Beating the Street (8 page)

This jolly fundmaking shows no signs of any letup. We've got country funds and region funds, hedge funds and sector funds, value funds and growth funds, simple funds and hybrid funds, contrary funds, index funds, and even funds of funds. Soon we'll probably see the all-dictators fund, the fund of countries with no vowels, the fund of funds of funds. The latest emergency instructions for every firm on Wall Street? In Case of a Sudden Drop in Profits, Start Another Fund.

We've lately reached an important milestone in fundmaking history: the number of funds now exceeds the number of individual stocks traded on the New York and American stock exchanges combined. This is even more remarkable when you consider that 328 of these individual stocks are actually funds in disguise. (See the discussion of closed-end funds on page 73.) So how can we begin to sort this muddle out?

Two years ago, a group of wizened (as opposed to wise) investors in New England asked ourselves precisely that question. We'd been invited to help the nonprofit organization I mentioned earlier (which shall continue to remain nameless) restructure its portfolio. Like most nonprofit organizations, this one was in constant need of capital. For years its investments were handled by a single manager, who divided the money between bonds and stocks, the way most investors do.

The issues we confronted in advising this organization how to redeploy its money were the same as those faced by the average person who must figure out the same thing.

First, we had to determine whether the mix of stocks and bonds should be changed. This was an interesting exercise. No investment decision has greater consequence for a family's future net worth than the initial growth-versus-income decision.

In my own family portfolio I've had to become slightly more bond oriented, since I now rely on investment income to make up for the absence of a salary. But I'm still heavily invested in stocks. Most people err on the side of income, and shortchange growth. This is truer today than it was in 1980, when 69 percent of the money invested in mutual funds went into stock funds. By 1990, only 43 percent of mutual-fund assets were invested in stocks. Today, approximately 75 percent of all mutual-fund dollars is parked in bond and money-market funds.

The growing popularity of bonds has been fortunate for the government, which has to sell an endless supply of them to finance the national debt. It is less fortunate for the future wealth of the bondholders, who ought to be in stocks. As I hope I convinced you in the introduction, stocks are more generous companions than bonds, having returned to their owners 10.3 percent annually over 70 years, compared to 4.8 percent for long-term government debt.

The reason that stocks do better than bonds is not hard to fathom. As companies grow larger and more profitable, their stockholders share in the increased profits. The dividends are raised. The dividend is such an important factor in the success of many stocks that you could hardly go wrong by making an entire portfolio of companies that have raised their dividends for 10 or 20 years in a row.

Moody's
Handbook of Dividend Achievers
, 1991 edition—one of my favorite bedside thrillers—lists such companies, which is how I know that 134 of them have an unbroken 20-year record of dividend increases, and 362 have a 10-year record. Here's a simple way to succeed on Wall Street: buy stocks from the Moody's list, and stick with them as long as they stay on the list. A mutual fund run by Putnam, Putnam Dividend Growth, adheres to this follow-the-dividend strategy.

Whereas companies routinely reward their shareholders with higher dividends, no company in the history of finance, going back as far as the Medicis, has rewarded its bondholders by raising the interest rate on a bond. Bondholders aren't invited to annual meetings to see the slide shows, eat hors d'oeuvres, and get their questions answered, and they don't get bonuses when the issuers of the bonds have a good year. The most a bondholder can expect is to get his or her principal back, after its value has been shrunk by inflation.

One reason bonds are so popular is that elderly people have most of the money in this country, and elderly people tend to live off interest. Young people, who have earning power, are supposed to buy all the stocks, to build up their assets until they, too, are old and need to live off interest. But this popular prescription—stocks for the young, bonds for the old—is becoming obsolete. People aren't dying as readily as they used to.

Today, a healthy 62-year-old is looking at a life expectancy of 82: 20 more years of spending, 20 more years of inflation to erode the buying power of his or her money. Senior citizens who assumed they could retire happily on bonds and CDs are finding out otherwise. With 20 years of bill paying ahead of them, they need to put some growth back into the portfolio to maintain their standard of living. With interest rates low, even people with huge portfolios are having trouble living off interest.

This has created a situation in which senior citizens around the nation are all asking, “How can I survive on a three and a half percent return from my CDs?”

Consider what happens to the retired couple whose entire net worth, $500,000, is invested in short-term bonds or CDs. If interest rates go down, they have to roll over their CDs at much lower interest rates, and their income is drastically reduced. If interest rates go up, their income goes up, but so does the inflation rate. If they put
the entire $500,000 into long-term bonds paying 7 percent, their income is a steady $35,000. But with an inflation rate of 5 percent, the buying power of this $35,000 will be cut in half in 10 years, and cut two-thirds in 15.

So at some point in their retirement, our generic couple may be forced to cancel some of the trips they wanted to take, or they may have to spend some of their capital, which reduces their future income as well as any inheritance they planned to leave to their children. Except among the very rich, the good life cannot long be preserved without stocks.

Obviously, how much you should invest in stocks depends on how much you can afford to invest in stocks and how quickly you're going to need to spend this money. That said, my advice is to increase the stock part of the mix to the limit of your tolerance.

I proposed as much to the trustees of the nameless organization. Before they decided to remodel the portfolio, the mix was 50 percent stocks and 50 percent bonds. The bond portion (invested in five- to six-year maturities) was yielding about 9 percent at the time, and the stock portion was giving them a 3 percent dividend, so the combined portfolio had a 6 percent return.

Normally, bonds are held to maturity and redeemed for the original purchase price, so there was no potential for growth in that half of the portfolio. The stock portion, on the other hand, could be expected to increase in value at 8 percent a year, above and beyond the dividend.

(Historically, stocks return nearly 11 percent, 3 percent of which is dividends, and 8 percent of which is due to stock prices going up. Of course, the big reason that stock prices go up is that companies continue to raise their dividends, which in turn makes stocks more valuable.)

With 50 percent of the money invested in stocks that grow at 8 percent, and 50 percent in bonds that don't appreciate at all, the combined portfolio had a growth rate of 4 percent—barely enough to keep up with inflation.

What would happen if we adjusted the mix? By owning more stocks and fewer bonds, the organization would sacrifice some current income in the first few years. But this short-term sacrifice would be more than made up for by the long-term increase in the value of the stocks, as well as by the increases in dividends from those stocks.

What you can expect to gain in growth and lose in income by adjusting the percentages of bonds and stocks in any portfolio is shown in
Table 3-1
. These numbers were crunched on my behalf by Bob Beckwitt, who has turned in a winning performance at the Fidelity Asset Manager Fund, which he runs.

Beckwitt is one of our resident quants. A quant is a complex thinker who deals in concepts beyond the grasp of most linear imaginations, and speaks a language that is understood only by other quants. Beckwitt is a rarity: a quant who can switch out of quant mode and communicate in normal English.

In all three scenarios analyzed by Beckwitt, $10,000 is invested. We're assuming here that the bonds are paying 7 percent interest and that the stocks are paying the current 3 percent dividend, and appreciate at the standard 8 percent a year.

In Case A, the entire $10,000 is put into bonds. In 20 years, the owner of this money will receive $14,000 in interest income, and then get back his or her original $10,000.

In Case B, the $10,000 is divided 50/50 between bonds and stocks. The result after 20 years is that the owner receives $10,422 in interest income from the bonds, plus $6,864 in dividend income from the stocks, and ends up with a portfolio worth $21,911.

In Case C, the entire $10,000 is put into stocks. Here the owner gets $13,729 in dividend income from the stocks, and ends up with a portfolio worth $46,610.

Since dividends continue to grow, eventually a portfolio of stocks will produce more income than a fixed yield from a portfolio of bonds. That's why after 20 years in Case B you actually receive $3,286 more in income than in Case A, and in Case C you're only losing $271 in income to get the full benefit of all the appreciation from putting your entire bankroll into stocks.

If you take this analysis a step further, you realize that theoretically it makes no sense to put any money into bonds, even if you do need income. This radical conclusion comes from another set of numbers I asked Beckwitt to crunch. The result is shown here in
Table 3-2
.

Let's say you have $100,000 to invest, and have determined that you need to make $7,000 in income to maintain your standard of living. The commonsense advice given to people who need income is to buy bonds. But instead, you veer off in a wild and crazy direction and turn the $100,000 into a portfolio of stocks that pay a combined 3 percent dividend.

TABLE 3-1. RELATIVE MERITS OF STOCKS VERSUS BONDS

Table 3-2. 100% STOCKS INVESTMENT STRATEGY

Begin with 3% dividend on stocks; assume 8% growth in dividends and in stock prices; spend a minimum of $7,000*

During the first year, your 3 percent dividend puts $3,000 into your account. That's not enough income. How do you cover this shortfall? You sell $4,000 worth of stock. If your stock prices have gone up at the normal rate of 8 percent, the portfolio will be worth $108,000 at the end of the year, so your $4,000 dip into capital leaves you with $104,000.

The second year, the dividend income from the portfolio has increased to $3,120, so you only have to sell $3,880 worth of stock. Every year thereafter, the dip into capital gets smaller and the dividends
get larger, until the 16th year, when the portfolio produces more than $7,000 in income from your dividend checks alone. At this point, you can maintain your standard of living without having to sell a single share.

At the end of 20 years, your original $100,000 has grown into $349,140, and you're nearly four times richer than you were when you started, in addition to your having spent $146,820 worth of income along the way.

Once and for all, we have put to rest the last remaining justification for preferring bonds to stocks—that you can't afford the loss in income. But here again, the fear factor comes into play. Stock prices do not go up in orderly fashion, 8 percent a year. Many years, they even go down. The person who uses stocks as a substitute for bonds not only must ride out the periodic corrections, but also must be prepared to sell shares, sometimes at depressed prices, when he or she dips into capital to supplement the dividend.

This is especially difficult in the early stages, when a setback for stocks could cause the value of the portfolio to drop below the price you paid for it. People continue to worry that the minute they commit to stocks, another Big One will wipe out their capital, which they can't afford to lose. This is the worry that will keep you in bonds, even after you've studied Tables 3-1 and 3-2 and are convinced of the long-range wisdom of committing 100 percent of your money to stocks.