This has been a roller coaster year for stock markets (as well as for my alleged Genghis Khan ancestry).  After the close of the markets on Friday the Wall Street Journal (WSJ) Online reported:

“Friday, the Dow Jones Industrial Average fell 40.58 points to 11150.22, leaving it up 0.4% for the quarter and ahead by 4% for the year. It was the fourth straight quarter the blue-chip average has posted an advance.

The Standard & Poor's 500-stock index fell 2.02 to 1270.85, leaving it down 1.9% for the quarter and up 1.8% year-to-date. The Nasdaq Composite Index shed 2.63 Friday to 2172.09. The tech-heavy index fell 7.2% in the second quarter and is down 1.5% for the year.”  Online.wsj.com, “Rocky First Half for Stocks,” June 30, 2006, 9:19PM.

First the good news – they got the numbers wrong (or more precisely they got the wrong numbers).  Now the bad news – they were pretty close.  Business journalists tend to focus on the price performance of the market indices which gives an incomplete picture of the actual performance of the market.  The stock indices such as the S&P 500 are a weighting of the stock prices of the underlying stocks (500 stocks in the case of the S&P 500).  When you invests in securities there are two components to your return; periodic income (such as interest and dividends) and appreciation in price (or as in the case of the quarter just ended - depreciation).  The price indices discussed in the WSJ article only include the price portion.  It is more relevant to focus on the total return, including the periodic income received.  Dividends (and interest in the case of bonds) are an important component of returns. 

Unfortunately, total return indices are not easily accessible to the average investor.  An easily accessible alternative is to look at the actual performance (total returns) of index mutual funds.  This has a second advantage over the price indices.  Investing has costs associated with it (trading and sometimes management fees).  The total returns of index funds, from fund families such as Vanguard and Fidelity, include not only income but also a reasonable amount for trading costs and management.  These are a better proxy of returns that are actually available in the market.  As an example, here is the performance through June 30, 2006 from a sampling of Vanguard index funds:

Note that the year to date return on the Vanguard S&P 500 Index Fund through June 30, 2006 was 2.64% versus the 1.8% reported by the WSJ.  This is not a stellar return, but gives you a better picture of what you could have achieved in this market.

Lets focus on what this data tells us:

·        The markets have been volatile this year with very strong returns in the first quarter (other than for long-term bonds) and poor returns in the second quarter.  Volatility like this occurs when there is uncertainty, which we have a lot of right now.  There is uncertainty as to inflation, interest rates and IRAQ.  The Federal Reserve Board has been steadily increasing interest rates to head off inflation, but there is uncertainty as to when they will stop and concern that they might raise interest rates too far.  Volatility is likely to continue until some of these uncertainties are resolved.

·        Broad U.S. market indices (as opposed to the S&P 500 which represents large stocks) have outperformed for all periods shown above except the second quarter.  The broad market index includes small and mid cap stocks which have outperformed large stocks in recent years, but which can be more volatile.  Also in times of distress there is often a “flight to quality” – large well known stocks.  Note, however, that investing in these broader market indices provides greater diversification than limiting your investments to one sector.

·        Broad international markets have outperformed the U.S. stock markets for the last five years, but not over the last 10 years.

·        Real estate in the form of Real Estate Investment Trusts or REITS (these are real estate businesses such as commercial property, hotels, apartments, etc., – not your local condo market) has continued to outperform the stock markets.

·        Long-term bonds, considered by some to be a bastion of safety, have been a lousy place to be.  This is not surprising since long-term bonds are expected to do poorly in a rising interest rate environment.

The bottom line is diversification, diversification and diversification.  No one can predict future returns.  By having an adequately diversified portfolio including U.S. stocks, international stocks, REITs and other assets you can obtain a satisfactory return while reducing risk.  With the introduction of many new Exchange Traded Funds (ETFs) which invest in asset classes such as commodities you can achieve even greater diversification while hedging against inflation.  Don’t put all of your eggs in one basket (but if you do watch that basket very closely).

If you want to learn a little more about the benefits of asset allocation (investing in different types of assets) – see that topic on my other blog (www.financial-education.com). Asset allocation involves selecting what percentage of your overall portfolio goes into stocks, bonds and other assets.  This does not necessarily mean, however, that you always keep these percentages the same - your asset allocation should also consider current market conditions.  For example, I don’t know what is going to happen to long-term interest rates in the future – but if interest rates continue to rise long-term bonds will suffer more.  You can currently obtain a rate of return on certificates of deposit, money market accounts and short-term government bonds which is not much less than investing in long-term bonds.  Why take the risk of investing in long-term bonds at this time?  It might be advisable to wait until long-term bonds returns are paying a sufficiently higher return to compensate you for the risk.