Our Community in Fairfax County, Virginia
Ever get junk mail from a self-proclaimed stock market expert with seven sure-fire stocks to invest in—but you have to buy the expert's newsletter to find out what those stocks are? Do these "experts" highlight their past recommendations that went horribly wrong, or do they only tell you about their biggest winners? Do you have a stock broker calling you with ideas of stocks to buy—after they have moved up in price—and occasionally on stocks to sell—after they have already tanked?
At our 1 May 2007 civic association meeting, senior financial consultant Andy Krosnowski from Krosnowski & Scott LLC (securities offered through First Allied Securities) provided us with information and advice on how to approach investing the smart way. Rather than give us hot tips on what stocks, mutual funds, bonds, or other investments to buy, he taught us how to think about investing from the perspective of minimizing risks and maximizing total return. And yes, we can do both!
You probably have heard that older investors who may need their money soon and have little tolerance for a large, multi-year drop in their portfolio's value should invest conservatively in bonds and money markets, focusing on safety and income. Middle aged investors should have a longer time horizon and invest roughly 40% in bonds and money markets and 60% in stocks, adjusting this ratio up or down depending on personal preferences (but always keeping at least 20% in each type of investment).
What you probably didn't know is that younger investors who choose to accept the greatest risk by investing solely in stocks, either individually or through stock mutual funds, are unlikely to do as well as their colleagues who choose a balanced approach as recommended for middle aged investors. Andy recommends the same balanced approach even for aggressive younger investors, and he has the research to show why.
This philosophy is known as the "margin of safety" concept. Benjamin Graham (known as Warren Buffett’s mentor and the Grandfather of "Value" investing) coined the phrase when referring to the fact that even the most aggressive stock investors should consider allocating approximately 20% of their assets to bonds and money markets. This insulates their portfolio during periodic stock market corrections and helps them to not panic and sell out of the stock market. By staying fully invested in the stock market over the long term, investors dramatically improve their chances of success.
Predicting which stocks or classes of stocks are going to be hot over then next few years is a losing proposition. Every investment firm that tries to do this invariably focuses on last year's hot picks, or they raise a bunch of possibilities for turnarounds in the next year with no guarantees. Their prediction performance, on average, is not much better than throwing darts at a page of stock quotes.
Andy recommends an investment philosophy of diversity. What will do better next year—US or foreign stocks, value or growth stocks, small or large companies—who knows? It changes every year or so. By diversifying assets across these investment categories, investors can obtain more consistent returns with less risk or price volatility than more concentrated, less diversified portfolios. Better yet, historical data shows that by selecting stocks or stock mutual funds that focus on companies with increasing annual dividends, you can get maximum returns at minimum risk.
Wharton Business School Professor Jeremy Siegel has conducted exhaustive studies of past stock market performance and found that stocks with a history of paying dividends that increase each year give better long-term results than either growth stocks, which pay no dividends, or stocks that pay the same dividends each year. These dividend growers were also 40% less volatile than growth stocks. Better results with lower risk—how can you beat that?
Professor Siegel studied US stock market performance over the last 200 years and determined the optimal mix of stocks and bonds that gave the highest possible return over 10, 20, and 30 year periods. Called the "efficient frontier" concept, his research shows an optimal mix having more fixed investments than you might expect for aggressive long-term investors and more stock investments than you might expect for conservative short-term investors:
Putting It All Together
Professor Siegel's table is a great starting point for determining the best mix of fixed and stock assets. For fixed investments, there are many good options available, such as US Treasury bonds, US Savings bonds, certificates of deposit, tax-free municipal bonds, corporate bonds, bond funds, and money market accounts. Each of these fixed investments has its own pros and cons, and you should diversify your fixed assets among several of these, if possible.
For stocks, it comes down to a choice between individual stocks, stock mutual funds, or a combination of both. Whether individual stocks or mutual funds, the best way to maximize yield is to focus on a diversified portfolio of dividend growing stocks. For example, consider one mutual fund company—American Funds. Its’ Global Equity Income Portfolio was ranked #1 out of 45 among equity income portfolio by Lipper Analytical Services over the last 10 years, and #1 out of 108 over the last five years (period ended 12/31/2006). Compared to other portfolios offered by the American Funds, the Global Equity Income portfolio was the least volatile, yet one of the best performers with an average annual return of about 11% over the past ten years (period ended 12/31/2006).
If you are looking to withdraw money from your stock investments, an equity income fund that focuses on dividend growing stocks worldwide is an excellent choice. Because these funds are paying roughly 3% in dividends, you can withdraw up to that amount each year without having to sell any shares. And if you withdraw less than the full dividend and reinvest the rest, you can increase the number of shares owned (and the amount of next year's dividends) while also drawing money for your personal use.
What about annuities?
If you are nearing retirement, you've probably been pitched about annuities and the lure of converting your retirement savings into monthly checks for the rest of your life. For people who feel they must have their principal guaranteed against loss or who need a guarantee of income from their investments from an insurance company, an annuity product may be worth consideration. However, for most people, Andy believes annuities are a bad idea. They have high annual fees (up to 3%), are not very liquid in case you later decide you need a large amount of money for an unexpected situation, and can guarantee your income only as long as the insurance company stays in business. Also, investment advisors make a lot of money up front when they sell an annuity and then tend to forget about you.
There are many alternatives that allow you to invest your retirement savings as you see fit and withdraw a fixed amount each month—like a self-directed annuity. Talk to an investment advisor and see what ideas they come up with.
Which mutual fund class is best for me?
If you plan to hold a mutual fund investment for the long term—over five years—invest in the A class of the fund. It will have the highest initial fee of all the different fund classes, but the annual fees are the lowest of all the classes and there is no fee when you sell, making it the best choice for the long term. However, if you plan to hold shares for less than three to five years, "C" shares may be more appropriate. Always read a prospectus before investing in mutual funds.
Andy Krosnowski would be glad to talk to anyone about these issues. His new office is close by, on the south side of Route 7 between West Road and Spring Street. Give him a call at 703-506-8310.