Should You Be In the Stock Market?

Photo by: mvhargan

I often hear people tell me that they’ve stopped contributing to their retirement account because they don’t think the stock market is going to go up.  It seems many of these people assume that a retirement account and the stock market are one and the same.  Most plans have many options, and nearly 64% have actively managed bond funds as an alternative.1

The fact that many people don’t even know what their options are in their retirement accounts suggests to me that they probably shouldn’t have been in the stock market in the first place.  Many people were initially sold on stock market-based retirement account options by claims that the stock market returned 8%, or 11%, or whatever their advisor was telling them. They put their finances on autopilot and never looked back.  At least they never looked back until 2008.

The Risk Premium

The philosophical rationale for why stocks should outperform “safe” investments, like government treasuries, is something called the risk premium.  In theory, if equities did not outperform safe investments, then rational actors would cease to buy the equities. The prices would decrease to a level where there would be an adequate risk premium.

This theory was put to the test during the recent financial crisis when, at the nadir of stock prices, there essentially was no risk premium for the previous thirty years.2  Since then, stocks have rebounded a good deal and the risk premium has returned. However, it points out an important fact: the risk premium is only likely in the long term and is not guaranteed.

Risk Tolerance

Because of the wild variability of the risk premium, the value proposition of equities decreases as you get closer to an expected retirement date.  Once you have a near-term window for beginning withdrawals, the amount of time your returns have to “average out” decreases, and your exposure increases.  As you get closer and closer to retirement, equities should become a smaller and smaller portion of your portfolio. (more…)

1. PSCA.org – 51st Annual Survey of Profit Sharing and 401(k) Plans [↩]
2. Bloomberg.com – Bonds Beat Stocks in ‘Earth-Shattering’ Reversal: Chart of Day [↩]

The Difficulty of Investing in 2009

Photo by: Mel B.

2009 is a dreadful year to try to invest.  While we have seen a massive rebound in stocks, there are a variety of factors that make long term planning very difficult.

Asset Class Difficulties

The first thing that makes the current economic climate so difficult is the correlation between asset classes.  Under normal circumstances declines in one asset class involve money moving to another asset class.  Thus when stocks go down, bonds or gold or another asset class is usually the beneficiary.

What makes the current economy so difficult is that you see capital essentially being “destroyed” by the deflationary spiral.  Forced liquidation on the part of many funds caused by redemptions and margin calls contribute to this problem as well.  While this problem was particularly pronounced in 2008, you continue to see deflationary pressures affecting all asset classes.

Government Intervention

One of the most obvious difficulties of building a long term plan in 2009 is the frequency and fervor of government intervention.  Policy makers are attempting to walk several fine lines and thus are constantly exerting strong forces upon the market.  In their zeal they make it very difficult to draw long range conclusions about what makes sense.

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5 ETFs That Can Help Balance Your Portfolio

Photo by: Nicholas_T

While I generally advocate against investing in individual stocks for amateur investors, I make some exceptions for ETFs.  Exchange Traded Funds are funds that trade on the stock market like a regular stock, but represent underlying assets like a mutual fund.  These ETFs give you an opportunity to hedge your stock market positions and provide some balance to your portfolio fairly easily.  While I would still recommend a lot of research before buying any of these, each of these ETFs gives you some ability to round out your positions.

GLD: Gold

I’ve been known to make fun of “Gold Bugs” now and again in my days, but you have to admit that with the specter of inflation looming over all of the spending and stimulus, gold becomes a bit more appealing.  The mechanism for this ETF is supposed to be fairly straightforward, and it’s done a good job of duplicating the returns of gold recently.  Because most of the currencies out there are from governments who are in straits just as dire as the USA, it can be appealing to find a “currency” that no government has control over.

TIP:  Inflation Protected Treasuries

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Investing Step 9: Allocation

Photo by: PinkMoose

This post is step 9 in our Investing Template.

After all your tax-deferred accounts are being used to their maximum potential, it is time to fund any other accounts.  Once that is done, you need to start deciding how to allocate your funds.  This is the problem that many people did not properly address before the real-estate bubble burst and is the most important step to maximizing your returns.

Time Horizon

As we’ve discussed, the first thing you must decide in each account is how soon you will need access to the money.  You need to create an allocation based on this and adjust it accordingly.  Typically the more risky investments will even out over time and give the best returns, but can give horrible returns in the short run.  Thus the sooner you expect to use the funds, the less risky your choices should be.

For example, many people who were expecting to retire soon are suddenly in a state of confusion, because they left their investments in stocks and had massive negative returns.  This can be crippling for someone who was expecting to retire next year.  If they are expecting to retire in 20 years, there’s a good chance their investments will rebound.  However, if your time window is getting close you should be moving to safer, less risky investments, including cash.

Risk Aversion

In addition to the wisdom of avoiding risk when you are getting close to withdrawing funds, some people are very reluctant to put their money at risk at all.  If you are in this class, you should probably look to maximize your returns with very low or no-risk investments.  There are still many options available, even when capital preservation is a high concern.

The Spectrum

Here is a rough guide of some types of investments to consider, from least risky, to most risky:

•         Short Term Loans to Stable Government Entities
•         Mid and Long Term Loans to Stable Government Entities
•         Short Term Loans To Stable (Blue Chip) Companies
•         Long Term Loans to Stable (Blue Chip) Companies
•         Real Estate
•         High-Yield Debt (junk bonds)
•         Equity (Stocks and Mutual Funds)
•         Futures and Options

Real estate property has long been considered a safe investment, but recently this has been put into question.  Like any investment vehicle it is more easily navigated by experts and it is also very difficult to diversify.

Futures and options are best left to the pros.  In fact I recommend against even investing in individual stocks.  We’ll talk more about this in the next section.