Monday, September 15, 2008
Retirement: Safety First
By KAREN HUBE
Risk experts explain how to keep your nest egg from cracking in shaky markets. Also, which investments offer the most stable returns during slumps? And, exotic real estate -- with an American twist.
THESE ARE SCARY TIMES FOR INVESTORS TRYING to protect and increase their retirement portfolios. With stock prices gyrating and major financial institutions crumbling, the mattress may look like as good a place as any to stash your holdings.
Not so fast. Take it from five titans of risk management: There are steps you can take to protect your nest egg for as longs the tumult lasts -- steps that will make sharp market dips much easier to endure.
Even better, without sacrificing those safeguards, you can position your retirement funds to participate in the earliest gains as the stock market begins to recover. And yes, these experts say, the market will recover.
So heed the practical advice and recommendations of the intellects whose views you'll read on the following pages -- Barton Briggs, Peter Bernstein, Charles Ellis, David Darst and Jeremy Siegel -- and reserve that mattress for some peaceful sleep.
Brad Trent
Peter Bernstein
Founder, Peter L. Bernstein Inc.
After almost six decades of contemplating market risk, Peter Bernstein knows how to spot investors' worst-case scenarios before they do. These days, what he sees concerns him deeply.
As the current economic crisis unfolds in ways that even the most bearish Wall Street strategists never predicted, Bernstein says any number of disasters could still be in store for investors. For those saving for retirement, in particular, taking protective measures is critical.
"The goal for investors right now should be survival, not making a killing," says Bernstein, who has been an economics professor and money manager, and is the author of several books, including Against the Gods, a classic on risk. "You should be thinking about how to hedge against extreme outcomes."
With markets down and unemployment and home foreclosures rising, what more could happen?
"A major bank failure, causing a run on banks in general," Bernstein speculates. Or "a run on the dollar, perhaps provoked by what foreigners view as too big a fiscal deficit."
Or runaway inflation or deflation, either of which could be disastrous for long-term retirement investors.
The next step of this crisis is hard to predict, Bernstein says, because the crisis is so unusual. "Nothing like this has ever happened before," he continues. "There have been credit crunches and housing crises and dollar crises, but having all the chickens coming home to roost at the same time and interacting with one another is unique. We have historical perspective on the parts, but not the whole, and that makes things both interesting and scary."
He suggests diversifying a portfolio so that it is not only exposed to many different markets, but also to ensure it can weather all kinds of scenarios.
For example, to guard against rampant inflation, every portfolio should contain at least a sprinkling of Treasury inflation-protected securities and short-term Treasuries, Bernstein suggests.
The TIPS come with a guaranteed return above inflation, and short-term Treasuries enable you to roll your money into higher-yielding issues every 90 days if inflation rises and interest rates follow.
"Short-term Treasuries aren't a very good holding under normal conditions, but they are a hedge against extreme conditions," Bernstein says. Long-term Treasuries are a good hedge against deflation, he adds.
Bernstein also recommends holding some gold as a hedge against a collapse in the value of the dollar if China or other nations decide they no longer want to invest as much in U.S. Treasuries. "In a total disaster, where there is a run from paper currency, you'll get your biggest bang for your buck in gold," he says.
You don't have to buy much gold to have an effective hedge, he adds, noting that "if everything hits the fan, gold could be worth several thousand dollars an ounce." It is now valued at about $750 an ounce.
Above all, don't let your defensive attitude waver, Bernstein counsels.
"Every day, we are faced by the possibility that something we never dreamed of will happen," he cautions.
"In 1958, I'd been in the business for seven years when, for the first time in history, bonds yielded more than stocks. My associates said, 'It's an anomaly, don't worry, it will be reversed.' It's 50 years later, and I'm still waiting."
Gary Spector
Charles Ellis
Founder, Greenwich Associates
In Japan, investors fill their stock portfolios primarily with Japanese companies. The French place their biggest bets on French companies. The story is the same in New Zealand, India, Russia, and around the globe: Investors favor their own countries' stocks.
For U.S. investors it's easy to criticize foreign investors for being provincial. But Charles Ellis, a former chair of Yale's Investment Committee and a consultant for institutional investors, has a suggestion for them: Look in the mirror.
The typical U.S. investor holds at least 85% of his stock portfolio in domestic stocks, even though the U.S. stock market accounts for only 40% to 45% of the world's total stock-market value.
"People feel more comfortable emphasizing their own country, because they recognize the company names," says Ellis, whose internationally renowned book is Winning the Loser's Game. "But from a pure investment point of view, it doesn't do any good" -- particularly for folks investing for retirement and other long-term goals, he says.
A U.S.-centric stock portfolio creates high levels of volatility, and denies investors the benefit of surging markets around the world, Ellis notes.
The best risk-adjusted returns over the long term can be scored by matching the market capitalization weightings of the world's markets, Ellis says. That would mean putting 45% in domestic stocks, 47% in developed foreign markets and 8% in developing foreign markets.
The idea is to have no bets on whether one market or another will be stronger in coming months.
"If you said, 'I don't really have a smart idea about the direction of the markets, I'm just a sensible person, what should I do?,' the answer is to go to a global index and start there," Ellis says. "If you have reason to make any changes from there...then you can adjust it from a neutral to an opinionated portfolio."
Traditionally, investors have been hesitant to plunge more deeply into foreign markets -- because of perceptions that foreign-currency exposure presents too much risk, foreign companies don't get enough oversight from their governments, and foreign markets are simply too volatile.
To Ellis, however, the truly global allocation of assets trumps all those concerns.
"There really is a free lunch, and it's called diversification," he says. "By diversifying, you reduce your risk substantially. It doesn't cost anything, and you get something for it."
Evan Kafka
Barton Biggs
Managing Partner, Traxis Partners
When the herd zigs, Barton Biggs zags. So it shouldn't be a surprise that while U.S. investors can't dump their technology stocks fast enough these days, Biggs has been declaring that now is the time to get into the trampled tech sector.
The best values right now, he says, are in large-cap, high-quality stocks around the world, "but particularly in the U.S., and within that category, technology appeals to me the most."
Biggs, co-founder and managing partner of the $1.3 billion hedge fund Traxis Partners in New York, is the former global investment strategist at Morgan Stanley.
"We've been in a period of stagnation in terms of tech spending since the bubble burst in 2000. The next recovery is going to be marked by unusual spending in all types of technology...and the sector will be one of the first areas to pick up as the U.S. and the world begin to recover," Biggs says.
A market recovery, he believes, will begin in the first half of 2009. By then, oil prices should be consistently below $120 a barrel, and the housing market should have started stabilizing.
Due to the government's takeover of Fannie Mae (ticker: FNM) and Freddie Mac (FRE) -- which he characterizes as "one of the most important events of the last 20 years" -- further declines in home prices are likely to be more moderate than expected earlier.
But don't wait for an economic recovery in order to step into large domestic stocks and global tech stocks, or "the markets will already be up," Biggs says. "I wouldn't be surprised if later, in retrospect, we will find that the stock market is at its bottom about now."
Biggs is a notoriously trend-bucking strategist, which has sometimes paid off massively for those who follow him. In the late 1990s, he spared his clients huge losses by predicting the technology-driven bull market was going to plummet. And in 2003, when investors were steering clear of Japan, he moved into the Japanese stock market, adding untold wealth to clients' portfolios in the following three years as Japan soared.
Today, while many Wall Street strategists are recommending an underweighted position in stocks, Biggs is defiantly upbeat." The public has been selling stocks and has an incredible amount of liquidity, and so have institutions and hedge funds," he says.
"The fact that everyone is cautious has raised a lot of investable funds, and that's bullish," he adds. "We're in a stage where ordinary investors ought to be buying on weakness," says Biggs.
Some of his top picks: Cisco (CSCO), IBM (IBM) and Google (GOOG).
Biggs is steering clear, for now, of stocks in the materials, energy, agricultural and industrial- and oil-commodity sectors, but notes that "those will come on strong again -- but not until further into the recovery."
Dave Moser
Jeremy Siegel,
Professor, Wharton School
To most investors, dividend-paying stocks seem about as cutting edge as a corded telephone. Yet Jeremy Siegel talks about stock dividends with the enthusiasm and sense of discovery of a first-time iPhone user.
Through his recent research, Siegel, a finance professor at the University of Pennsylvania's Wharton School of Business, has become enamored of the dividend, and hopes to elevate its status from a humdrum staple for retirement-income seekers to a punch-packing contributor to younger investors' retirement portfolios.
He argues that the tendency of investors to look solely at the growth rates of earnings, sales and cash flow hurts them in the long run. The bias toward high-growth companies causes them to miss out on the high dividend-paying companies whose total returns, contrary to popular perception, have historically outshined the performance of growth stocks over time, he says.
"Everyone thinks it's old-fashioned to think about dividends, but investors have historically gotten about an extra two or three percentage points a year of higher returns by investing in the highest dividend-yielding stocks and reinvesting the dividends," says Siegel, author of The Future for Investors, Stocks for The Long Run, and other books.
One of his most striking examples is the difference in fortunes between people who invested in IBM rather than Standard Oil, now ExxonMobil (XOM), in 1950. Over the next five decades, through 2003, IBM trounced Standard Oil in per-share growth of revenue, dividends and earnings. But Standard Oil had a higher total return: A $1,000 investment in Standard Oil would have grown to $1.26 million with dividends reinvested, compared to $961,000 -- 24% less -- for IBM investors. "And that was before the recent energy price increases," Siegel says.
While financial companies historically have been reliable dividend payers, the dividends on Fannie Mae and Freddie Mac have been halted, and 21 financial-services firms have cut their payouts since the beginning of this year, according to Standard & Poor's. In a typical year, two or three financial firms cut their dividends, but the majority of them increase their payouts.
Long a supporter of index investing, Siegel now favors index funds that rebalance on a dividend-weighted basis. Siegel is a senior investment strategy adviser at WisdomTree, which has developed a series of funds that operate this way.
A dividend-weighted index rebalances regularly to favor stocks that pay the highest dividend. Most indexed portfolios, in contrast, rebalance based on the market capitalization of the stocks. With a dividend-weighted index, investors end up buying stocks when their prices are low relative to their fundamentals. A high dividend yield is a strong indication that a stock is undervalued, Siegel says.
Throughout history, dividend-paying stocks have gotten the spotlight. When the tech bubble burst in 2000, many investors sought out dividend-paying stocks to try to steady their portfolios. In 2003, payouts got a boost when the tax rate on dividends was changed to the 15% capital-gains rate, versus the higher income-tax rates.
Some of this tax benefit may get rolled back if Sen. Barack Obama (D.-Ill.) is elected president; he has said he would raise the dividend tax rate to 20% -- "but that's still a preferred rate," Siegel points out. He adds that investors who keep a steady spotlight on the high dividend-paying stocks in their portfolios are likely to have a brighter retirement.
Gary Spector
David Darst
Global Wealth Management Group,
Morgan Stanley
David Darst is the Iron Chef of the investment world. As chief investment strategist at Morgan Stanley's Global Wealth Management Group for the past 11 years and one of Wall Street's foremost experts on asset allocation, Darst spends much of his time considering the perfect ingredients -- of a portfolio, that is. He takes a little of this, blends it with a little of that, and -- voilà ! -- produces nourishing retirement portfolios.
Investors who have seen the air sucked out of their retirement portfolios lately might need convincing. The problem in the typical portfolio, Darst suspects, is that most people skimp on alternative investments like commodities, real estate and hedge funds.
"The perception is that they're too risky, but we view the benefits of alternatives more by the reduced volatility they bring to a portfolio than by an increased return," says Darst, who recommends that folks with $1 million to $20 million to allocate 20% to alternative investments, and those with less, 8%.
While any particular alternative investment may, indeed, be more volatile than the broad stock or bond markets, a portfolio diversified across stocks, fixed income, and a number of different alternatives will likely be less risky than one with fewer asset classes -- and it may even score higher returns, Darst says.
Consider a portfolio with 40% invested in stocks and the rest split between commodities and real estate. That may sound risky, but according to Ned Davis Research, in the 35 years through 2007, such a portfolio had the same risk as a portfolio with 40% invested in stocks and 60% in bonds. Yet it gained almost two percentage points more per year -- 12.47% versus 10.5%.
Within an alternative-investment portfolio, Darst recommends a 50% weighting in hedge funds, which gives investors the potential to benefit from talented money managers who have the freedom to invest where and how they see fit, without constraint.
Some 20% should be in real assets, such as commodities and gold. Both provide a hedge against inflation, and gold in particular has been a historic refuge in times of turmoil in the financial markets, political instability, or other crises.
Another 20% should be directed to managed-futures funds, Darst says. These invest by going long or short futures contracts in a broad basket of commodities and other investments, including metals, grains, sugar, foreign currencies, stocks and bonds.
Managed-futures funds provide a cushion to portfolios in down markets, because they typically are inversely related to the stock market, Darst says.
During the period 2000 to 2002, when the tech bubble burst and the Standard & Poor's 500 cratered 31%, the Barclay CTA Index of Managed Futures Funds was up 20%. In the fourth quarter of 1987, when the U.S. stock market crashed and the S&P 500 lost 22.5%, the Barclay index was up 13.8%. This year through August, the S&P 500 was down 14%, while the Barclay index was up 6.95%.
Lastly, Darst recommends placing 10% of a portfolio in Treasury inflation-protected securities to get their risk-dampening benefits, Darst says.
While he has usually included real estate in the alternative-investments portfolio through direct investments or REITs (real-estate investment trusts), he predicted enormous volatility in the sector last December and made a tactical move to eliminate real estate from his models.
For the average investor, however, it would take a rare event to prompt the removal of an asset class from the alternative-investments portfolio, because that could mean missing its next surge.
Says Darst: "You want to have all of your relatives at the table. Not just the 17-year-old singer in the family that everyone has always listened to, but the quiet nephew who turns out to win the Pulitzer Prize."
Follow advice like that, and investors themselves just might take home a prize.
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