I have frequently emphasized the importance of a diversified portfolio and of having a significant portion of common stocks, even in retirement.
Although I have been retired for 18 years, I still maintain about half of my portfolio in some form of common stocks — either the shares themselves or mutual funds or exchange-traded funds (ETFs).
I recommend the book Stocks for the Long Run by Jeremy Siegel (McGraw-Hill) for investors who wanted to get into common stocks. Siegel is a professor of finance at the Wharton School of the University of Pennsylvania. He has revised and updated the book now in its fifth edition. It contains valuable information for investors who expect to continue to invest in the stock market.
Siegel analyzes the economies of China and India, and offers guidance for investing in these economies. He devotes a lot of attention to global markets, discussing their nature and size and sharing his long-term projections. He also emphasizes the importance of including global investments in your portfolio.
An important chapter covers structuring a portfolio for long-term growth. Siegel specifies guidelines for successful investing, which requires maintaining a long-term focus and a disciplined strategy. Here are some of the principles he recommends, with my commentary.
• Keep your expectations in line with history: Over the last two centuries, stocks have returned between 6 and 7 percent after inflation, including reinvested dividends. Stocks have sold at an average price/earnings (P/E) ratio of about 15. In the future, he points out, there may be reasons that the stock market may rise to a higher P/E ratio than 15, such as lower transaction costs and lower bond returns. A good rule to remember when you are projecting the future is “the rule of 72.” If you divide 72 by the expected total return, the result is the number of years for your investment to double in value. Thus, an 8 percent return will double your investment in nine years.
• Stock returns are much more stable in the long run than short: Investments in stocks will help you compensate for future inflation; bond investments will not. There will be years in which the overall stock market will be negative. That should not prevent you from maintaining a significant portion of stocks in your portfolio following a fall in stock prices. Investors who bailed out of stocks completely following the stock market fall in 2008 found it very difficult to get back in the market, and missed excellent returns the last few years.
• Invest the largest percentage of your stock portfolio in low-cost stock index funds. This may be one of the best recommendations, especially for investors who don’t have a huge portfolio. Even if you have a small portfolio, you have the same diversification as a large investor in the same fund. A good example is the track record of a broad-based fund such as Vanguard’s Total Stock Market Index Fund Investor Shares (which I have invested in for many years). It returned approximately 30 percent in 2013.
• Invest at least one-third of your equity portfolio in international stocks, specifically those not based in the United States. Siegel cautions investors not to overweigh your portfolio in high growth countries whose P/E ratio exceeds 20.
• Tilt your portfolio toward value stocks by buying passive indexed portfolios of value stocks. Siegel points out that value stocks, which have lower P/E ratios and higher dividend yields, have had better results and lower risk than growth stocks. I agree. I have consistently invested in this type of index fund, and the results have been very good.
• Establish rules to keep your portfolio on track. Siegel devotes a chapter to discussing the common psychological pitfalls that cause poor market performance. It is too tempting to buy when everyone is bullish and sell when everyone is bearish.
Worried that the stock market is due for a correction? Siegel offers the following guidance for 2014: “This bull market is not over, although gains won’t be as large as 2013. Stock returns likely to average 6 percent to 7 percent over the next three to five years.”
Financial columnist Elliot Raphaelson can be contacted at elliotraph@gmail.com.