By Kenneth Coleman
The Investment Tracker
College professors were not interested in the stock market until the early 1970s. Their early works were seldom challenged. For years we have been told certain investment strategies are sure winners all of the time. Most investors lost a lot of money when they bought into the buy and hold mantra of mutual funds. This may comes as a surprise to many of you when I state there are other exaggerated and outright bogus claims both from mutual funds and investment brokerages.
Walter Updegrave, author of the book Investing for the Financially Challenged, exposed some of the bogus claims mutual funds and brokerages were making in a May 1999 article titled, "Everything You Think You Know About Investing Is Wrong." His article was subtitled, "Four of the Most Widely Held Investing Truisms," in which he maintains that these claims are not quite as true as we would like them to be. It appears that early research was simply allowed to go unchallenged.
Here are four of the bogus claims Updegrave discusses: (1) stocks are guaranteed to outperform bonds; (2) small caps generate higher gains than big caps: (3) value stocks beat growth stocks; and (4) asset allocation determines the size of the return on your portfolio. Since space is limited, I will review only the first two bogus claims. I will cover the latter two in the September issue.
Updegrave explores the possibility that these four verities are not as invincible as we have been led to believe. "That they have limitations or exceptions we gloss over in our desire for a sturdy hitching post in today's volatile markets. Could it even be, as 83 year-old Nobel Prize winner and economics text book guru Paul Samuelson suggests, that some of these percepts have gradually crossed the line from the truth to dogma, which he defines as 'a truth so truthful that we dare not question it." Closely examining these four truisms, he debunks some and points out "...how others have been stretched or misconstrued."
The most important thing Updegrave attempts to accomplish is to put these truisms into perspective. He wants to make it possible for readers to decide to what extent they should factor these false truisms into their investing strategy. Few dared to push the buy and hold strategy once the whistle was blown. Now, it is referred to as a long-term investment strategy.
First, Updegrave debunks the belief that stocks always outperform bonds. He states this is, "...the most widely held and least challenged belief in the investing world." Most of you cut your teeth on investment advice that claims stocks earn considerably more than bonds 100% of the time. Consequently, many of you who built your portfolio strictly on stocks may have shortchanged your chances of earning larger profits.
Stocks for the Long Run, written by University of Pennsylvania professor Jeremy Siegal, is the bible for encouraging a lack of diversity in one's portfolio. Siegal goes as far as to suggest that long-term investors could leverage their portfolios when stocks were not overvalued by as much as 131%. That means you leverage buy - buy on margin an additional 31% of stocks in your portfolio.
Siegal's evidence for stock superiority came from Ibbotson's work "showing that stocks have gained 11.2% annually since 1926 vs. 5.3% for government bonds." "Siegal provides the coup de grace..." when he states, "There has never been a thirty-year holding period since 1831 when stocks did not beat bonds." Samuelson counters this claim when he states that because of overlap, "we only have six discrete thirty year stretches...rather than the 168 mentioned in Siegal's book."
Samuelson goes on to note "that these six circumstances...were hardly enough to make for a bullet proof case." There is no guarantee that stocks are sure long-term winners because of this.
According to Samuelson, estimates made of long-term earnings of 11.2% annually since 1926, like buy and hold, are bogus. The fact is, "since 1926 stocks have fallen short of a ten percent benchmark nearly half the time..."
The fact that the market has gained an incredible 18% on average since 1993 is one reason the 11.2% earnings rate is bogus. The chances of this happening again anytime in the near future are slim to none. So, what can you expect to earn investing in stocks for the next ten years?
According to the Leuthold Group, a Minneapolis research firm, it "...has calculated that investors who bought stocks when P/E ratios were 21 or higher received annualized returns of just 6.9% on average over the next three years and just 4.8% over ten years."
The P/E average for the S&P 500 is currently 22.55. This means the current market could be expected to increase 7% to 10% at best for the remainder of this business cycle. This should help convince you that it is important to know when to buy than what to buy. The belief that no one can time the market is another false truism.
There is a way to drastically increase government bond earnings. I wait until a business cycle is nearing a bottom (when interest rates appear to be as high as they will go) before I start buying bonds. That is when I began buying bonds on a monthly basis (dollar averaging). That usually comes when bonds hit an average interest rate between 7% to 9%.
Dollar averaging into bonds provides investors a better chance of obtaining the highest rate. Your bonds become more vulnerable when interest rates go down. Stocks should do about as well as bonds in the near term (approximately one year). Natural resource stock should begin to outperform both the Dow and bonds roughly six months tone years after that. Bonds will soon begin outperforming both the Dow and natural resources once interest rates increase considerably. Again, this will happen once the current business cycle bottoms out.
The belief that small cap stocks always beat large caps is also bogus. This claim is credited to University of Chicago Ph.D. Rolf Banz. His research revealed for the forty years through 1975, the smallest stocks on the NYSE generated higher returns than the big bruisers even after adjusting for their greater risk."
Banz admitted straight out he did not know what caused this so-called small stock effect. However, he did warn investors that his research should "be interpreted with caution." He called for more research on the subject.
Nevertheless, the mutual fund industry cranked out more than 750 small stock funds in the 17 years since Banz published his landmark paper. The Russell 2000 Index of small stocks has lagged the large cap dominated S&P 500 by nearly seven percentage points annually over the 15 subsequent years since Banz published his research.
I will review the other two bogus truisms that caused people to make poor investment decision in my next newsletter. They are the beliefs that value stocks earn more than growth stocks and asset allocation accounts for 90% of your returns (profits).
You can increase your profits considerably, just not as much as 90% when you invest using the business cycle correctly, you will not get caught in a stock market collapse.
Editor's Note: Ken Coleman is editor of Kenneth Colemans' Investment Tracker, 4805 Courageous Ln., Carlsbad, CA 92008, 1 year, 12 issues, $139 which specializes in Domestic and Global Money Flow Analysis. Experience has taught Mr. Coleman what drives stocks, bonds and commodity markets, thus the economy. It's money. Visit the web site at www.TheInvestmentTracker.com.
