Close Your Ears to the Pied Piper

Remember the old story about the Pied Piper of Hamelin? The children who marched behind him, transfixed by his intoxicating tune, were never heard from again. My greatest concern for investors at present is that they might also follow their ears and invest with their eyes closed.

Everywhere you turn, investors are hearing catchy songs about “second-half recoveries” and the need to stick with long-standing investment strategies. I contend that the present crises involving the U.S. dollar, debt securities and derivatives, tight credit markets, global competition for finite resources, and the leveraged state of the American consumer require a new paradigm for investors.

Many investors are understandably vexed by the turmoil and volatility affecting their portfolios of late, but their uncertainty is met with unrelenting claims that cookie-cutter, business-as-usual approaches to investing remain the best options available. The cover-page headline from the latest issue of Money magazine is a perfect example. Offering a handful of mutual fund selections, the article confidently declares them “The Only 7 Investments You Need.” I take issue with the recommendations, and because I know that millions of people have their financial hopes riding on a similar formula, I have genuine concern for their portfolios.

Money would have you lose money
The Money article recommends four stock funds, two bond funds, and a money market fund. All of the stock and bond funds are index funds except the T. Rowe Price New Horizons Fund. For starters, the four stock funds are down an average of 9.96% year to date, so these vehicles are clearly not within the realm of what is presently working for investors. More disturbingly, however, the average loss from these funds during the last bear market was 16.91%. For investors who believe present market challenges will be less severe and of shorter duration than the bear market that ended in 2003, these funds might appear attractive, but Fools know that this is not a typical downturn.

The sector weightings and top holdings of these four stock funds also raise red flags for me. For example, the Fidelity Spartan 500 Index (FSMKX) and Vanguard Value Index (VIVAX) funds share seven of their top 10 holdings in common. While the repeated positions in oil giants ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) might soften the landing if $200 oil becomes a reality, overlapping exposures of that magnitude are not part of a winning formula, in this Fool’s opinion.

Furthermore, financial stocks comprise 27.7% of the Vanguard Value fund, 16.7% of the Fidelity Spartan 500, and 25.6% of the global equity fund selected for the article. In fact, if you purchased all seven of the recommended funds in equal parts, you would end up with 10.8% of your assets in the stocks of financial companies. Show me one successful money manager who is recommending more than 10% exposure to financials.

Gross says bonds are gross
With U.S. Treasuries accounting for all 10 of its top holdings, the Vanguard Total Bond Market (VBMFX) fund might look like a safe harbor. In truth, 38% of the fund’s assets are in mortgage-backed government bonds, issued by Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) . Another 8.5% is in corporate bonds issued by financial companies. Even if no issuers default on the bonds, the yield is still likely to fall prey to inflation.

Bill Gross is the managing director of PIMCO, the largest fixed-income money manager in the world. In his latest letter to clients, Gross urged investors to avoid Treasuries, TIPS, and other conventional bond types in favor of commodity-backed assets and foreign equities. The reason: The official U.S. inflation figures, known as CPI, do not reflect reality. He argues that real U.S. inflation is likely closer to the 7% global average, that Treasuries offer a negative real yield as a result, and that even the supposed inflation protection offered through TIPS is inadequate because of that disparity.

So much for the other bond fund recommended by Money magazine, which is comprised entirely of TIPS. If the inflation they claim to protect us from is grossly understated, then these vehicles become just another conduit for losing money.

Close your ears; open your eyes
For all the shortcomings I found with this article in Money, it did contain two pieces of advice I can agree with. First, it recommended a money market fund, and I can’t argue with having some cash on the sidelines in anticipation of future opportunities.

Second, the authors’ “best advice” certainly applies: “Turn off the noise and focus on your true goals.” If your goal is to adapt when markets experience disruptions of historic proportions, then the Fool within you might question the wisdom of conventional wisdom. Identify who your Pied Pipers are, and make sure you’re not marching behind them when they sing their sweet songs.

Further Foolishness:

T. Rowe Price New Horizons Fund is a Motley Fool Champion Funds recommendation. A 30-day trial of the newsletter is free.

Fool contributor Christopher Barker captains yachts and writes about stocks. He can also be found acting Foolishly within the Motley Fool CAPS community under the username TMFSinchiruna. He owns no shares in the companies mentioned. The Fool has a disclosure policy.


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