is CNBC and the ongoing clamor of upgrades, downgrades, and smugness that makes up the bulk of that station's programming. Most of the station's commentary—other than finance guru Suze Orman—isn't helpful for long-term investment strategy and really only serves to amplify conventional market wisdom and heighten your sense of insecurity. Get shut of it. You need to start with that much. Your retirement does not depend on the next round of corporate earnings or the monthly report on the Federal Reserve's Philadelphia-region business activity index.

From there, it's time to start ignoring the investing blogs that constantly advise shifting from one position to the next, and particularly to leave behind the rumors and stock-touting that make up the bulk of investing discussion boards. This isn't to denigrate blogs: I wrote one for three years covering the ups and downs of the market on a daily basis, and there are many terrific individuals out there watching the market and writing interesting things in the blog format. Many of them, because they're concentrated on one thing, are particularly astute. But consider them the way you consider your favorite sports columnist—something to enjoy without having to follow to the letter.

There are also those (and this is especially true of message boards) that don't go much further than being a tout service. Furthermore, you can go and chuck into the trashcan every magazine telling you about "the best funds to buy now" and can every weekly or daily newspaper yammering on the newest strategy designed to avoid all of the pitfalls that they somehow didn't manage to pick up on when they were advising you to buy the last fad—the one that led the market into the toilet when stocks tanked just a few years ago.

It was this advice that gave birth to the main idea of this book. In a busy daily routine that involves holding down a job, caring for children, maintaining a house, and myriad other responsibilities that many of you have, it's hard to find time for anything. And as a result it requires triage: You have to worry about your money, but the requisite amount of time you need to truly keep track of individual shares is more than a person with a full schedule can bear. You've got to take care of medical expenses, funding your retirement, education for your children, making sure bills are paid, mortgages are taken care of, and taxes are accounted for, in addition to putting your money away in investments that are properly diversified in a number of areas. Within that investment portfolio you have to diversify between stocks, bonds, cash, and a number of other asset classes we'll get at later—and keep track of when it's time to rebalance your portfolio. With all of this in mind, something has to give—and the research into positions on individual shares is a prime candidate, and so are the costs associated with trading and paying for active management that already put you three lengths behind the field before the starting gun has been fired.

Now I know you're probably wondering, is it possible to still put together a portfolio that does well without buying individual stocks? Most assuredly it is, but it comes from paying attention to your costs, making sure you don't forget about your investments for months on end, and understanding what you need to retire with the kind of life you want. That's plenty of work to do without delving into individual names, particularly when most professionals are already pretty poor at trying to outdo the major market averages in the first place.

And that's another point to consider: There's an argument that simply investing a lot of your money in index funds (which is in part what this book advocates) means you're going to underperform the market no matter what, but I think that's the wrong parameter to begin with. After all, major indexes are representative only of themselves: the Standard & Poor's 500-stock index may rise a certain percentage in a given year and may be averaging 7 or 8 percent per year for the last 30, but if you only need 5 percent a year, the S&P 500 is meaningless. If you need 10 percent, it's just as meaningless—it's only a guide to itself. The goal isn't necessarily going to be to hit the market's average for a number of years, but to garner strong enough returns that will allow you to live as you want in your retirement. If you can do this with nothing but the carried interest from government bonds because you already have a massive nest egg, then good for you—you have little reason to invest in riskier assets. If you're struggling to fund a retirement, the reality is that you're going to have to take more risks. This is all the more reason, however, to keep costs low, so you're spending less of your capital on overhead.

This book is not designed to be defeatist. It's meant to help navigate through tumultuous markets, which we're bound to see more of in the coming years, and also to try to shift away from the reflexive notion that stocks are all that matter when it comes to putting together a portfolio.