It’s the start of a new year. What will the future bring and how can you best take advantage of the opportunities it holds? This is the time of year when there are lots of prognostications about what the stock market and economy is going to do over the next year. First, let me be clear: no one can predict the future so take all the prognostications for what they are…someone’s best guess. Here is my best guess for the economy, interest rates and stocks along with my recommendations for your best investment strategy for 2014:
The economy. The economy has continued to improve over the past four years and I expect this trend will continue through 2014. The Federal Reserve, led by Chairman Bernanke, has recently begun reducing monetary stimulus by tapering off asset purchases from $85 billion per month to $75 billion per month. The Fed is doing this because they believe the economy is gaining strength and requires less support. By all accounts, Bernanke’s successor, Janet Yellen, will take a similar conservative approach related to economic stimulus.
Interest rates. After reaching historical lows in July of 2012, interest rates have begun to rise. In July 2012, the 10-year treasury was at 1.45%. Recently, it crossed 3%. It’s hard to even guess what interest rates will do over the next twelve months but it seems likely that rates will rise over the next three to five years. Since 1900, the yield on the 10-year treasury has averaged 4.9% and since 1981, it has averaged 6.7%…meaning that interest rates have a good ways to go before they return to more normal yields. This will likely continue to produce headwinds for bonds and bond funds.
Stock market. The way our economy is working its way out of the Great Recession of 2008 seems to be particularly good for the stock market. In reaction to the 2008 financial crisis, corporations severely cut expenses; much of which came in the form of employee layoffs. In addition, they took cash flow and profits and stored much of it as cash, reduced debt or, in some cases, repurchased their stock. In other words, corporations became very conservative and that set the stage for excellent performance these past four years and should continue to serve them well as they employ those assets over the next three to five years.
So how do you turn this information into an investment strategy? I would ask you to consider a five step approach:
- Decide on your overall allocation between stocks, bonds and cash. I usually begin with what I call a ‘neutral’ allocation of 60% in equities (stocks) and 40% in fixed income (bonds, CDs and money market). Over my past thirty-something years of observation, this allocation produces about eighty percent of the returns of the stock market with about half of the volatility. From this starting point, I let personal facts (risk tolerance, number of years until retirement, retirement income analysis) guide me to a higher or lower allocation to stocks. For example, if you are ten years or more away from retirement, you may want to increase your stock allocation.
- Decide how much cash you need. If you will need access to a portion of your money within twelve to twenty-four months, that money should be held in a money market account. You just have to accept the fact that you’ll earn little or nothing on this portion of your investment account.
- Decide how to invest your bond allocation. Based on my outlook for interest rates, I recommend bonds with a maturity of five years or less or using short-term, low duration no-load bonds funds. Vanguard’s Short-Term Investment Grade Bond Fund (symbol: VFSTX ) and PIMCO Short-Term Fund (PSHDX) are good examples of taxable funds. For tax free funds consider Vanguard Limited Term Tax-Free (VMLTX) and Vanguard Short-Term Tax Free (VWSTX).
- Decide how to invest your stock allocation. For more conservative investors, I continue to favor large blue chip companies with great balance sheets and who have an excellent dividend-paying history. This can be done using an exchange traded fund (ETF) such as DVY (Yield 3.1%); a mutual fund such as Vanguard’s Dividend Growth Fund (VDIGX) yielding 1.9%; or by picking a diversified basket of individual stocks such as Southern Company, Exxon, General Mills and McDonalds. If using individual stocks be sure to hold a minimum of twenty stocks in order to reduce what I call ‘single-company risk’. More aggressive investors may want to add international stocks, emerging market stocks as well as small and mid-cap stocks to the mix using either ETFs or no-load mutual funds.
- Rebalance your portfolio periodically. Once you’ve set your allocations, at least once per year, rebalance back to your original allocations. This forces you to ‘sell high-buy low’ and will serve you well over time.
My final suggestion is to pay attention to expenses. Using discount brokers (Schwab, Vanguard, TD Ameritrade), ETFs, and no-load index-oriented mutual funds will help keep your expenses low. If all of this is too unfamiliar or confusing, consider hiring a professional to help guide you. Be sure that their investment approach makes sense to you and that you understand how they are being compensated.