A friend of mine -- an aerospace engineer -- refuses to own stocks. Lately, he also refuses to own actively managed funds. He's asked his 401(k) administrator to move his retirement savings into a "stable value" fund to preserve cash.
But I think he's brilliant -- and not just because he's my friend.
Why stocks stink
His reasoning for not owning equities is simple and ironclad. He doesn't know how to value stocks in this market and refuses to buy anything he can't price effectively.
He's also nervous about the economy and U.S. competitiveness compared to China, India, and the rest of the emerging world.
He doesn't see how trillions in stimulus will boost earnings for suddenly lagging American stalwarts such as Pulte Homes (NYSE: PHM ) and Vornado Realty Trust (NYSE: VNO ) . And without increased earnings, my friend argues, there's no reason for stocks to rise.
He's right. The stimulus, while in my view necessary, could lead to higher inflation and obscure the real price of risk. That's a huge problem. A fair assessment of risk is elemental to all stock valuation.
OK, then, how about an alternative?
So there are excellent reasons to avoid stocks right now.
You may lack the time to study businesses. Or perhaps you're like my friend and lack the temperament to invest now, when artificial sweeteners such as the stimulus have turned the science of valuation into an art form. Or maybe you're like me and just plain tired of taking losses.
I didn't lose as much as the S&P 500 did last year -- our portfolio was down roughly 32% versus 40% for the broader index -- but that's little consolation. Losses are losses and, in 2009, I'm still taking them. I'm sick of it.
In every case, it's tempting to ask: Shouldn't I just flee to cash?
The answer is no.
Remember my friend's point about inflation? Cash is guaranteed to lose. You want some exposure to stocks so that you'll have a share of the gains when Mr. Market steps back from the ledge. Sooner or later, he will -- you want to be in the market when he does.
A market-matching index fund is the lowest-cost way to keep skin in the game without taking extra time to study and value businesses. Mix in a healthy cash position, and you've got a formula that should preserve wealth as you seek upside.
You want some exposure to stocks so that you'll have a share of the gains when Mr. Market makes his way back up. A market-matching index fund is the lowest-cost and, in my view, most Foolish option for the stock-shy. Mix in a healthy cash position and you've got a formula that should preserve wealth as you seek upside.
Um, is there are door number three?
But what if you want to do better than matching the market? Let's face it -- matching the market hasn't been so nice lately.
In that case, you'll have to take on the extra risk that comes with buying stocks. But even then, you can limit your downside by betting on managers who've steered their businesses through earlier recessions.
Macon Brock Jr. co-founded retailer Dollar Tree (Nasdaq: DLTR ) in 1986 and assumed his current position as chairman in September of 2001, in the wake of the dot-com meltdown. Six months earlier, Menderes Akdag took the reins of PetMed Express (Nasdaq: PETS ) and has been CEO ever since. They're survivalists -- builders of durable businesses that handily beat the market during 2008.
Recession-tested managers are typically more conservative than their bull-market peers, and they excel at allocating capital. They've seen the destruction excess can wreak, so they avoid it, choosing instead to invest in sustaining competitive advantages built over decades.
Businesses like these are easier to value because they have a history. They're proven, and they've rewarded those who've bet on them for the very long term. They are, in short, the sorts of companies that David and Tom Gardner seek for Motley Fool Stock Advisor -- Disney is an active pick. Collectively, the portfolio is beating the market by more than 40 percentage points. Care to learn more? Click here to get 30 days of free access to the service.
My friend is right; you needn't own individual stocks. But if you're like me -- if you must invest because you're passionate about business -- then seek first the recession-busters, businesses that already have a history of rewarding those who held during prior recessions.
Chances are, they'll do it again.
This article was originally published on March 23, 2009. It has been updated.
Fool contributor Tim Beyers didn't own shares in any of the companies mentioned in this article at the time of publication. Both our Stock Advisor and Inside Value services have singled out Disney as a stock to own. Baidu is a Rule Breakers recommendation. The Motley Fool has an ironclad disclosure policy.