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Thursday, August 26, 2010

Where to Invest Now

As I was leaving the TV station earlier this week, I was stopped by a friend who asked for my thoughts on the markets. He had recently upped his contributions to the retirement plan and indicated his intention to invest 100% in bonds based on his dismal outlook for the economy. Hmmm. At first blush, this seems like a perfectly reasonable and conservative approach. It’s hard to argue that the outlook for the economy doesn’t paint a bright picture, at least in the near term. And setting up a systematic savings program is one of the most basic keys to accumulating wealth. However, I suggested he consider a slightly different approach to his investing strategy.

First let’s look at the stock market. For the decade ending 2009, the stock market has delivered negative returns and this year continues to disappoint investors. Could it be that much of the downside risk is already wrung out of the stock market? Sure, it could go down further but for someone who is systematically putting fresh money in each month, I’d say the stock market is a very good bet if you don’t plan to touch your money for at least five years. At this point, the greatest risk to the stock market may be ‘event’ risk…something like Greece defaulting on its sovereign debt. There is a small risk of a double-dip recession, but that seems unlikely. The good news is that corporations have used the economic downturn to take dramatic steps to cut expenses and improve systems. In short, they are lean and mean! Once the economy perks up, increased revenue will quickly accrue to their bottom line…think profits!

Now let’s take a moment and review the bond market. We are in the midst of the worst interest rate environment that I can remember. The Federal Reserve has set interest rates at zero percent and is actively pursuing policies that continue to keep interest rates low. It’s a disaster for retirees who depend on interest income to pay their bills each month. Investors, afraid of the stock market, continue to pile money into bonds and bond mutual funds, and in many cases, are buying longer maturities and lower quality just to get any kind of yield. What this creates is a kind of bond market ‘bubble’. Eventually, the Federal Reserve is going to take the lid off of interest rates and we’ll likely see them rise dramatically. At that time, bond holders, especially holders of longer maturity bonds or bond funds, will see values drop dramatically. Worse, it may be years before bonds recover from the bursting bubble.

What’s an investor to do? Since the stock and bond market future is never predictable, consider a mixture of high quality dividend-paying stocks (examples: AT&T, Southern Company and Eli Lilly) with bonds having medium to short maturities (example funds: VFSTX, PTTOX). You’ll want to own a basket of at least 20 stocks. Keep a close eye on your bond funds and be ready to shorten maturities when the Fed begins raising interest rates. An allocation of 60% stocks and 40% bonds should allow you to capture much of the stock market return with significantly less volatility.

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