Rational Investing: Navigate investment roads cautiously

Although the year finished with a whimper rather than a bang, the markets provided positive returns for the year, despite fading at the end. The Dow Jones Industrial Average increased 6.4 percent, the Standard & Poor’s 500 was up 3.5 percent, and the Nasdaq returned 9.8 percent.

For many investors, the benchmark is the S&P 500, which did not have a difficult 2007 performance to surpass.

A benchmark for most serious investors is not necessarily relevant, because knowledgeable investors will have a targeted rate of return that they, working with financial professionals, have established as the rate of return that will reach their goals with the least amount of risk. It is the most logical way to construct and manage a portfolio that is designed to get from Point A to Point B without major disruptions. It’s sort of like driving from Springfield to St Louis: You can get there a lot faster at 95 mph than at 70 mph, but one little slip-up and – whoops – there goes the car and who knows what else.

All investors are encouraged to use the rational approach and to begin by establishing their own risk tolerances. Then, they need to figure out their realistic goals, where they stand relative to those goals, and determine what rate of return will get them there without unwanted risks.

For the majority of investors, that means allocating the portfolio investments among multiple investment styles, capitalizations and geographies.

Using the Springfield-to-St. Louis analogy, this method is like having extra insurance, as well as alternate routes available if there are problems on Interstate 44. For example, portfolios that were concentrated in small company stocks, analogous to driving at high speed, didn’t reach their destination last year. Those that were diversified, especially if they owned mutual funds or exchange-traded funds that consisted of foreign assets, should have had a better-than-market total return, and were much more likely to have met their individualized targeted rate of return.

That was last year; what about 2008?

The Wall Street Journal, months after the same matter was addressed in this column, has noted that the markets are getting nervous about the political pandering and protectionism that both parties are blathering about. And the candidates, each trying to appear more generous to the voters than their competitors, are avoiding the third rail issues of the future insolvency of Social Security and Medicare. Once again, we have campaigns of more style than substance, with market concerns rising that the economy could once again be damaged by the unintended consequences of politicians overhauling the tax code or some other ill-conceived measures. So the overhang of this concern – mentioned here and in WSJ but not yet picked up by the general media – will grow.

Then there are the subprime mortgage and declining home price problems that we hear about daily. Add the chatter about a possible recession, stagflation, energy costs, unemployment and any other negative items the media can report ad nauseam, and you have an investing public that is skittish at best.

The result: valuations that are becoming compelling. Although trying to call market, industry or sector bottoms is, to use a hackneyed expression, “like trying to catch a falling dagger,” we believe it is time to begin scaling into the better financial issues and the stocks of large capitalization growth companies. And don’t forget an allocation to foreign issues, best diversified with ETFs or mutual funds, as their growth period is far from over. If you are truly a long-term investor, and you can bear extreme price volatility without hitting the panic button, include India, China and Brazil ETFs in your portfolio.

The market’s downside may not have been exhausted, but when that has occurred we will only know it in hindsight, so use others’ uncertainty and discontent, and start getting your cash reserves to work.

Clark Davis is a 37-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company. He can be reached at cdavis@slia.com.