The Paradox of Stocks

Questions we always hear:

• Why should I stay invested in the stock market? I put all that money into my retirement account, and it still fell in value last year.

• Shouldn't we just sit tight in cash and wait for things to turn around?

• My 401(k) is down after contributing money in the last 4 years. How am I supposed to retire if all it ever does is fall?

• I am retired, and I don't want to see my investments fall in value any further.

These are all valid questions or concerns. Investing in stocks isn't for the faint of heart. Nor is it for people with a short memory or short amount of time until they need the money. The stock market isn't like an interest bearing checking account, where the money earns a rate of interest and is available all the time. The stock market is more like a roller coaster. You can decide if you want to get on. But once you do, you are just along for the ride, with no control over the speed or direction. Yes, both a roller coaster and the stock market go up and down, and sometimes both make you want to scream.

In investing, we have control over three of the four things that will affect returns over time. We can control risk, time horizon, and expenses, but we cannot control return. We do our homework, think, act prudently, and have to patiently wait for our return.

Why invest in stocks then? Simple: over the next twenty years, the economy and company earnings will grow and grow and grow. After inflation is taken into account, stocks will provide a return that will exceed almost any other kind of investment. What does the next year hold? Who knows?

If you make $50,000 a year and need to replace that in retirement, you will need roughly 20 times that to provide for a secure retirement (right at $1,000,000 in retirement savings). The value of a home or other non-income producing real estate does not count towards this total, unless you intend to sell them to fund your retirement. Seems like a mountain of money, doesn't it? Depending on your age, risk tolerance, and time horizon, it may be unattainable.

Example of time horizon

Your time horizon is tricky, and it depends on both your age, as well as your goals. For someone turning 65 this year, it would be easy to think that they need to convert their portfolio to bonds and focus solely on income. That would be a mistake. Someone turning 65 today can expect to live to their early 80s and will rely on their retirement accounts for those 15 years. Inflation can eat up a bunch of their purchasing power during that time.

The very young have a long time horizon until retirement but are under tremendous demands financially: paying for college (or paying off student loans), saving for a first house, or starting a family. Therefore, the young typically have multiple time horizons. Short-term for down payment for house, longer-term for college savings for children, and very long-term for retirement saving.

One of the largest problems today is that people do not own stocks; they own mutual funds. So the focus is on recent market returns and not the fundamentals of what is owned. If you owned Coke, GE, Gillette, Wal-Mart, and Bellsouth, would you be so quick to sell them if they where down 15-20% over the last year? No, because you know the companies, use their products, and have a pretty good idea about the fundamentals. Now turn those few stocks into a mutual fund that is down 20% in the last year and things don't look nearly as good. Why? A focus on recent returns instead of fundamentals.

So after all this, what is the paradox of stocks? It's quite simple, when most people agree that the stock market is the place to be, prices are high and rising. Everyone is happy to get their statements. It is then that the stock market is the most dangerous place in the world to have your hard-earned money. Good feelings = bad investment. When the market is low and falling, everyone is upset and not even opening their statements. Then, it's time to step up and purchase equities for the long-term. Bad feelings = Good investment opportunity.

It's time for investors who are picky about fundamentals and who can be patient to step up and start buying.

 

Copyright Cornerstone Investment Management and Consulting, LLC 2011. All rights reserved.