Long-term solutions to short-term fear
Even with the stock market's recent tumble, Vanguard's chief investing guru, Gus Sauter, says index investing is still the way to go.
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| Sauter: "If you've made a good plan and truly assessed how much risk you can bear, you should be better prepared psychologically to stick out a bad market." |
NEW YORK (Fortune) -- Popular index investments like the S&P 500, the Nasdaq, and the Dow Jones industrial average have plummeted this year while select stocks like Wal-Mart, Family Dollar, and Amgen rose by double digits. Even so, Gus Sauter, managing director and chief investment officer at Vanguard, believes that indexes are still the smartest strategy for long-term investors.
He argues that the chances of choosing winning stocks all of the time are slim and that the downside of a single investment going bust can be too much for many people to bear. (Lehman Brothers, Bear Stearns, and Washington Mutual shareholders would likely agree).
While the highs will never be as high, a diversified basket of stocks should never see such lows, Sauter says. This position makes sense for him. His company Vanguard became a mutual fund powerhouse by giving investors access to broad swathes of stocks for bargain-basement fees.
Fortune caught up with Sauter at a conference held by Nasdaq and the Journal of Indexes where representatives from the American Stock Exchange, Goldman Sachs (GS, Fortune 500), Standard and Poor's, Barclay's (BCS) and Vanguard met to discuss how exchange-traded funds and index funds have been stress-tested over the past year, who has best survived, and whether investors will stay with index investing.
Sauter gave a few tips on how to ride out the current storm and where he sees bright spots even now when things seem so grim.
What should investors consider before getting into the stock market, especially when so much of the market is in free fall?
The first thing is to establish an appropriate asset allocation. The key is to determine how much risk you can handle. That will affect how much of your money goes to stocks versus less risky asset classes; and it will also determine what kinds of stocks you own. For example, emerging market stocks are generally riskier than U.S. large cap stocks.
The current turmoil is an important reminder that stocks go through volatile periods and that they don't always go up. But investors who have been willing to sit through those periods have done very well. That's why it's important to establish an asset allocation. If you've made a good plan and truly assessed how much risk you can bear, you should be better prepared psychologically to stick out a bad market.
When is the best time to invest in the stock market? Should investors wait for things to turn around before putting money into equities?
For someone who has a long investing horizon, even now would be an okay time to get into the market. First, it's impossible to time markets and wait for stocks to hit their bottom. Second, there have always been patches of volatility for stocks; and they have still provided one of the more attractive rates of return for long-term investors than any other asset class.
The best way to get involved is to dollar-cost average, meaning that you put a certain amount of money into your investment every month or quarter, no matter what's going on. Then you won't exclusively buy high or low.
What if I'm an investor who is on the verge of retirement and I've watched my saving get wiped out this year?
Hopefully investors started to reallocate money to less volatile assets like bonds or money markets as they got older. That's part of the asset allocation process. Many people feel less comfortable with risk as they age and their investment horizons get smaller, so they start to pull back from stocks.
Investors who made that choice hopefully blunted some of the downturn. But it is likely that many people will have to suffer through this volatility. They may have to work for an extra year to make up for the investment loss.
I do want to throw one word of caution out there. Just because a person may be 65 doesn't mean he or she should necessarily take a very short-term investing view. A person who is 65 now could live to be 90, and that could mean sticking with a longer term game plan.
As Vanguard's chief investment officer, what is your greatest fear right now?
That the fundamentals for company performance are not being reflected in the marketplace. The market has decoupled, meaning that stock prices are not tracking the value of a company. They track investor sentiment instead, so people are trading out of fear rather than the quality of a company. That makes things even more volatile. The Federal Reserve and the Treasury have taken steps to restore confidence, which is important right now.
What is the implication of recent moves by the Fed and the Treasury to for investors?
The government is trying to make sure that financial services companies like banks and brokerages have enough equity capital to restart their engines. This means banks having enough money to lend and brokers having enough money to make markets for other investors.
I would say that the government is starting to catch up with this beast and is clearly committed to fight a significant downturn. There are some small signs that liquidity is starting to pick up in the fixed income market, but we still have a long way to go. Nevertheless, the economy will continue to decline even after the markets have bottomed.
Where do you see bright spots?
There are a lot of potential bright spots right now because prices have gone so low. In fixed income, high-credit quality corporate bonds are providing tremendous opportunities because the prices have fallen and the yields are high.
In fixed income, I also like TIPS, or inflation-protected Treasury notes. They represent a good value because they are price for negative or very low inflation over the next few years. So if you think inflation rates will return to a normal level or even rise, TIPS are attractively priced.
As I said before, stocks have decoupled from fundamentals, so we think they will turn around when the market realizes that they are cheap. While we do expect the economy to be soft for six to nine months, maybe even longer, that's already factored into the price of stocks. 
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