Weathering the storm

Investors know all too well that the stock market has provided subpar returns over the past five years. The Standard & Poor’s 500 Index (S&P 500) fell nearly 50 percent from 2000 to 2003, registering the steepest decline since the Depression. Despite the market’s recovery during the past two years, the S&P 500 stands 20 percent lower than its March 2000 peak. It’s easy to get discouraged when a money market fund has been better than the stock market over the past seven years, but smart investors know that success lies in keeping a big-picture perspective over the long term.

Cautionary words

This tepid environment often begs the question, “What else can I invest in that offers decent returns?” While investor interest in real estate, bonds and hedge funds is currently high, these investments may be poised to disappoint. For instance, real estate investment trusts (REITs) have more than doubled in the past five years. Their performance was bolstered by historically low mortgage rates. For the first time ever, REITs are trading at higher earnings multiple than stocks, so as mortgage rates start to climb, a headwind could develop, limiting real estate appreciation.

Bonds are often seen as a “safe harbor” during uncertain times, and they remain an important part of a diversified portfolio. However, current long-term yields are uninspiring. An investor purchasing a 10-year United States Treasury Note now will receive a return of 4 percent upon maturity. After inflation and taxes, it will have a real return of less than 1 percent a year.

Hedge funds are also becoming popular. However, their high expenses and lack of transparency are a concern. Since February 2003, the CSFB-Tremont hedge fund index has underperformed the S&P 500 by 13 percent. In a lower-return, lower-volatility market, hedge funds may disappoint.

Asset allocation is key

So what is an investor to do? First, it is vital to focus on asset allocation and diversification. Second, focus on higher-quality companies, which show steadily rising earnings and dividends. Landmark academic studies indicate that over the long term, more than 90 percent of an investor’s returns can be attributed to asset allocation — the mix of stocks and bonds in a portfolio — and not simply to security selection.

Each investor’s situation is unique, consisting of asset composition, cash-flow plans and risk tolerance. There is no “one-size-fits-all” recipe for asset allocation. It is important to keep in mind that over longer term periods, stocks handily outperform bonds. The fact that stock market returns have been negative on an annual basis since 2000, ironically, raises the probability that future returns will improve. The bottom line is, it is vital not to shy away from stocks now.

Keep the faith in stocks

Although stock market returns may continue to be lower than their historic average, returns in the 8 percent range are likely over the coming decade. The chart above breaks down stock returns over the past 75 years (including the last two decades), as well as an estimate for future returns. Even though 8 percent stock returns are well below the 18 percent average annual return of the past two decades, they are still superior to the return an investor is likely to receive from bonds.

It is vital to ensure your asset allocation and investments mesh with your cash-flow plans and risk tolerance. A focus on quality stocks and diversification is likely to offer decent returns over inflation in the coming years.

M. Jay Wertz, CFP, is a portfolio manager and shareholder of Johnson Investment Counsel Inc., one of Greater Cincinnati’s largest investment management firms. Johnson Investment Counsel manages more than $3.2 billion in assets and has been serving clients nationwide since 1965 through three divisions: Johnson Wealth Advisors, Johnson Institutional Management and Johnson Trust Company, Greater Cincinnati’s only independent trust company.