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Seriously, why buy stocks?
After years of wall-to-wall, solid-red stock returns, why do financial advisers still tout stocks?
April 18, 2003: 2:53 PM EDT
By Walter Updegrave, Money Magazine

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After several years straight of across-the-board, solid-red stock returns, why do most financial advisers still tout buying stocks over the purchase of fixed-income investments like Treasurys? Is it due to some kind of national economic conspiracy?

-- Michael Paschal, Los Angeles, CA

Hmmm, if I'm not mistaken I think there was a meeting of financial advisers on that grassy knoll in Dallas in 1963 during which they all agreed that they would recommend buying stocks even in periods when stock prices were down! But don't worry, Oliver Stone is working on a movie that will expose the whole crooked scheme.

Seriously, if there is a national economic conspiracy to recommend stocks, then I guess I'm a willing co-conspirator (unindicted to this point). I can't speak for my fellow conspirators, but I can tell you why I believe long-term investors should still be buying stocks for their portfolios.

Look ahead, not behind

The basic reason is this: When you are investing, you should be choosing where to put your money based on what assets you think have the best shot of delivering superior gains in the future, not just what's doing well at the moment.

Yes, the stock market has gotten absolutely hammered over the past three years and seems unable to rouse itself from its torpor. And, yes, it would have been great if we could have seen the downturn coming and jumped out of stocks and into bonds before our account values got hammered.

But since no one's crystal ball is that clear, we must invest using history as a guide (though definitely not a clear prediction of the future) and a bit of common sense.

Smart people, stupid money moves
Holding off on contributions
Bear market bingo

So what does that mean for the current situation? Well, I could buy Treasurys, as you suggest. Assuming I buy 10-year Treasury bonds, at today's prices I would essentially be locking in a 10-year return of just under 4 percent. So, the question is, would it be reasonable for me to assume I could do better in stocks?

When I say "stocks" I'm not talking about a handful of stocks that some pundit feels are the best buys now. I'm talking about a broadly diversified portfolio of stocks, along the lines of the Standard & Poor's 500 index or, better yet, the Wilshire 5000, which tracks the entire U.S. stock market.

There's no way to answer that question definitively, of course, unless I know how much the earnings of U.S. publicly traded companies overall will grow in the years ahead and how much investors are willing to pay for those earnings.

Investing against the grain

But I do know that stocks have tended to generate higher-than-average gains after major downturns and when people are most fearful of investing in stocks, as they are today.

I also know that by some valuation measures stocks are attractively priced. One model, known as the Federal Reserve Stock Valuation Model because it's based on analysis of stock values mentioned in a Fed monetary policy report several years ago, values stocks by comparing their likely future earnings stream to the income one would receive from 10-year Treasury bonds.

Recently that model estimated that stocks were undervalued by nearly 40 percent. I think that figure is definitely on the high (make that very high) side, in part because Treasury bond yields have sunk so low.

And stocks can remain undervalued for a long time, just as they hovered at bloated prices for a long time. (For more on how to interpret the Fed model and to get current readings, click here and then click on "Stock Valuation Models" and "Weekly Data.")

Still, in the past, when stocks have become very undervalued on the basis of this model, they've usually outperformed Treasurys over the next couple of years.

There are no guarantees in life -- or stocks

Clearly, there are no guarantees here. As I said before, just because something happened in the past doesn't mean it will repeat in the future. Which is why I don't recommend that anyone put all their money into just stocks or just bonds. I believe you need both.

What's more, you also need a broad spectrum of different types of stocks and bonds. How you divvy up your holdings among stocks and bonds is largely an individual matter based on your tolerance for risk and your investing time horizon, but for suggestions on how you might consider structuring our portfolio, you can check out our Asset Allocator.

If I haven't convinced you to invest at least some of your money in stocks, then I hope I've at least convinced you that there's no vast advisers' conspiracy to draw investors into the stock market for whatever ulterior motive. After all, we've already got enough to deal when choosing investments without throwing paranoia into the mix.

(Note to advisers: The Committee To Lure Unsuspecting Investors Into Stocks will meet next Thursday at the usual time and place. For reservations on the committee's fleet of black helicopters, call Oliver Stone.)

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged."  Top of page

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