We seem to be in the midst of a meltdown in technology stocks that took a lot of investors by surprise with its severity. If this market had human qualities, it could be described as capricious, furious and punitive.

But the market is nothing more than a complex collection of many constantly changing forces. It seems impossible to understand at any given moment and can be only imperfectly explained in hindsight. In some ways, the market is much like the weather.

When the weather treats you badly, you need two things: Protection and perspective. The same is true when the market treats you badly.

Readers of this newsletter know how to protect themselves from the market. If you are a buy-and-hold investor, you know you need to include enough fixed-income investments in your portfolio to bring the overall volatility within your tolerance for risk. If you are a market timer, you need to have a systematic way to get in and out of the market, and you need to follow your plan in a disciplined way without fail.

The other item, perspective, is sometimes hard to come by in the midst of a rapidly changing, unpredictable storm. But as somebody who’s been in the investment business since the 1960s, I’d like to offer some observations that I hope will help you with perspective.

The following thoughts aren’t everything you need to know, and they aren’t in any particular order of importance. But if you can integrate the following ideas into your everyday thinking about investing, you will be ahead of most other investors.

Too few investors know what compound rate of return they need. A financial writer for a national publication asked for my comments on the investments she and her husband had made. Their investments seemed quite aggressive to me, and I asked her how much return they needed to make their objectives. She said she thought they needed 12 to 15 percent annually. When we ran the numbers, it turned out they could meet their goals with a 6 percent return. But because they had not figured that out, they were taking a lot of unnecessary risk, including the chance that they could lose substantially and have to start over again. And this is somebody who spends all her time writing about investing.

Knowing your desired compound rate of return (CRR) requires you to set a goal and set a time frame for meeting it. There are several ways to do this.

First example: I want to retire at age 62 with at least $2 million in financial assets. In this case, the goal will dictate some required rate of return, depending on how much time you have before you’re 62, how much money you have now and how much you will add annually until you reach 62. If the required rate of return is easy to accomplish (7 percent or less) you are in great shape. But if you would have to take high risks to accomplish your goal (15 percent or more), then you should change one of your other assumptions to bring your expected return to a reasonable level (10 to 12 percent). You could do this by giving yourself a later retirement date, by adding more to your savings or by reducing your wealth target and planning to work part-time for the first few years of your retirement.

Second example: I want to retire as soon as I have accumulated $2 million in assets. This leads quickly to the tradeoff between risk and return. You could decide to invest very aggressively in hopes that you will speed the day of your retirement. But if you do that, you must understand that you are taking the chance of losing so much money along the way that you instead postpone requirement. Or you could let your risk tolerance dictate your investments, allowing the resulting rate of return to dictate the timing of your goal. This is the preferable approach.

In my own case, my relatively low risk tolerance is the driving factor in the assets I have set aside for my own retirement. Thus I invest my retirement money in a well diversified combination of equity funds and bond funds, all governed by market timing.

For the money I have set aside to be left to my children and grandchildren, I believe my own risk tolerance is irrelevant. I want these assets to achieve the highest possible returns that are consistent with what I consider a prudent level of risk. Thus this money is invested in a diversified combination of equity funds with timing and leverage and without any bond funds.

I asked a roomful of participants at a conference of certified public accountants last year how many of them knew the rate of return they needed on their investments. Less than 10 percent of them raised their hands. And these people were at this conference because they were interested in becoming investment advisors!

My advice: If you are unsure about how to go through the process of determining the return you need, get some help from a fee-only financial planner who charges by the hour. You don’t necessarily need a full-blown financial plan, and you should be able to determine this information in an hour.

Too few people know how to plan their investment withdrawals during retirement.  We wrote several comprehensive articles on this topic last year, all of which you can find on our Web site, which has the same address as the title of this newsletter.

One of the key variables is a person’s desire either to “die broke” or to leave a financial legacy for his or her heirs. An important factor that can’t be known in advance is just how long we’ll live. Another is the impact of future inflation. Thirty years ago, $30,000 a year could produce a comfortable retirement for most people. Today, that would seem inadequate to the majority of retirees. Those who retired on fixed incomes that seemed more than adequate in the 1970s may be struggling now.

I can offer a few rules of thumb to help in your planning.

Investors underestimate the amount of difficulty required to get through any part of life, including investing. For the millions of people who started their investing life in the 1990s, when the stock market seemed to move in only one direction, the long bull market may have been a mixed blessing. Sure, it made a lot of money for a lot of people. But it taught those people some false lessons, including the notion that making money in the market was easy and nearly guaranteed. And it taught them, perhaps, to think that “risk” was an outdated concept that didn’t apply to them.

But now the markets are struggling with lower corporate earnings and a possibly impending recession, and technology stocks have fallen mightily (CMGI, once a respected Internet “incubator” down 96 percent in 2000, Microsoft, once the pillar of the new economy, down by two-thirds). Nothing in the 1990s prepared new investors for the reality that markets can go down in addition to up. And unfortunately many of them have no clue what to do.

My advice: Revise your definition of “normal” to include struggles and setbacks. Figure out in advance how you’ll handle them. Seek the humility to realize that it’s just theoretically possible that you might not know as much as you think you know.

Investors tend to have either way too little exposure to equities or way too much.  A middle ground, such as the Worldwide Balanced accounts we advocate, seem to elude too many investors. I know a 55-year-old woman who retired last year with a $300,000 portfolio invested in a handful of individual stocks, including Microsoft and InfoSpace. Her goal was to retire, taking out $30,000 a year, and to never have to go back to work.

When we talked, this woman scoffed at my suggestion that she should include bonds in her portfolio. But last year Microsoft lost two-thirds of its value and InfoSpace, described on Yahoo as “a leading global provider of cross-platform merchant and consumer infrastructure services,” tumbled from a high of $138.50 to less than $6. This woman’s portfolio put her retirement at enormous risk. If she continues to take out $30,000 a year, she could be broke within five years. I told her to go back to work and build up more assets.

On the other end of the scale, some investors have all their money in money-market funds and certificates of deposit, with essentially no protection against inflation.

My advice: Most people seem to prefer either bonds or stocks, depending on what they know, what they trust, what they understand and of course their circumstances and risk tolerance. But for most investors, it’s not at all a bad idea to have at least 20 percent of your portfolio “in the other camp.” Having 20 percent of a portfolio in a conservative equity fund gives the CD investor at least a fighting chance to keep up with inflation. And putting 20 percent in bonds gives the aggressive equities junkie a bit of ballast to flatten out the volatile ups and downs of the market.

Many people resist this notion, and for that reason I sometimes recommend that an investor put 20 to 40 percent of a portfolio into a balanced fund that includes both stocks and bonds. To some die-hard equities fans, this seems to be more acceptable than a straight bond fund. And a balanced fund may be more acceptable to ultra-conservative investors who are nervous about owning equity funds.

I continue to think a 50/50 split is excellent for many retirees and people approaching retirement. If you’re in one of those categories, you should consider it carefully.

Diversification is not an evil scheme designed to prevent you from making money. Diversification is one of the wisest ways to be a good investor. A 50/50 diversification in stocks and fixed-income investments is no exception. From 1965 through 1974, U.S. stock prices had an annualized return of only 1.25 percent. In those same 10 years, one-month certificates of deposit returned 6.5 percent.

Too many investment decisions are made on the basis of emotions instead of facts and logic.  Once we make an emotional decision, we tend to rationalize it any way we can. We were approached last year by a man who at age 50 wanted our help planning an immediate retirement with his $140,000 of investments. When we told him a portfolio that size couldn’t possibly support him for the rest of his life, he replied that he might not live very long. It wasn’t a case of any medical problem, only his overriding desire to get out of the workforce.

I know a young woman in her 30s whose parents each gave her $2,000 a few years ago to invest in Roth IRAs, so she would have a start toward retirement. This young woman understood the nature of the gift and the benefits of a Roth IRA. A year later, she was strapped for cash, having just started a business; she was convinced she would make so much money in this business that in a few years she would be rolling in dough. Against the strong advice of her parents, she cashed the IRAs.

That action cost her more than she knows. She knew she would pay a 10 percent penalty to the IRS and that she wouldn’t have that start toward her retirement savings. But she has not yet learned that after she cashed out the IRAs, her father changed his will. Instead of leaving her a sizeable bequest, his estate will create a trust that will pay her annual income but no principal. After her death, the principal will go to charity.

My advice: Listen to your parents.

Most investors underestimate the importance of dumb luck, or the random nature of the market.  For example, you may have lived in the Seattle area in the mid 1980s and invested a bit of money in Microsoft soon after the stock went public in 1986. You could call that a smart decision, but it was just luck that you happened to live near where Bill Gates was founding this company at a time you had money to invest. You could have concluded that since you had been so successful in picking Microsoft, you could invest in other promising technology companies.

You might have been fortunate enough to invest in America Online or Dell Computer and hang onto them through the 1990s. But you might have just as easily invested in CompuServe or Apple Computer, the stock of which traded in a relatively narrow range for a dozen years before it finally took off early in 1998. Or you could have invested heavily in technology stocks at the end of 1999, having no idea that nearly one in six of them would fall by 90 percent or more in the year 2000.

My advice: Enjoy your successes, but beware of giving yourself too much credit for brilliance. You may be brilliant indeed. But you also might be merely lucky.

Many investment advisors underestimate the importance of managing risk because they do not understand how much time and work it takes to accumulate significant investment assets.  Very few investors ever acquire $500,000 or $1 million or more by having it handed to them through inheritance or gift. It is not “easy money” to them. In most cases, investors accumulate assets by working hard, by doing without, by managing well, and sometimes by taking very significant risks along the way. Yet too many investment advisors treat wealth as if it dropped out of the sky, ready for a financial planner to play with.

I frankly don’t know how else to explain a question we recently received via email from a reader. At the start of last year he had hoped to retire in three years. He had invested his whole $475,000 portfolio in technology and Internet stocks, and they were worth only $265,000 by the end of the year. We thought it was particularly ill-advised for anybody three years away from retirement to invest so aggressively, with virtually no diversification.

This investor said his advisor told him the 44 percent loss in his portfolio last year was “only a hiccup” and suggested he should stay the course with the stocks he had. We disagree strongly. An investor on the verge of retirement has no business investing more than 10 percent of a portfolio in technology stocks. Unfortunately, this investor will probably have to pay a heavy price for his lack of diversification last year and for the poor advice he got: He may have to delay his retirement by several years.

My advice: Deal with investment advisors who have been around long enough to appreciate the many years of effort, sacrifice and patience that goes into accumulating wealth.

 

 

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