Investing in the Stock Market Has Certain Parallels

By Tom Madell

Here is something for stock investors to contemplate: Investing during a bull market presents a similar challenge to the person confronted with a bowl of potato chips and being tempted within by the now famous advertising slogan: "Bet you can't eat just one!"

Sure, eating more than just a handful or two will be pleasurable to most people but is the pleasure worth the potential pain? Eating up to 3 oz. of the typical chip might expose you to up to half your recommended daily intake of fat and up to one quarter of your daily calories, not to mention a possible stomach ache.

Obviously, the potato chip dilemma would be on a much smaller scale, but a bull market also seems to work by enticing more and more investing, and typically, the initial result is likewise very pleasurable. Since very few things, including eating chips and stock investing offer clear boundaries between what is indeed pleasurable vs. what is downright unwise and likely to cause pain when carried too far, it follows that there is never any clear one-to-one relationship between degree of indulgence and what happens next. Thus, the person who eats many potato chips may or may not suffer any immediate ill effects, or even any at all, while continuing to enjoy the taste.

Likewise, the investor who begins or adds to his/her stock position in the throes of what appears at the time to be a near endless flow of gains, may or may not with any certainty come to regret his/her actions. As the expression goes, "you pays your money and you takes your chances." More than that though, the greater your degree of indulgence, the more likely it is that you are potentially being suckered into the potential excesses that the masses of all investors have created by not being willing to contain their enthusiasm. It's also a little like a game of musical chairs: for those who remember it, the game must eventually wind down and only a few who were seeking chairs can end up considering themselves relatively lucky in the game, those who were not forced out early on.

It is important to recognize, additionally, that individual investors such as you and me, are apparently not the ones driving the markets right now. Large institutional investors and traders are likely the ones hoping to profit from shorter-term market surges. Since these players, and their computers, always have their eyes and screens peeled, they hope to ride the market's momentum and get out immediately if they think they need to. The smaller investor is much less likely to be able to make such an immediate response if the market turns sour and is therefore more likely to experience significant losses, or at least temporary "paper losses," when an inevitable correction occurs. That's why most investors should base their decisions on what's best for long-term gains rather than succumbing to short-term motives.

Like certain other things in life as well, an over-involvement effect can often come into play even under what appear to be the most favorable of circumstances. Indulging what seems to be a never-ending source of pleasure can become excessive and lead to seriously harmful effects. Moderation in even the good things in life seems be a good rule of thumb to follow.

New Model Portfolios for the Third Quarter, 2014

Overall Allocations to Stocks, Bonds, and Cash

For Moderate Risk Investors

Some Moderate Risk investors may be reluctant to commit 25% of their overall portfolio to cash as recommended above. I agree that such a large amount may drag down your overall portfolio returns. However, having a position away from either stocks or bonds will be an advantage if (or more realistically, when) either or both of these asset classes start to correct from their current near highs, with the greater danger being at least temporary negative returns for stocks.

As an alternative, you may want to take some of the allocation slated for cash and instead shift it to a bond fund that appears to be stable enough in price that, for the time being and perhaps much longer, there is little risk of negative returns and that will give you a small dividend instead of the near zero return for money markets. The fund is the Vanguard Short Term Investment Grade (VFSTX) fund. This fund is currently paying about 1.5% and has also shown a small amount of price appreciation over the last number of years. Be aware, however, there is no guarantee the fund won't show some price depreciation once interest rates go up, something that may not occur until some time next year.

If you choose to do this, do not now count this shifted bond investment as part of your 25% in bonds. Rather, still count it as cash. Your 25% cash position (consisting of money market and bank held deposit accounts) will also now include the extra amount invested in VFSTX. For example, you might have 20% in MM accounts and 5% in VFSTX, for a total of 25%.

For Aggressive Risk Investors

For Conservative Investors

Allocations to Specific Funds

1. Stock or bond funds with (C) are particularly recommended for Conservative investors; likewise, (M) for Moderate; (A) for Aggressive.
2. ETFs (exchange traded funds) of the same category can be substituted for any index mutual fund in this table; e.g. Vanguard FTSE Europe ETF (VGK) can be substituted for VEURX.

Comments on Changes Since April

We are substituting Vanguard Europe (VEURX) for our former pick of Vanguard Pacific (VPACX). While we still like VPACX (or DXJ, as mentioned in the June Newsletter) for aggressive investors, our four other International choices all seem likely to be stronger options for the typical investor.

In general, the International category is now the least overvalued category of stock funds we cover. This should eventually justify the raise in our allocation to 30% of the stock portfolio although International funds have generally lagged behind the US markets so far in 2014.

We continue to like the Energy sector which we first called a Buy in our Sept. 2013 Newsletter. The category has outperformed the S&P 500 by about 6% over the last 12 mos. and is still not overvalued as are almost all other sector funds (although close to it).

Although we usually avoid investing in somewhat esoteric categories such as Precious Metals, we think that for aggressive investors who wish to diversify away from more traditional stocks as well as bonds, or think that inflation may possibly lie ahead, some limited exposure to a Precious Metals fund may be in order. My research-derived measure of valuation shows that the category is an outright Buy.

One such fund would be the Vanguard Precious Metals and Mining Fund (VGPMX). While the fund has underperformed other Precious Metals funds, its longer-term record is good. Investors interested in the category should do further research to see if this fund might suit their selection criteria.

1. Select a fund, if available, that has your own state's bonds for double-tax exemption, such as, for example, the California Intermediate-Term Tax-Exempt Fund (VCAIX) if you live in California.
2. If you want to use VFSTX as a substitute for some of your cash position, refer to the comment above under "Overall Allocations to Stocks, Bonds, and Cash."

Comments on Changes Since April

We have for quite a while believed funds that emphasize corporate bonds will fare better than ones investing primarily in government bonds and we still do.

Two exceptions are municipal bonds and international bonds. Municipal bonds are one of the last bastions to help non-retirement account investors get a break on their taxes and so should continue to be sought after by moderate to high income investors, keeping after-tax returns high as compared to comparable taxable bonds. They are also underpinned by stronger state coffers as local economies recover from previously poor finances in the aftermath of the recession.

International bonds should continue to do better than many comparable US bonds because, generally, economic growth is likely to continue be somewhat weak in many areas overseas. Also, important non-US central banks are still likely to be in easing modes as compared to the US Federal Reserve which is getting somewhat closer to ending its stimulative policies. Both of these factors should be supportive of international bond fund prices as compared to similar US bonds.

As we've suggested earlier, short-term bonds, such as VFSTX, can be expected to return only meager returns that the only category of fixed-income type funds they should beat out are money market funds.

We continue to like LSBRX. The only question looking forward is whether the fund can continue to do well if stocks start to fall, since its big position in low quality bonds can suffer much more than higher quality bonds would in the event of a tumbling stock market.

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We plan to publish a performance summary of how our prior Model Portfolios have been doing over the longer-term some time in the next 10 days. Please look for it on our site.

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