Confused

What’s an investor to do?

Housing is in a bubble. Stocks are in a bear market and no rally can be trusted. Treasury bonds have miniscule yields. Corporate bonds can turn to junk before you pick up the phone to sell. Mutual funds never do as well as the indexes and the indexes are all headed down. Ginnie Mae funds are reducing payouts. Venture capital is dead. Hedge funds hedge against gains not losses. Buildings cannot be leased in a recession. The REIT rally may be over. Gold is too unpredictable. The commissions alone prevent any possibility of profit from options. Money markets don’t go down, but who can save for retirement or retire on a 2% yield?

Short-term there is nowhere to turn. How about the long-term? Where is the best place to invest for the next ten to twenty years?

It is common knowledge that stock indexes have outperform bond indexes and gold indexes over the last 200 years. Commercial real estate indexes, REIT indexes, home price indexes, oil and gas price indexes, Ginnie Mae indexes and other asset class indexes are relatively new; few have been in existence more than 30 years. Yet stock indexes have consistently outperformed these newer indexes. Stock indexes are the undisputed champions of any investment index challenge.

Based on past performance, most experts expect stock indexes to win future challenges as well. Despite a severe and possibly continuing bear market, plenty of evidence can be assembled to show that periodic deep declines in stock prices are offset in the long run by greater and longer bull runs.

Journalists, TV commentators, and financial planners as well as all forms of stock peddlers continue to recommend stocks as the best long-term investment for everyone with a long-term investment need. Unfortunately, this is terrible advice now at the end of the great bull market. But it was also terrible advice at the beginning of the bull market in 1982.

“Invest in stocks for the long run” is terrible advice because individual investor’s returns from stocks are rarely half the index return and often lower than the individual’s returns from other asset classes. Investors’ returns in a given asset class are not correlated to the index returns for that asset class. In some asset classes, individuals capture a high percentage of the index return. In other asset classes, individuals routinely outperform the index. In stocks, individuals woefully underperform the index. More people have the personality to make higher returns in bonds, buildings, or home equity than in stocks. For example, Dalbar’s 2001 study “Quantitative Analysis of Investor Behavior” indicates that from January 1984 through December 2000 the S&P 500 Index returned 16.29% a year but individuals investing in professionally managed stock funds only made 5.23% a year. Individuals investing in fixed-income funds made 6.08% a year compared to the long-term Government Bond Index that returned 11.83% a year. Individuals had higher absolute returns in fixed-income and also captured a higher percentage of the index’s return. Other studies by Morningstar, Fidelity, Brad M. Barber, and Terrance Odean also show that individuals significantly under perform stock indexes.

The studies all indicate that individuals make tactical errors. Individuals follow the market rather than anticipate it, buying after the market has risen and selling after the market has declined. They trade too often. And they pay excessive fees, commissions, and spreads.

For decades individuals have been advised to stop making tactical errors and simply buy and hold. Unfortunately, only the rare investor has the personality to buy and hold during routine stock market conditions: pressure by brokers to trade stocks and stock funds; corporate scandals; political and economic uncertainty; herd movements into and out of sectors; mass exoduses out of stocks into bonds, tax shelters, real estate, hedge funds, or other hot products; marketing blitzes from brokers, commission based financial planners, mutual fund houses, and variable annuity companies; arguments with a spouse over market declines; the comparative security of paying down the mortgage; or the allure of new cars, new homes, or exotic vacations.

The vast majority of investors cannot buy and hold stocks for the long run and are not likely to change personalities anytime soon. Years of therapy, spiritual practices, 12-step programs and other personality changing techniques are more than most investors are willing to do to become compatible with stocks. However, many investors who do poorly with stocks do well with bonds, home equity, commercial real estate, CDs, tax lien certificates, Ginnie Maes, collectibles and other asset classes.

More people achieve higher returns with home equity than with stocks. About two third of American households own homes and are able to hold on to them for an average of seven years. While home price indexes returned 6% a year over the last 30 years, due to mortgage leverage of greater than 50%, individuals made at least 12% a year from home equity, far better than the stock returns of 5% a year cited in the Dalbar study. Even during periods when home prices are flat, individuals often do better paying off a mortgage than by investing in stocks. Simply paying off a 7% mortgage captures all the available return, 7% a year.

Most investors should abandon stocks and seek out asset classes that match their personality. Granted, matching personality to asset class is a fuzzy process. Few investment advisors or journalist have any experience or understanding of how to find compatible asset classes for different personalities. Nevertheless, quoting precise stock market returns for the last 10, 50, or 100 years and advising everyone to buy and hold stock to capture 100% of this return is disingenuous and harmful. Already retirements have been postponed and lost, college funds destroyed, and family stress increased. Individuals are already moving out of stocks and searching for their comfort zone. The time has come for investment advisors and financial media to catch up.

It will not be easy for individuals to get free of the “stocks for the long run” myth. Direct stock seller promotions will continue to fill mailboxes, magazine, newspaper, and TV space. However, the biggest obstacle to abandoning stocks for compatible investments is the tax code.

Tax deductions created the real estate bubble of the 1980s and the elimination of write offs lead to the real estate crash. Much of the cash that fueled the stock bubble came from the U.S. treasury as well, in the form of tax deductions and exemptions for 401ks, IRAs, annuities and other retirement and tax deferred plans. Pursuing tax deductions and exemptions, without asking if they were compatible with stocks, individuals poured trillions of dollars into the stock market over the last decade. While a $10,000 investment in a stock fund saved $2,000 in taxes, was it worth it if investors sold out at $5,000 and lost many nights sleep? Would not investors have been both richer and happier with no tax savings and $10,000 in CDs, home equity, a Ginnie Mae fund, or a building? Recent legislation to increase the contribution limits to IRAs and other retirement accounts was misguided. Winning votes by pumping up the bubble will not render individuals compatible with the stock market.

Matching personality to asset class is a complex, difficult process. However, that is no reason to ignore the process. Much is at stake. Individual investors must take the lead and hope that journalists, independent financial planners, and the tax code will follow. The recent run up in home prices and small shift out of stock mutual funds and into bond funds is a sign that many individuals are taking actions to find their comfort zone and stroll away from the turmoil of the stock market, high index returns and all.

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