Now is the perfect time to invest

Mutual Funds12/16/2008 12:01 AM ET

Now is the perfect time to invest

It's tempting to stay on the sidelines of a turbulent stock market, but you should take advantage of today's rock-bottom prices. Here's why -- and how.

By Tim Middleton

The 2007-08 bear market has been the worst since the Great Depression, more savage than that of 1973-74, which most of us remember only dimly, if at all, and 2000-02, which we remember all too well.
What's more, the combination of two deep bears in less than a decade has poisoned many people against common stocks. The Standard & Poor's 500 Index ($INX) has gone down an average of 0.9% a year over the past 10 years, from November 1998 through November 2008. Given this sobering lesson, who would want to own these things?
You would.
Whether you're just getting started as an investor or rebuilding a portfolio shattered by the recent chaos, you need to remember that how well you do depends on what you pay at the outset. And prices now are at rock bottom.
"Today, in my view, the stock market is presenting you with one of the great buying opportunities of your lifetime -- perhaps the greatest," says Steve Leuthold, the manager of the Leuthold Core Investment (LCORX) fund, which ranks in the top 2% of similar funds over the past 10 years. "Buy 'em when they hate 'em."
Since this bear market began 14 months ago, virtually every asset class, from foreign and domestic stocks to commodities to real estate, has been driven down at least 50%. Even among bonds, only U.S. Treasurys have held up well. The benefits of diversification, in short, have proved to be illusory.
But that doesn't mean -- in the words every market loser has uttered -- that this time it's different.
"The importance of asset allocation, the insidious power of inflation, diversification using uncorrelated asset classes and long-term stock market performance still exist," says Michael L. Kalscheur, a financial consultant with Castle Wealth Advisors in Indianapolis. "Most people are looking at the most recent information and assume that's how it will always be. It will not always be this way."
Whether you're building a portfolio or rebuilding an old one, the tried-and-true lessons still apply: Balance risks against each other while relying on equities to build wealth. If you have become increasingly defensive over the past year -- and most people have -- now is the time to reverse the process.
How much worse could it get? I believe the bear market is over. But say I'm wrong and it's not. Having fallen more than 50% already, just how much further can stock prices fall? How much risk remains?
Junk bonds are yielding 22%, nearly twice their historical average. Since the vast majority of corporate bonds are rated junk, do you really believe more than half of the American private sector is going to go broke? That didn't happen even in the Great Depression.
Here is what you should not do in the coming year: Wade cautiously back into risky markets such as stocks, dollar-cost averaging your way back to a normal, stock-heavy portfolio.
This is the time to plunge. Dollar-cost averaging is almost never a good idea, as I explained in a recent column, but it's a really lousy idea right now.

That's because stock market recoveries tend to be front-loaded. Since 1900, according to Leuthold's research, "the median first-year price gain of 40.9% represents almost half of the median 83.6% total bull market gain for the Dow." Gains in the first three months are the sharpest of all, averaging just over 18%.
So take the money you've got to invest -- all of it -- and build (or rebuild) your portfolio today.
By the way: I'm doing this myself in my own portfolio, and subscribers to my newsletter, ETF Insider, have already done it, effective Dec. 1. Since bonds have remained positive throughout the bear market, we had profits in them, which we trimmed. We added that to the cash hoard we had built up when we cut back on our riskiest positions earlier in the year, and we swapped nearly everything into foreign and, primarily, domestic stock funds. We also bolstered our holdings of emerging market stocks and commercial real estate, which had been beaten down the most.
Continued: Building your portfolio
Building your portfolio How you allocate your assets is the most important decision you will make in terms of future returns. That, rather than individual-security selection, accounts for 90% of total portfolio returns.
The most attractive asset classes on a total return basis are:
Domestic small-capitalization stocks.
Domestic large-cap stocks.
Emerging-markets stocks.
Foreign developed-market stocks.
Since an investment portfolio is long term by its nature -- money you need in only a few years should be protected in Treasury bills and short-term bond funds -- at least 50% of it should be apportioned among these groups. And for Mr. or Ms. Typical Investor, I would make this equity allocation 75%.
Stocks provide the most reliable mixture of potential for capital growth and protection against inflation. For young investors, my allocation recommendation would be 100%, and indeed that's where two of my three children have their investments. (The third may buy a home soon and so holds a considerable portion in bonds.)
The most attractive assets for diversifying risk in a stock-heavy portfolio are:
Domestic high-quality bonds, particularly mortgage and corporate bonds.
Foreign high-quality bonds.
Domestic commercial real estate, in the form of funds that invest in real-estate investment trusts, or REITs.
Commodities, notably energy.
Cash, in the form of T-bills or money market accounts.
In taxable investment accounts, municipal bonds take the place of corporate, U.S. government and mortgage bonds. Munis are particularly cheap right now, yielding far more on an after-tax basis than taxable bonds.
During periods of high inflation, Treasury inflation-protected securities, or TIPS, can take the place of at least some of the high-quality bond allocation. That's not the case now, however.
Assuming you have 75% of your assets in equity funds, I would allocate the balance like this: 5% in a commodity/energy fund, 5% in REITs and 15% in domestic high-quality bonds such as Pimco Total Return (PTTRX), the most widely held such mutual fund.
I wouldn't own foreign bonds at the moment because the U.S. dollar is rallying, and currency translations are therefore increasingly unfavorable. For the same reason, I would be light on foreign developed-market equities -- but not emerging markets, where currencies play less of a role.
Both energy and REITs are down much, much more than stocks in the current market, so you could snap up real bargains there.
Higher returns ahead If you think this plan is too risky, think again. Just as relatively low stock returns this decade could have been predicted (and in fact were, by Warren Buffett, among others), based on extreme out-performance in the 1990s, relatively high returns going forward are almost reflexive. This cycle is known as reversion to the mean, and the mean returns of stocks over long periods are in the low double digits.
"History shows us that after a substantial bear market, we can expect the returns of equities to be higher in the near term," notes Tom Adams, a financial adviser with Mentor Capital Management in Elmhurst, Ill.
Having pointed out the negative returns of stocks over the past 10 years, Leuthold tracked the history of stock performance in every 10-year period in which the market averaged an annual gain of 1% or less. Then he looked at the succeeding 10 years. The worst performance in those periods was a gain of 101% between 1938 and 1948. The best was a surge of 325% between 1974 and 1984. The average was 183%.
Buffett, so negative on stocks as this decade began, has lately become outspokenly bullish. No investor in our lifetimes has proved more adept at understanding the market.
So whether you are new to investing or renewing your commitment to it, you have chosen a very favorable time. Don't dally. Your financial future depends on what you do now.

At the time of publication, Tim Middleton didn't own any fund mentioned in this article.

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