The economic recovery coming out of the recent recession has been anything but robust, with tepid job creation and other economic numbers that, while positive, have been weaker than what we usually see coming out of an economic downturn. Investors have viewed the recovery as fragile and vulnerable, capable of being "knocked over with a feather." This past summer, the concerns about a so-called "double-dip" recession took center stage, and the market took a nosedive. A return to recession conditions would mean that expectations of future earnings were too high (earnings per share are the denominator in the P/E ratio, so if the expected earnings turn out to be too optimistic, stock prices are likely to fall). The market started to price in the prospect of slower growth--or no growth, or worse, negative growth--and stocks fell. When it appeared that the recovery was still on track, stocks rallied, until the European crisis replaced the double-dip as the major concern. The market has been struggling with two opposing forces: relatively good economic news at home and bad new from overseas. When it looks like the Europeans are getting their financial act together, stocks have a good day. When it looks like they really have not effectively dealt with the crisis, stocks have a bad day. And so on. This volatility is likely to persist for some time, so we need think about our risk tolerance and conduct a little portfolio check-up.
Let's consider the nature of risk. No one boards an airplane and thinks about the "risk" that the flight will land safely at its destination. No, we think of risk in terms of bad things, the risk of loss: having our house burn down, getting sick, losing a job, having our business fail.. In the financial sense, though, risk more explicitly includes the potential for good, as well as bad, outcomes. Put another way, risk is the chance that the actual outcome will be different from the expected outcome, perhaps better than expected or worse than expected. If we insist on being exposed to no risk whatsoever, then we might as well put all of our investment money in Treasury Bills (if we put it under the mattress, it could be stolen or burn up in a house fire). In order to have the potential for higher returns, we have to take some risk. It is the potential for those higher returns that compensates us for taking the commensurate risk, and as the potential for higher returns grows, so does the potential for big losses. No risk, no reward. No guts, no glory.
We can reduce some of the company-specific risk through portfolio diversification. We want to own stocks in a variety of different industries, where some are less sensitive to the economic cycle than others. I also like stocks that pay dividends, so that we are not only "paid to wait" for future capital appreciation, but also "paid to endure" the volatility, as well. Right now, the market is offering up some some very attractive dividend yields in several different industries. We need some low-Beta stocks in the consumer staples area, such as Proctor and Gamble (PG, $64, 3.25% yield), Kraft (KFT, $36, 3.20% yield), and Pepsi (PEP, $64, 3.20% yield). We might want to take a look at Johnson and Johnson (JNJ, $63, 3.60% yield) in diversified healthcare and Merck (MRK, $35, 4.80% yield) in pharmaceuticals. You wouldn't know it from the recent action in the stocks, but growing worldwide demand for energy is a major investment theme where investors should have some exposure. Conoco Phillips (COP, $68, 3.70% yield) would be a portfolio candidate here. We could also consider an oil-services company like Schlumberger (SLB, $67, 1.4% yield). Not all of our companies need to pay big dividends, and that's a good thing because we'll want some exposure to technology. EMC (EMC, $22, no dividend) is a data storage company that stands to benefit from major trends in "big data" and cloud computing. Qualcomm (QCOM, $53, 1.6% yield) supplies the chips and other technologies that go into smartphones and other wireless devices. Finally, we might want to look at a media company like Disney (DIS, $35, 1.65% yield). Disney owns a lot of content, including all of the Marvel Comics characters. Disney also owns ESPN, and I don't think the value of ESPN is fully reflected in Disney's stock price.
No matter how successful we are at diversification, the inescapable truth of investing is that the majority of a portfolio's return is determined by asset allocation (the relative percentages we invest in stocks, bonds, and hold as cash). We can pick the very best stocks from a variety of industries, but if the overall market is sinking, then we are going to lose money, at least on paper. We can reduce company-specific risk through diversification, but the only way to address the risk of an entire asset class (like stocks) is to manage the percentage of our assets we have exposed to that asset class. The asset allocation decision needs to be based on each investor's own financial profile--there is no "one size fits all" answer here. Someone with 20 or more years until retirement who can regularly add to their investment account from current income can afford to have more exposure to stocks than someone whose retirement is within a few years. Time is usually on our side, and the longer it is until we need the money the more we can allocate to stocks, generally. Stocks would be appropriate for a child's college fund if the child is five years old. By the time he or she gets to high school, however, we need to start converting those investments to cash. The challenge today is that bonds, with the 30-year Treasury yielding 3%, don't seem to offer much compelling value. (There are some values in specific bonds, but you have to find them.) One strategy is to keep some cash and be ready to buy stocks the next time we are ambushed by the news out of Europe.
A few months ago a friend of mine was telling me of his frustration with the market volatility. He said he was thinking of just selling all of his stocks and holding cash until the market settled down. I strongly suggested that he not do that. If he had followed through with his plan, he would have sold at just about the market low since July. That's the problem with what is known as "market timing"--it just doesn't work the vast majority of the time. We might get lucky occasionally, but the typical result is that we end up selling low and buying high. It's important to own some stocks, because that's where we have at least the potential for growth and returns that can exceed what other assets offer right now. We need, though, to understand what we own and why we own it, and to be able to sleep at night with the portion of our investments we have in stocks. Some famous advice from Warren Buffet is worth remembering as well: "Be greedy when others are fearful, and fearful when others are greedy."
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If all that can grant you some peace of mind, then I recommend getting away from it all with some diversions. Specifically, pour yourself a cocktail or other libation. I suggest the 12-year old McCallan. Then, pop an old movie into your DVD player and enjoy. I especially like The Big Sleep, starring Humphrey Bogart and Lauren Bacall. That's the movie version of Raymond Chandler's first novel; William Faulkner was one of the screenplay writers. Two other classics in this genre are The Maltese Falcon and The Thin Man, both based on the Dashiell Hammett detective novels. At our house we like to watch The Thin Man on Christmas Day, and it is sort of a Christmas movie in that the story takes place in New York over the Christmas holidays. Then, there's always It's a Wonderful Life and the original Miracle on 34th Street (which features a very young Natalie Wood). Relax, and the only things you'll need to kick are your shoes off.
Life is short. Get busy.
Jim
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