Millionaire Teacher (12 page)

I resumed my aggressive stock-buying plan in 2008 when the stock market traded at a 20 percent discount to its 2007 peak.
Figure 4.3
shows what kind of hammering the stock market took in 2008. And I happily increased my purchases with my monthly savings as the markets plummeted by 50 percent from 2007 to a low point in March 2009. It was like wandering into an Apple computer dealership and seeing the discount bins filled to the brim with the latest iPhones. Stocks were selling at 50 percent off—and nobody was lining up to buy them! At one point, the stock indexes had fallen so far that I sold a large amount of my bond index so I could buy more of my stock index, mindful of keeping a balanced allocation of stocks and bonds. When the stock markets fell, my bond allocation ended up being significantly higher than 35 percent of my total portfolio. Selling off some of my bond index to buy more of my stock index also helped bring my portfolio back to the desired allocation.

Figure 4.3
Worldwide Stock Market Sale

Source:
Vanguard historical prices for total U.S. and international indexes

With stock prices falling so heavily, I finally understood Buffett's comments in 1974 when he was interviewed by
Forbes
magazine. Faced at the time with a stock market drop of a similar magnitude, he said he felt like an oversexed guy in a harem.
13

Again, did the economic downturn in 2008–2009 eat into the profits of U.S. businesses? Certainly some of them lost money, but not all. If stock prices fall by 50 percent, it can only be justified if business earnings have fallen (or expected to fall) by 50 percent. As always with the stock market, investors' fear and greed can produce irrational price levels. In 2008–2009, I prayed stocks would remain cheap.

Obviously, praying for something so nonspiritual was the wrong thing to do. Perhaps divine intervention punished me for it when the markets rose. Between March 2009 and January 2011, the U.S. stock market index rose 85 percent and the international stock market index, which I was also buying, rose nearly 90 percent. I'm not the sort of guy who normally gets depressed, but the indexes I was buying were getting pricier by the month. I would have preferred it if the markets had stayed low.

People don't normally get such wonderful opportunities to take advantage of crazy, short-term discounts. But with sensational financial television programs based on financial Armageddon, with a rough economic period, and with the Internet spreading news of emotional market sentiment far and wide, we had a recipe for some remarkable stock market volatility over the past decade.

Most people, unfortunately, are easily conquered by their enemy in the mirror. They like buying stock market investments when prices are rising, and they shrink away in horror when they see bargains. How do we know? We just need to observe what most investors do when stock markets are falling or rising. John Bogle, in his classic text,
Common Sense on Mutual Funds,
reveals the startling data while asking the rhetorical question: “Will investors never learn?”

In the late 1990s, when stock markets were defying gravity, investors piled more money into the stock market than they ever had before, adding $650 billion to stock mutual funds during this period. Then when stock prices became cheap in 2008 and 2009 with the biggest market decline since 1929–1933, what do you think most American mutual fund investors were doing? When they should have been enthusiastically buying, they were selling off more than $228 billion of stock market mutual funds.
14

What we do know about the future is that we will once again experience unpredictable stock market shockers. The markets will either fall, seemingly off a cliff, or they'll catch hold of a rocket to soar into the stratosphere. Armed with the knowledge of how stock markets reflect business earnings you won't be seduced to take silly risks, and you won't be as fearful when markets fall. By building a responsible portfolio of stock and bond indexes, you'll create more stability in your account while providing opportunities to take advantage of stock market silliness.

The next chapter will show you in detail how to achieve this in the simplest, possible way.

Notes

1.
John C. Bogle,
The Little Book of Common Sense Investing
(Hoboken, New Jersey: John Wiley & Sons, 2007), 51.

2.
Ibid.

3.
John C. Bogle,
Common Sense on Mutual Funds
(Hoboken, New Jersey: John Wiley & Sons, 2010), 28.

4.
Jeremy Siegel,
Stocks for the Long Run
(New York: McGraw-Hill, 2002), 217–218.

5.
Ken Fisher,
The Only Three Questions That Count
(Hoboken, New Jersey: John Wiley & Sons, 2007), 279.

6.
Ibid.

7.
“Coca-Cola Report,” The Value Line Investment Survey, November 9, 2001, 1551.

8.
“Long Term Performance of Major Developed Equity Markets,” Management and Factset Research Systems, accessed April 15, 2011,
http://www.fulcrumasset.com/files/Long%20Term%20Equity%20Performance.PDF
.

9.
Quote DB, accessed April 15, 2011,
http://www.quotedb.com/quotes/3038
.

10.
“A Long-Term Perspective Chart,” The Value Line Investment Survey, 1920–2005.

11. Burton Malkiel,
A Random Walk Down Wall Street
(New York: WW Norton & Company, 2003), 86.

12.
Lawrence Cunningham,
The Essays of Warren Buffett
(Singapore: John Wiley & Sons, 2009), 86–87.

13.
Forbes, from the archives, “Warren Buffett—1974,” accessed on January 5, 2011,
http://www.forbes.com/2008/04/30/warren-buffett-profile-invest-oped-cx_hs_0430buffett.html
.

14.
John C. Bogle,
Common Sense on Mutual Funds
, 32.

RULE 5

Build Mountains of Money with a Responsible Portfolio

“Eat your Brussels sprouts,” I used to hear when I was a kid, “and you'll grow into a big, strong boy.”

So I ate a bowl of Brussels sprouts for breakfast, a plate of Brussels sprouts for lunch, and a casserole dish of Brussels sprouts for dinner—seven days a week.

If that were true, I'd probably resemble a green, leafy ball with legs by now. Brussels sprouts might be good for you, but you need to eat more than a bunch of tiny cabbages if you want to be healthy.

In the same vein, a total stock market index fund might be good for you as well, but it doesn't represent a balanced portfolio.

If that were all you bought, your portfolio would gyrate wildly with the stock market. If the market dropped 20 percent, so would your overall portfolio. If the market dropped 50 percent, so would your total investments.

This isn't good for any investor, especially those approaching retirement and needing more stability. If a 60-year-old plans to use her portfolio as a nest egg, she's not going to be comfortable seeing all of her hard-earned money plunge into what might look like a bottomless crater during a sharp market decline.

Only an irresponsible portfolio would fall 50 percent if the stock market value were cut in half. That's because bonds become parachutes when stock markets fall.

What Are Bonds?

Bond is a secret British agent with a license to kill. He sleeps with multiple women, never dies, and every 15 years or so, gets a body transplant to look like a completely different guy.

Financial bonds are just as riveting.

Bonds get less shaken and stirred

Long term, bonds don't make as much money as stocks. But they're less volatile, so they can save your account from falling to the bottom of a stock market canyon if the market gods feel like purging for fun.

A bond is a loan that you make to a government or a corporation. Your money is safe as long as that entity (the government or the corporation receiving the loan) is able to pay the money back, plus annual interest.

The safest ones you can buy are first-world government bonds from high-income industrial countries. Slightly riskier bonds can be bought from strong blue-chip businesses such as Coca-Cola <
www.coca-cola.com
>, Wal-Mart <
www.walmart.com
>, and Johnson & Johnson <
www.jnj.com
>.

Riskier bonds pay higher interest, but there's a higher chance that they might forfeit on the loan. The higher the interest paid by a corporate bond, the higher the risk associated with it.

If you're looking for a safe place for your money, it's best to keep it in short-term government bonds or short-term, high-quality corporate bonds.

Why short-term? If you buy a bond paying four percent annually over the next 10 years, there's always a chance that inflation could make a meal out of it. If that happens, you're essentially losing money. Sure, the bond is paying you four percent annually, but if you're buying breakfast cereal that increases in price every year by six percent, then your four percent bond interest is losing to a box of cornflakes.

For this reason, buying bonds with shorter maturities (such as one- to three-year bonds) is wiser than buying longer term bonds (such as 10-year bonds). If inflation rears its head, you won't be saddled with a 10-year commitment to a certain interest rate. When a short-term bond expires, and you get your money back, you can buy another short-term bond at the higher interest rate.

If this sounds complicated, don't worry. You can buy a short-term government bond index, and you never have to worry about an expiration date. It will keep pace with inflation over time, and you can sell it whenever you want. It's easy.

If you want to know how bonds work, here's the skinny

You don't need to know the intricacies of how bonds work. You can just buy a government bond index (which I'll show you how to do in the next chapter) and that bond index can represent the temperate part of your investment account. But if you want to know how bonds work, here it is in a half-page nutshell:

If you bought a five-year government bond, you would know immediately what the interest rate would be, and that the rate would be guaranteed by the government. If you loaned a government say, $10,000, they would promise to give you that $10,000 back. Along the way, you would be guaranteed to earn $500 each year in interest payments, assuming that the interest rate was five percent annually.

If you choose to sell that bond before the five years are up, you can do that, but bond prices fluctuate every day. Instead of getting back your $10,000, you might get back $10,500 or $9,500, if you sell before the maturity date.

When inflation/interest rates rise, bond prices fall. If inflation were running at three percent annually when you bought a bond that yields five percent in interest, and if inflation suddenly jumped to five percent, then no new investors would want to buy a bond like yours (paying five percent interest with inflation at five percent.) If they did, they wouldn't make any money after the increase in the cost of living. But if the price of that bond dropped, the new investor would be lured by the idea of paying $9,500 for the same bond that you paid $10,000. When that bond expired, the new investor would get $10,000 back.

If interest rates dropped, a friend of yours might be dying to buy your $10,000 bond that pays five percent in interest annually. But he wouldn't be alone. Institutional bond traders would rush to buy that bond quickly, resulting in a price increase for it—perhaps from $10,000 to $10,300. Bond-price adjustments are similar to stock-price adjustments. If there's more demand, the price will rise.

Your friend, however, would earn five percent annually on $10,000 (not on the $10,300 he paid for the bond). When the bond expired, he would receive $10,000 back. You'd brag. He'd get upset. And if your friend were anything like my dad, you would find cat food in your shoes the following morning.

You can see why there's a bond “trading market” as people try to take advantage of these price movements. It only follows that there are actively managed mutual funds focused on buying and selling bonds as well.

Bond index funds are the winner

In case you're tempted to buy an actively managed bond fund, remember this: bond index funds beat them silly. Costs matter even more in the world of bond funds.

Figure 5.1
reveals that from 2003 to 2008, the average actively managed government bond fund with a sales load (that crafty commission paid to advisers) made 3.7 percent annually and the average actively managed bond fund without a sales load made 4.9 percent annually. As with actively managed stock market mutual funds, those without sales-load fees outperform, on average, those with sales-load fees.

Figure 5.1
Comparison of Funds

Source:
John C Bogle
, Common Sense on Mutual Funds

During the same period, a U.S. government bond index averaged 7.1 percent annually. Whether you're buying stock indexes or bond indexes, active management generally slashes your return potential because of the hidden fees associated with them.
1

Ensuring that your account has a bond index, a domestic stock index, and an international stock index provides you with a greater statistical chance of investment success.

What percentage of your portfolio should you have in bonds?

The debate over what percentage you should own in stocks and what percentage you should own in bonds is livelier than an Italian family reunion.

A rule of thumb is that you should have a bond allocation that's roughly equivalent to your age. Some experts suggest that it should be your age minus 10, or if you want a riskier portfolio, your age minus 20; for example, a 50-year-old would have between 30 and 50 percent of his or her investment portfolio in bonds.

Common sense should be used here. A 50-year-old government employee expecting a guaranteed pension when he retires can afford to invest less than 50 percent of his portfolio in bonds. He can take on greater risk (on the promise of higher returns). Stock returns don't always beat bond returns over the short term, but over long periods, stocks run circles around bonds. That said, bonds could be your secret weapon when stocks hit the skids.

Trounce the professionals with a balanced portfolio

If you're adding $200 a month to a portfolio, you could add $60 a month to a bond index ($60 is 30 percent of $200) and $140 a month ($140 is 70 percent of $200) to your stock indexes.

In any given year, as you know, the stock market can go crazy, rising or dropping by 30 percent or more. Dispassionate, intelligent investors can simply rebalance their portfolios if they're too far from the stock/bond allocation they set for themselves.

For example, if a 30-year-old man has 30 percent in bonds and 70 percent in stocks, he will want to maintain that allocation.

If the stock market falls heavily in a given month, the investor will find that his portfolio (which started out with 70 percent in stocks) now has a lower percentage in stocks than his goal allocation of 70 percent. So what should that investor do when adding fresh money to the account? He should add to his stock indexes.

If the stock market rose considerably during another month, the investor might find that stocks now make up more than 70 percent of his total portfolio. What should he do with fresh money? He should add to his bond index.

Profiting from Panic—Stock Market Crash 2008–2009

When stock markets fall, most people panic, sending stocks to lower levels. Dispassionate investors, however, can lay the groundwork for significant future profits. My personal portfolio was far larger after the financial crisis compared with its level before the crisis scuttled the markets. Following the strategy to keep my personal portfolio aligned with my desired allocation of stocks and bonds was the key. As I mentioned in the previous chapter, I started 2008 (before the stock market crash) with a bond allocation at roughly 35 percent of my total portfolio as shown in
Figure 5.2
.

Figure 5.2
Portfolio at Age 37

Then the stock markets started falling, giving me a disproportionate percentage in bonds. I invest monthly, so when the markets fell—to keep me close to my desired stock/bond allocation—I bought nothing but stocks and stock indexes. But no matter how much money I was adding to my stock indexes, the markets continued to drop heavily during the end of 2008 and the beginning of 2009.

Figure 5.3
shows what my portfolio was looking like during the first few months of 2009.

Figure 5.3
Portfolio at Age 38

Despite my monthly stock market purchases, I couldn't get my stock allocation back to 65 percent of my total. As a result, I had to sell some of my bonds in early 2009 to bring my portfolio back to my desired allocation.

Naturally, I was hoping the markets would stay low. But they didn't. As the stock markets began recovering later that year, I switched tactics again and bought nothing but bonds for more than a year. I was low on bonds because I had sold bonds to buy stocks, and my stocks were rising in value.