Comeback Insurance for the Stock Market
Some day the sun will shine and the flowers will bloom and the economy will recover. Companies will still be in business and begin to grow profits and the stock market will rise again. It's hard to look past the current carnage but how do you prepare for a brighter future? Do you abandon the stock market permanently as two generations of Americans did after the Great Crash and the Depression? Or do you participate as did the people who reentered the market and enjoyed a two decade bull market after World War II.
One way to participate is to put together an ultra-diversified portfolio. Think of an ultra-diversified portfolio as comeback insurance for the stock market. In normal times, diversification is seen as a luxury or something that prevents you from racking up big gains. In tough times, it may be the difference between riding out the storm and getting permanently sunk.
What is ultra-diversification? In simple terms it means buying lots and lots of different things. So far in this super bear market, everything has been falling and falling a lot. It hasn't mattered what stocks you owned anywhere in the world; they've all gone down. Usually that's not the case and this is unlikely to last forever.
Even now financial stocks -- primarily banks -- have been hammered mercilessly. While the broad averages are down roughly in half since the bear market began, Citicorp is down more than 95 percent from its peak of the last year and many formerly blue chip stocks are down nearly as much. While they may regain prior values, it will be a long tough slog and many may never regain their formerly lofty heights.
Trying to foresee the future is always difficult. Now it's impossible. The carnage of a bear market and steep recession obscure the good things that are happening in the economy. By the time they become apparent, the next bull market leaders will have already made big gains. The best way to capture those gains is by holding broad batches of stocks.
While some fallen angels will recover, it's much more likely that the broad market averages will benefit fully from the eventual economic recovery. Oftentimes, only a handful of stocks, industries or geographies benefit from a market move. In 1998, the S&P 500 rose more than 20 percent. That increase was accounted for entirely by fewer than ten stocks, mostly big technology companies. Without those, the index actually would have been down slightly for the year. Picking them out ahead of time was nearly impossible. Two years later to do well one needed to hold small cap value stocks and no technology. A few years later, the ticket was energy stocks.
Who is that nimble? Who is that adroit?
By the sheer law of large numbers -- if enough monkeys press on the keyboard, they'll eventually produce Shakespeare -- someone will appear to be doing well. Is it luck or skill? It may be skill in some small number of cases but even if it is, it's nearly impossible to identify that skill ahead of time. Those who persist in trying to find that rare skill more likely hold themselves open to scams or legitimate but equally devastating disappointment.
The solution is easy. Hold everything. Hold a little bit of as many securities as you can all over the world. You'll capture the best and the worst but over time these returns have been robust. Including the Great Depression of the 1930s and the current unpleasantness, stocks over the years have returned more than 10 percent a year on average. That means that a portfolio doubles every seven year on average merely by matching the market returns. While no year is average, over the long term -- 10, 15, 20 years -- returns begin to converge on those averages. That may seem like a long time but investing, as opposed to speculating, is a long-term proposition. For those who truly want to invest, the wait is worth it and the returns that accrue are spectacular. It just takes patience and heeding the fundamentals of investing.
Ultra-diversification means holding thousands of securities around the world. The most widely held index funds, those based on the S&P 500, naturally enough hold 500 of the biggest U.S. stocks. That's good most of the time but what about when small stocks do well or Asian stocks? In the early 1970s you needed to own big fast growing stocks. In the late 70s it was commodities and small stocks -- how to know that ahead of time? How to know to jump off commodity stocks in 1980 after a great five year ride and not get back on for more than twenty years. How to know to get off small stocks in June 1983 after a great eight year ride and not get back on for almost a decade. Who knew that tech would be a disaster for most of the 80s and the ticket in the 90s before being a disaster again?
A guest on television got it right last summer. He said that if you think you know what's going on, you're just not paying attention. He was being honest and right.
No one knows where the winners will come from and the best chance to hold them is to buy as many different securities as you can all over the world. A few mutual funds hold thousands and thousands and they are well worth searching out. Look at the actual holdings, not the names. Just because something says "world" or "total" doesn't mean it has as many names as possible. No one knows the optimal number to be properly diversified, but if the cost is reasonable, more is better. And remember, a few holdings, those needles in the haystack that can rise 10 - 50 - 100 times, can make all the difference and just make sure you have them.