The Key Question Most Investors Overlook

Most investors focus on the wrong question, and that costs them money. Too many investors try to answer the big question of the day.

Today, the big question drawing attention is whether the bear market is ending or the stock market is getting ready for another sharp drop. A few years ago, investors searched for the next red hot market sector or mutual fund.

It would be great to know the answer to the big question. The odds of you getting the answer right then investing to capitalize on it, however, are low. Even worse, you then have to answer the next big question or all your gains will disappear. The process never stops.

The question you should be asking is: Which risks am I willing to take? Once you know that answer, developing an investment strategy and putting together your investment portfolio are fairly simple.

Let’s turn back to today’s big question of whether or not the bear market is over and the big question of a couple years ago. Someone who answered the questions right and aggressively invests accordingly could have a total return of 100% in a year. For example, ProFunds UltraBear fund returned over 26% in the last 12 months, and ProFunds UltraBull returned over 100% in 1999.

Unfortunately, the cost of answering the big question wrong in either situation would be quite substantial. Those who believed the bull market would continue and invested in ProFunds UltraBull lost 100% in 2000.

That’s why I say to ignore the big question of the day. The consequences of being wrong are too great for me. I won’t take that risk and won’t recommend portfolios that cause you to take such risk.

The great thing about investing is that you can make good returns and increase your wealth over the long term without taking those risks. We’ve developed a system at Retirement Watch that avoids the big risks while capturing solid gains.

The first step is to set up what I call a safety fund as explained in the new subscriber report How To Get The Most From Retirement Watch and briefly on page 11 of each issue in the section titled “About Our Model Portfolios.”

The safety fund has a couple of levels. The first level consists of enough money to pay for one year’s living expenses minus other sources of income such as Social Security). Invest that money in a very safe vehicle such as a money market fund, treasury bills, or certificates of deposit.

The next level of the safety fund contains enough money to pay for two to five years of living expenses. You decide on the amount based on how safe and conservative you want to be. This money is invested in intermediate bonds. You can buy treasury bonds direct from the Treasury. Or you can purchase bond funds such as Vanguard Total Bond Index or PIMCO Total Return. Or the money can be invested in my Income Core Portfolio.

The safety fund ensures you can ride out almost any bear market without dipping into your long-term portfolio and selling stocks at the bottom. You also will be less likely to let the emotions of a bear market cause you to throw out your long-term plan, as many people are doing now.

The average bear market lasts about six months, and it takes stock investors about two years to get even after the bull market peak. There also are the extended bear markets of the 1930s and 1970s (and perhaps the 2000s) to consider. That’s why I consider having up to six years of spending safely tucked away. That should get you past almost any bear market bottom.

Having a safety fund doesn’t mean we throw caution to the wind in the rest of the portfolio. I still don’t want to endure periods of steep losses even in the long-term portfolio. It takes too long to make up the losses. Instead, I follow the bedrock principles of balance, a margin of safety, diversification, patience, and discipline to generate steady, solid long-term returns.

As you know I recommend dividing the long-term portfolio into two portions.

The Core Portfolios are fairly traditional long-term diversified portfolios.Though the investments are different for the different types of investors, there are common principles and investments.

Stock investments in the Core Portfolios are value-style investments. Studies I’ve seen and conducted conclude that value stocks earn better long-term returns. There are times when growth stock funds earn the highest returns, even eye-popping returns. Yet, as we’ve seen since 2000 they rarely, if ever, keep those returns. For example, from 1986 until the market peak in March 2000 the annual return for the average growth stock fund was over 16%. Today, that average annual return since 1986 has declined to about 10%.  Value stock funds earn solid returns in bull markets and flat markets and retain more of their gains in bear markets. Sometimes they earn positive returns in bear markets, as in 2001.

That’s why my I’m a value stock investor for the long-term. Investment fads come and go, and the investments with the highest short-term returns always change. Value investing endures as the long-term winner.

I’ve emphasized value even more in recent months. American Century Income & Growth was our top choice for core U.S. stocks in the Sector and Balanced Core Portfolios. It beat the S&P 500 over time, but that index became too growth-oriented for me, so we moved to American Century Equity Income. This fund seeks more value and looks for stocks with above-average dividends, a characteristic that will be more important in the future.

Rounding out our long-term value stock investments are Schroder Opportunity and Tweedy, Browne Global Value. SCUIX invests primarily in smaller stocks. This is an important part of a long-term portfolio. Studies show that small value stocks have the best long-term returns. There are many fine small value stock funds to choose from. More are listed on page 11 of each issue.

TBGVX applies its strict margin of safety approach to find stocks with the best values in the world, excluding emerging markets. Usually about 85% of TBGVX is invested outside the U.S. and the rest in U.S. stocks. The fund trailed U.S. stock indexes in the bull market but has done better than both U.S. and international indexes the last couple of years.

Each of these funds achieved outstanding long-term returns with low risk. They earned solid returns in the bull market and first part of the bear market. They preserved most of those gains in the last year.
I’m keeping an eye on SCUIX. It recently changed its name, and I want to be sure that does not lead to a more growth-oriented investment approach.

In the Balanced and Income Growth Core Portfolios these equity investments are supplemented with some safe, high-yielding income investments. Again, we don’t own the highest yielding investments. Those investments often lead to big losses down the road. I look for conservative, value-oriented income funds with low expenses. Low expenses are especially important when bonds yield 4% to 6%.

Investment success over the long haul and especially in difficult times is achieved by building a solid investment pyramid.

The base or foundation of the pyramid is the most important part. For us, the foundation is the safety fund. You’ll be more confident in your long-term investments and stick with the plan when three to six years of expenses are tucked away in secure investments.

This solid foundation allow us to take a little more risk in our Managed Portfolios. In the Managed Portfolios we take positions for one to three years. Even here I seek investments that have value and a margin of safety. I don’t want an investment with the highest potential return in the portfolio if there also is a high potential for a significant decline.

Many times the investment with the best value turns in some of the best returns in the next one to three years. This happened most recently in early 2000. We switched out of growth stock funds into value stock funds, such as Dodge & Cox Stock. DODGX was one of the highest-returning funds for the next two years, while growth stocks lost substantial value.

Finally, at the top of the pyramid, for those who want this piece in their portfolio, is the Aggressive Portfolio. Even my Aggressive Portfolio has a margin of safety in its buy and sell rules. The recommendations are on page 11 of each issue.

Most investors get mediocre returns because they ask the wrong questions, and that leads to poor decisions. Your first decisions should be to define which risks you are willing to take and which you want to avoid. The answers will help you build a solid pyramid of investment success in which you will have confidence.