Are stock price movements random, or can you predict them? This is a question that is at the heart of a lot of investment theory debates. What you perceive as the correct answer plays a big a role in which investments you buy and which you don’t.
A big proponent of the concept that stock price movements cannot be predicted is Burton Malkiel. Burton is the author of “A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing” (W. W. Norton, 2011), and he just published the 10th edition of this popular book. Burton believes that the market is efficient, meaning that stock prices automatically adjust to any new news. As a result, he believes investors are better served using index funds than attempting to beat the market by picking individual stocks. You can read a transcript of my interview with him starting on page 7.
I first read “A Random Walk Down Wall Street” several years ago, and it continues to have a big influence on my personal investing strategy. Even though my book, “Better Good Than Lucky” (W&A Publishing/Trader’s Press, 2010), focuses primarily on explaining how to analyze individual stocks, I recommend using index funds in it.
I realize this may come across as a contradiction, but it is actually about managing risk. An index fund ensures that no matter what happens, a portion of your portfolio will be tied to the market’s return. Simply put, index funds give you protection against bad mistakes. If you combine index funds with an active investment strategy, you still give yourself the opportunity to profit from the upside of making astute stock, bond and fund choices.
This leads me to the second article in this month’s issue, “The Top Funds Over Five Years.” If you are going to use actively managed mutual funds, you want to focus on performance, risk and cost. The best funds are not those that generated the highest returns last year, but those that have made their shareholders wealthier and outperformed their category peers over a span of several years. In addition, they offer good returns relative to the level of risk the fund managers take and do so in a comparatively cost-efficient manner. The five-year rankings start on page 12.
Keep diversification in mind when looking at the top funds. Though gold and emerging market funds may have dominated the list of the top five-year performers, several bond categories also produced comparatively good five-year average returns. A diversified portfolio of mutual funds from several categories would have helped your net worth increase.
This is the strategy AAII Founder and Chairman James Cloonan uses for the Model Mutual Fund Portfolio. He has combined a diversified group of mutual funds with a history of good performance to create a market-beating portfolio. You can see the current portfolio, find out what the latest fund addition is and read about the selection rule James may be revising on page 33.
Speaking of funds, as I write this, money has flowed out of municipal bonds for 14 consecutive weeks, according the Investment Company Institute ICI. Worries about state and local budgets, intensified by comments made by a highly regarded bank analyst on “60 Minutes” a few months ago, have sent municipal bond prices falling. This raises the question as to whether the current level of fear is justified.
For an answer, I reached out to Annette Thau, who recently published the third edition of “The Bond Book” (McGraw-Hill, 2010). Annette explained that concerns are misplaced since the risk of default is actually pretty low. What is a threat, however, is a rise in interest rates, as she discusses on page 23.
Finally, if the volatility of the stock market and the uncertain outlook for bonds have you feeling a bit befuddled, an alternative option is an inflation-indexed immediate annuity. These policies provide a series of payments that are indexed to an inflation gauge (e.g., the Consumer Price Index, or CPI) in exchange for a single premium payment. Paula Hogan provides more details on page 29.
Wishing you prosperity,
Charles Rotblut, CFA
Editor, AAII Journal