Build The Goof-Proof Portfolio
Forget about chasing hot stocks. To reach your financial goals, buy blue chips and follow this strategy for avoiding major mistakes
(MONEY Magazine) – In almost every game or contest, you have to choose between two strategies. Do you go all out, even if it means taking big risks? Or do you proceed cautiously, accumulating small advantages that will ultimately lead to victory? Amateurs typically take too many chances when they go for the gold, like the weekend tennis player who strains for a difficult shot and hopes it won't be returned. Professionals, on the other hand, know that the key is to avoid making unnecessary errors. They try for consistent small successes, like a chess master who maneuvers to win a single pawn advantage that will bring triumph if it can be preserved for the entire game.
As you sit down to review your investments for the year, you might apply the same metaphor to your strategy. In other words, have you been investing like an amateur or a pro? Are you constantly working to ferret out hot stocks with the biggest profit potential while trying to beat the market every quarter? Or do you concentrate on consistently matching or slightly outpacing the averages over five-year stretches, while striving to minimize your losses and expenses?
If you're doing a bit too much of the former, and your portfolio is suffering as a result (as it almost certainly would), you need to do two things: First, avoid the six big money mistakes that my colleague Jean Chatzky lays out on page 92. Second, remember this lesson from Warren Buffett: The stock market is designed to redistribute money from the active to the patient. The keys to reaching your financial goals consist of getting started right, fine-tuning your strategy as conditions change and always remaining focused on the long haul. Hot stocks that you can boast about owning at your New Year's Eve party are not the investments that will ensure your ultimate success. You won't get any envious glances from your friends if you announce that you held down your trading costs and investment management fees for the 17th year in a row. But your portfolio will continue to grow—and that's a lot more important than bragging rights.
Winning by not losing
Over time, even the most successful professional money managers can't beat the major market averages by more than a percentage point or two a year. Most pros are happy not to lose—they just want to keep pace with the Dow and S&P 500 indexes. But while the chances to excel are limited, the opportunities to goof up are almost endless. The more energetically you trade, the more you spend in commissions and fees. And every time you sell one stock and buy another, you create the opportunity for a mistake that results in a loss.
If this all sounds rather discouraging, it shouldn't. Instead of focusing on the limits to your long-term returns, recognize that you don't have to jump through hoops to be successful. Since you probably can't earn much more than the average market return anyway, you shouldn't waste a lot of time on market-beating schemes, and you shouldn't constantly feel as though you're not doing enough. Moreover, it's not that hard to come close to matching the overall market return. You can get there, less a small management fee, simply by buying three or four stock-index funds. And if you're the sort of person who takes comfort in keeping things simple, that's perfectly okay—at least until you're ready to step up to the next level as an investor.
This story offers you a user-friendly guide for setting up a goofproof equity portfolio and adjusting it as market conditions change. It isn't hard to get in trim for 2005, whether you're a fund investor or you prefer buying individual stocks, especially the Dow 30 and other blue chips. Follow the five principles outlined in this story, and over the long run you'll stand an excellent chance of earning the full market return.
Seizing the moment
This is a particularly good time to be reassessing your investments. Year-end is traditionally when many investors look at their portfolios and decide whether to sell stocks that have gone sour and deduct the losses for tax purposes. And since many stocks are flat or down for 2004, there's a lot of opportunity for tax-based selling. In fact, your stock mix may very well be out of whack nowadays. The boom and bust of the past decade was so extreme that just about everyone has held on to something too long or bailed out at the bottom. There's no need to justify those decisions—we all have brokerage statements we don't want anyone to see. Instead, your focus should be on getting in shape for the coming decade. We've witnessed enough of a rebound in the economy to be reasonably sure that a severe bear market like the one from 2000-03 isn't about to reappear. The recovery has been weak, however, causing slumps in many stock market sectors. Assuming the economy picks up again in 2005, which seems quite likely, the undervalued parts of the market should bounce back.
Conservative shares, especially those that pay dividend yields above 2.5%, have generally been strong performers over the past two years. And they look like they still have a ways to go before they're fully valued. Growth stocks, on the other hand, have lagged ever since the bear market began. Such companies are able to increase their earnings so fast that their share prices can often outpace the stock market's historical average return of just over 11% a year. But these stocks ran up so much during the boom of the late '90s that when the bubble burst, their prices tumbled. Now, after years of poor performance, the stocks have finally fallen enough to look cheap by historical standards (see the charts above).
As a result, there are plenty of stocks that look poised for a rally. One of the best places to look for top-quality stocks, both conservative and aggressive, is the Sivy 70, a list of large U.S. companies that I believe are the ones most individual investors should pick from to develop the core of their portfolios. The current list, ranked according to timeliness, appears at the end of this story. Not all 70 are a bargain at the moment, but you can start following the stocks that seem appropriate for your own portfolio and wait for the opportunity to scoop them up. You don't have to do all your buying at once. Mutual fund investors can turn to "The Case for Growth Funds Now" on page 78 for our take on four well-managed choices.
Building the base
No matter what your own financial goals may be, at the moment you have plenty of attractive investments to choose from. Here are the essential principles on how to combine them.
Focus on shares of the largest companies. Blue chips are easy to follow because the companies are closely tracked by the media and by stock analysts. Giant companies are also generally more stable than smaller ones, which often depend on a narrower range of products. As a result, Dow stocks and the largest companies in the S&P 500 offer the optimum trade-off between risk and return for most individual investors. If you want to include aggressive, small tech stocks or some conservative stocks that offer dividend yields above 2.5%, that's perfectly fine. But blue chips should make up the bulk of your stockholdings.
Deciding on your exact stock mix at any given point is largely a question of your appetite for risk. To some extent, you can afford to take the biggest risks when you're young and you have plenty of time to make up for any unexpected losses. That capacity to absorb losses decreases as you get closer to retirement. But there are other factors to consider.
Most people overestimate the amount of volatility they can handle, and underestimate how volatile even stocks in staple industries can be. Procter & Gamble has at times suffered huge losses within a three-month period. Your choices also depend on the amount of money you have. With a large enough portfolio, you could have most of your retirement money in dividend-paying stocks and live off the income without ever having to sell.
Own stocks with a variety of earnings growth rates. The market is always in motion, and different stock sectors lead at different times. You can average out those variations by selecting leading companies across the entire spectrum from growth to income. Growth stocks get almost all of their return from increases in their share prices and very little from dividends. Ideally, their earnings rise at a double-digit average annual rate, and eventually their share prices reflect that.
The total return you earn, in fact, consists of dividend income as well as the price appreciation of the shares you own. Conservative stocks that offer income as well as some growth potential typically get at least a quarter of their total return from dividends that work out to 2.5% to 4% of the share price. When such yields are added to potential appreciation in share price, those stocks can offer a return of 10% or more annually, even if earnings growth is as low as 6%.
As a rule, growth stocks do best when the economy is speeding up, while conservative stocks hold up best when business conditions are slowing down or deteriorating. If you loaded up on the most popular high-P/E stocks during the late-'90s boom and never sold, you might still have too much money invested in growth companies. But since many of those stocks are trading well below their recent highs, you don't want to dump them. Instead, make sure your new purchases are in other sectors that will help balance your overall portfolio.
Buy stocks in at least eight industries. Every business responds differently to changes in the economy, and the best diversification comes from having at least eight stocks in very different businesses. You should have more if you can afford to, although there's little incremental benefit beyond a couple dozen.
It's especially important to include the shares of one or more companies that actually benefit from inflation—in sectors such as energy, mining or real estate—because most other kinds of stocks suffer when inflation accelerates. So putting, say, 15% of your portfolio in inflation hedges will help protect you against one of the greatest and least-recognized dangers—that inflation will silently erode your purchasing power.
Such a rise in inflation would make stocks with ample dividends the best choice for the income portion of your portfolio. Over the past 20 years, as interest rates have plummeted, investors have come to think of bonds as the answer to their income needs. But interest rates are now so low that they would have a hard time falling much further—and they may well rise as the economic recovery proceeds. As a result, bonds are unlikely to provide compelling returns over the coming decade, because they probably won't enjoy any price appreciation.
Build your portfolio over time. It may not be immediately obvious, but diversification over time is even more important than diversification among types of assets. You have no way of knowing where the markets are headed next, and historical benchmarks are only a general guide to whether stocks are cheap or expensive. So adding money to your portfolio a little at a time, ideally over 30 years or longer, will even out a lot of unpredictable fluctuations.
With mutual funds, that's easy to do. Individual stocks, however, must be bought one at a time. Start with those that look cheapest. Sometimes even though a company's business remains basically sound, its share price declines substantially, so that the stock trades at a P/E ratio significantly below its historical norm. When that happens, you can reasonably consider the stock cheap, even if you don't know exactly when it's going to rebound.
Plan on holding stocks as long as possible. As the recovery continues, some of your holdings will appreciate faster than others and a few may suffer an outright decline. Resist the temptation to keep changing your mix to own whatever seems to be doing best. Ideally you should make adjustments no more often than once a quarter—and once a year is probably sufficient. Rebalancing is easy with mutual funds. Just move a little money from the funds that are up the most to the laggards. With individual stocks, you'll probably want to sell one or two holdings and buy one or two new companies. Ideally, you shouldn't have to move more than 20% of your portfolio in any single year.
There are two irrefutable arguments for moving slowly and cautiously. First, every trade incurs some kind of cost. Second, there's always a chance that you will abandon an underperforming investment right before it begins a comeback, and move into a top performer that is ripe for a downturn. That's not to say that if a stock is tanking, you shouldn't find out why. But if you set up a properly diversified portfolio, you'll be less likely to sell in a panic if an otherwise solid stock hits a rough patch.
Deciding to go ahead and sell is always difficult, unless you're selling purely to free up funds so that you can buy something else. If you buy a stock because you think it's worth a specific amount, based on the price/earnings ratio or some estimate of the value of the company's assets, there's an argument for selling when the share price reaches your target. If you bought the stock because you like its growth prospects, you can hold on as long as the earnings come through year after year. Sell only if you believe the growth rate has decayed and won't recover. Income investments should be sold if they miss a payment or if their credit rating deteriorates significantly.
Choose stocks like those in the list on these pages, buy when the shares are undervalued, and hang on for five years or longer, and you'll stand an excellent chance of matching or even slightly outpacing the market averages. Combine that with a regular savings discipline, and you should have little trouble reaching your long-term goals.
NOTES: As of Oct. 25. P/Es based on projected 2005 earnings. Growth is compound annual rate projected for the next five years. PEG ratio, a measure of a stock's valuation, is P/E divided by growth rate.