Greetings, fellow Fools! I created a bit of confusion last week when I wrote in our Human Genome Sciences (Nasdaq: HGSI) buy report that we had made a mistake by not putting our spare cash in the general market while we were deciding on an individual stock for our portfolio. We should have bought Spiders (AMEX: SPY), which are shares of the S&P 500 Index, like we did in 1998.
Several people disagreed with my assessment. Outtacash questioned the benefit of putting money in index shares for the short-term. Doesn't the Fool say that we shouldn't invest money in the stock market if we will need it within the next five years?
That's true. You should only invest money that you won't need for at least five years -- preferably longer. But there are two reasons I think we should have bought index shares. They have to do with the two purposes of our portfolio, which are to maximize our investment returns and to examine our Rule Breaker stock selection strategy.
1. We seek high returns on our investments through maximum exposure to stocks.
It is not our purpose in the Rule Breaker Portfolio to teach portfolio allocation. We hold a bunch of risky stocks because we're investigating the Rule Breaker strategy of stock selection, but that doesn't mean that we advocate the same for you. You need to decide for yourself what mix of stocks best reflects your confidence in your stock-picking abilities and your risk tolerance.
However, we do say this about portfolio allocation: If you've got money that you don't need for a long time and you want to invest it, put it in the stock market. Don't split it among cash instruments, bonds, and stocks, as some personal finance advisors will suggest. Put it all in the market.
We have allocated the pot of money in the Rule Breaker Portfolio for investment. We don't need it for other things. As such, it is best to have it constantly in the best investment vehicle we know of: the stock market. In Stocks for the Long Run, Jeremy Siegel found that over 30-year periods, stocks outperformed bonds 100% of the time. Over 20-year periods, stocks outperformed bonds 94% of the time. Over five-year periods, stocks outperformed bonds 71% of the time. Over one-year periods, stocks outperformed bonds more than 59% of the time.
The market is our key to the best investment returns. We go one step beyond in our portfolio, though. We think that we can yield even better results from focused investments in individual stocks. The concept is very similar to our sell strategy: We sell when we have found a better place for our investment. It is as though we owned index shares alone, but we sold them to buy individual stocks when we found some that we think can beat the market.
When we don't have one, though, we are best served to revert to the market. That's the best place to maximize our investment returns. Sure, a money market might outperform stocks during a short period of time, but it's not profitable to try to time market declines. As explained in this Fool's School article, market timing is bunk:
"Consider, for instance, the returns on small company stocks between 1925 and 1992. If you had been invested in small company stocks over this period, your average annual return would have been 12.1%. If you sat out the single best month during that 67-year period, you would have only made 11.2% a year. If you missed out on the best five months, well, forget it... you would have only notched gains of 8.5%. Anyone can guarantee that their money is in the market during its best days in order to nail the 10.5% average annual return in large company stocks and the 12.1% average annual returns in small company stocks. All they have to do is not try to time the market."
So we don't try to time it. We're all stocks, all the time. We only leave it when we think -- arrogantly -- that we can do better. That's not a strategy for everyone, but we enjoy it.
2. We clarify the performance of our portfolio by buying index shares.
In addition to maximizing our investment returns, index shares help us measure our performance using the Rule Breaker investment strategy (and the strategy of the Fool Portfolio before it).
We benchmark the performance of our portfolio against the various market indices. Spare cash in the portfolio is not involved in our investment experiment. When it is in cash, it affects the overall returns of the portfolio relative to the S&P, sometimes significantly. The Fool Portfolio underperformed the market in 1997 by more than five percentage points. If we had stashed the portfolio's cash into the S&P 500 until needed, it would have handily beaten the market.
Index shares won't always have that impact, of course. The point is that a casual observer would look at our returns from 1997 and say, "Those Fools' stocks underperformed." That wasn't the case. The cash underperformed. The underperformance was our fault, but not because of our stock selection.
By buying index shares, we avoid the whole issue of the performance of cash vs. the market. The index shares will perform nearly exactly in line with the market. That means that they can be canceled out of our relative returns, and any over- or underperformance of our portfolio can rightly be assigned to stock selection.
That's why I think that we should buy index shares with any spare cash in our portfolio in the future. It improves our chances of netting higher returns on our investment and it allows an observer to assess our stock selection returns more easily and accurately. If you think I'm still missing the point, let me hear about it on the Rule Breaker Strategies discussion board.
If you're looking for a little lighthearted fun, take a shot our Rule Breaker Crossword Puzzle!
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