FOOL ON THE HILL
Market Schmarket

Is your portfolio in shambles? Life savings, MIA? Angry? Anxious? Get in line, says Dayana Yochim. Forget the highbrow academics and sweeping stock market analysis. She goes straight to the source -- top Fool Tom Gardner -- for answers about her dying portfolio.

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By Dayana Yochim (TMF School)
July 31, 2002

Forgive my self-centeredness, but I don't care about "the market" right now. Don't bother me with sweeping historic comparisons and highbrow back-and-forth about corporate governance. Arthur Andersen, Harvey Pitt, WorldCom, Enron, Britney, and Tauzin-Dingell (H.R. 1542) can have the headlines for all I care. I've got bigger worries.

The balance in my 401(k) account is just a shell of its former glory. The gains in my IRA are MIA. If my online portfolio was sound-enabled, I'd get a sickening sucking sound every time I pressed "update." My stomach hurts. My life savings has been shelled. And I'm quite serious.

But this time, I'm going to the top. Tom Gardner, I demand answers.

Dayana: Tom, what's happening to my portfolio? Is this whole market dip serious? Is this a drought? A blip? A 40-year famine? Evolution? Revolution? Give me some context so I know how long to freak out.

Tom Gardner: Start with where we are. The market is down more than 40% since March 2000. Some liken this to 1974, when the 40% downturn presented a great buying opportunity. Others liken it to 1930, where a 40% downturn was just the beginning of more misery.

Unfortunately, there are useful comparisons to both.

The late 1920s and 1930s showcased full-scale corruption. Head of the New York Stock Exchange Richard Whitney, more than $6 million in debt, was sent to Sing Sing jail for 40 months. He'd borrowed illegally from investment trusts and speculated, without success, in apple brandy and peat fertilizer companies while sitting as the head of the exchange.

Like now, there were massive mis-selling scandals back then, too. In 1928, the National City Bank sold $90 million (valued at more than $700 million today) of what it knew were worthless Peruvian bonds to unsuspecting customers. TIME magazine began referring to their executives as "banksters." We have a few of those, at least.

So, the 1930s present obvious parallels to today. Fast forward, and just look at the telecom industry of the last 10 years. It swelled with corruption, insider dealing, offensive executive pay packages, and terrible mismanagement. Auditors of these companies (and obviously of companies in the cable and energy industries, too) twisted accounting principles to their breaking point. And, I believe, broke the law in select cases.

So I see as many comparisons to the 1930s as to the 1970s, which were mostly about stock overvaluation, political scandal, and poor fiscal policy. For that reason, there are as many reasons to think this is a wonderful buying opportunity as to believe it will be a long time before we experience a rolling 10-year period of double-digit market returns.

I believe investors should plan for mediocre stock market returns of 5%-8% per annum.

Dayana: I appreciate your history lesson and chipper outlook, but 5%-8% per annum isn't why I got into this whole investing thing in the first place. What happened to the "11% historical returns" that I was promised?

Tom Gardner: Well, first of all, recognize that your real rate of return may still be attractive. If inflation remains this low, and you take home 8% annual gains, you haven't done half bad. I'd say there are more reasons to be worried about deflation in our economy than inflationary pricing power.

On the returns side, I simply don't believe we'll see foreign money return to the U.S. stock market to any level comparable to the late 1990s. Until the markets are cleaned up and investors trust that executives won't disgustingly make $25 million while their company collapses, I think the rebound will be a slow one. On top of that, it is simply rare that our economy zips back out of recession... you can expect some dips with those zips.

Dayana: I hate to be a Fool who follows the pack, but the advice to diversify into bonds, real estate, foreign stocks, and mutual funds is starting to sound pretty reasonable right now.

Tom Gardner: It is reasonable. But diversification strategies are circumstantial. The Motley Fool Investment Guide for Teens is hitting the bookshelves right now. I'm not about to tell a 16-year-old to significantly diversify away from the stock market. Virtually all of a teenager's long-term assets should be in a stock market index fund.

But the 47-year-old that's adapting now to a beaten-down market has very different challenges. I do still think that substantial portions of their long-term future savings belong in the U.S. stock market. What you don't need for 10 years or more should be indexed or indexed alongside carefully chosen stocks. If you need the money in five years, lean toward the total bond market index fund. And the money you need in a year or two belongs in CDs.

Every investor who encounters The Motley Fool should know we believe the Total Market Index Fund from Vanguard or exchange-traded funds on the American Stock Exchange provide instant equity diversification at minimal cost. For those unwilling to pick stocks, I think all of your equity portfolio should be in index mutual funds.

Dayana: Well, at least I listened to my bosses. Most of my dough is in index mutual funds. Still, you guys made it sound so easy. Pick great companies, sit back, and watch 'em grow. So imagine I'm a 43-year-old that has just lived through a 50% decline in her portfolio. My mutual funds are beaten down. My stocks are in shambles. Help me out. Gimme a magic bullet. Tell me what to do to fix this mess I'm in.

Tom Gardner: Okay, here's a four-step process.

First, sell any mutual funds in a tax-deferred account that a) charge more than 0.50% per year and b) have underperformed the Wilshire 5000 (or S&P 500) during your holding period. If you choose to keep the proceeds in mutual funds, then purchase exchange-traded funds or index funds from Vanguard.

Second, run the same numbers above on any mutual funds that you hold outside of tax-deferred accounts. Include the capital-gains tax distributions as costs in evaluating the performance of your funds. Take some time to calculate the tax cost of moving this money over into index funds. My rule of thumb -- if you have 10 years or more before you need the money, move the money from underperforming managed funds into index funds.

Third, in evaluating stocks, you have to learn how to assess the financial statements of your companies. And you must work to put a price tag on the business. In my investments of the past 15 years, I believe I did a solid job of assessing the financials of my companies. However, I did a poor job of putting a fair price on their business.

Read about valuing a business off free cash flow, which can be mastered and put to good use. Get help from expert investors like those spending time in our Berkshire Hathaway (NYSE: BRK.A) discussion board. And consider signing up for Motley Fool Stock Advisor, where David and I select a stock each month. Over the past six months, my five recommended companies have been beating the market by an average of 17%. Why? Simply putting a price tag on great businesses based on free cash flow. I've learned my lesson.

And your fourth and final step should be to see things as they are and live within your means. Very few people are celebrating their financial standing today. Most people, like you and me, are re-evaluating how much we need to save, what we enjoy doing in our lives, how to spend our time and money, and how to be conservative, smart, and successful with our investments. To make the best decisions right now, we have to first see things as they are rather than as we wish they'd be. Then we need to take steps to make them as we wish they'd be.

Few of us don't have challenges right now. So join in. Ask for help here as needed. And start on your way tomorrow morning.

Dayana: Thanks, Tom. I've got a lot to think about. And maybe even a little less hand-wringing in my future.

Most of Dayana Yochim's life savings were last spotted in an index mutual fund, though some were lollygagging in an underperforming actively managed mutual fund. The Motley Fool is all about panicky investors like Dayana writing for other investors.