The Rules of Rational Exuberance

As the bulls rush back into stocks and broker greed builds, diversification and risk management are still the keys to success

By Christopher Farrell

Signs of the economy's renewed vigor have pushed the stock market to its highest level in 14 months. With the benefit of hindsight, investors were right in April and May, when they drove stock valuations higher despite a dearth of statistics suggesting a turnaround was coming.

Investors were not irrationally exuberant, a charge levied by a number of pessimistic money managers. Now, many economists are raising their growth forecasts for the second half of the year from the 2% to 3% range to 4% to 6%. The gap between 4% and 6% largely reflects forecaster differences over how quickly employers will ramp up hiring over the next several months.

There's still a lot to worry about. The labor market remains weak, for one. The federal budget deficit is ballooning, and energy prices are high. Yet the odds are good that the stock market will continue to surprise on the upside. Stronger corporate earnings in the months ahead should boost confidence in equities.


  Managers' animal spirits are stirring with business investment in equipment and software running at its fastest pace in three years. With the Federal Reserve showing little inclination to hike interest rates, their relatively low level today should encourage investors to favor riskier assets like stocks, observes Martin Barnes, managing editor of Bank Credit Analyst.

Despite the 16% gain in the Standard & Poor's 500-stock index and the 38% surge in the Nasdaq so far this year, investor enthusiasm for equities seems measured rather than frenzied.

Still, I received my first cold call in three years the other day. It was deja vu all over again. The broker from the quickly mumbled no-name firm insisted we had talked a year ago. Had I listened to him back then and bought the stock he was recommending, I would have made 200% on my investment. Didn't I like to make money? Well, he had another hot stock just for select customers the outfit was trying to cultivate. Right, and pigs fly.


  Investor beware. The Wall Street greed machine is about to go into high gear. Brokers' commissions have been scant these past few years, and nothing loosens investor purse strings like a sustained stock market rally. So, now's a good time to review some investment basics.

Trying to beat the market is a loser's game. Terrance Odean and Brad Barber, two finance economists at the University of California, Davis, looked at the trading accounts of more than 66,000 households at a large discount brokerage firm from 1991 to 1996. The stock market recorded an annual return of 17.9% during that period, while those who traded the most, after taking into account commissions, scored just 11.4%. Now you know why they named their paper, "Trading is Hazardous to Your Wealth."

Individual investors who trade stocks by the hour or the week, or those who move in and out of mutual funds several times a month or quarter, are wasting time and money. No evidence shows that all that trading activity creates wealth. Abundant data show that a disciplined, long-term approach with minimal trading increases the odds that you will reach your long-run financial goals.


  What matters is managing risk. The only way investors create the opportunity to earn a higher return is to take on greater risk. Risk means different things to different people, and that should be reflected in investment portfolios. It's not just an appetite or distaste for embracing uncertain outcomes. A tenured university professor enjoys a level of job security that allows for greater risk-taking with investments, assuming a bold temperament. A marketing account executive on commission is always at risk of losing income or job, and a more conservative portfolio is sensible.

Rather than worry over whether now is the time to buy into high-tech stocks or flee bonds, investors should spend some time mulling their comfort level with regard to financial risk.

The central investment strategy is diversification, the concept of not putting all investment eggs in one basket. Now, everyone got a lesson in the benefits of diversification over the past three years. For instance, the Russell 3000 returned -10.73% and the Russell 200 growth index -22.17% on an annualized basis over three years, while the Vestek Broad bond market index returned 8.92% and the Vestek 90-day T-bill index 3.14%. The trick is to mix and match the major financial market assets to create a well-diversified portfolio for good times and bad.


  Diversification includes putting some money into foreign markets. The idea of investing overseas to cushion swings in the U.S. market has fallen into disfavor. The world used to be made up of national markets, and the relationship or correlation between countries was relatively weak. Investors could both reduce the risk of their portfolios and enhance returns through geographic asset allocation. But with goods, services, capital, and labor crossing the globe as never before, the correlation between the U.S. stock market and foreign bourses has tightened considerably. Why bother diversifying overseas in a world of high correlations?

The answer is that diversifying still reduces risk even if correlations are high. That's the conclusion of a recent paper by Santa Clara University finance economist Meir Statman and Jonathan Scheid, senior research analyst with Assante Asset Management, whose working paper is available for downloading.

Statman argues that money managers have focused too much on correlation and not enough on "dispersion," the "deviation of returns of undiversified portfolios from that of a diversified portfolio." Put somewhat differently, investors are smart to disperse their assets into many baskets because all eggs in one basket are likely to meet a similar fate, while eggs in many baskets may meet different fates.


  Statman and Scheid note that the correlation between U.S. and international stocks was 0.85 in the 60 months ending in December, 2002. That's higher than any time during from 1974 to 2002. (A correlation of 1 means the movements are the same.) Nevertheless, the researchers found that the expected dispersion in 2003 is 4.92%. So, investors owning an undiversified U.S. stock-only portfolio or an undiversified international stock-only portfolio should expect to lead or lag behind a well-diversified global portfolio by 4.92% in 2003. Diversifying overseas is a sensible strategy.

The essence of investing is uncertainty. You can't eliminate it. As Peter Bernstein, the dean of finance economists emphasizes, it's in the nature of the beast. But a focus on risk management and the technique of diversification will limit any losses and enhance your chances of achieving your financial goals at the same time.

Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online

Edited by Beth Belton

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