Finally, it looks safe to get back in the stock market. The bad old days of economic crisis are behind us. The Christian Science Monitor called this bull market a “humdinger.” The Dow went from 14,000 to the never-before-seen level of 15,000 in just 66 days. Break out the Champagne! Or not. Mohamed El-Erian, CEO of PIMCO, told The Wall Street Journal: “In virtually every market segment, we are trading at very artificial levels.” Why? Individual investors (folks like you) are buying stocks again. From 2009 to 2012, investors pulled $380 billion out of equity mutual funds. This year, they dumped $66 billion into stock funds. Now there’s talk of a new bull market— four years after it started.
This is why Wall Street calls mutual fund investors the “dumb money.” As a University of Chicago finance professor, Andrea Frazzini pretty much wrote the book on dumb money. Along with Yale’s Owen Lamont, Frazzini found that investors chase whatever funds have been doing well recently, often getting in just before the returns go downhill. In fact, most mutual fund investors’ timing is so bad, the researchers found, that “to achieve high returns, it’s best to do the opposite of these investors.”
Just because Main Street finally noticed that stocks are a good investment, that doesn’t mean the next bear market is around the corner—so don’t sell everything. Don’t buy it all, either. Rather, you need to be so broadly diversified that some of your holdings will stay strong even if others take a hit.
The classic low-cost portfolio is a 60/40 mix of stocks and bonds. From 1926–2012, it returned 8.7 percent, according to Vanguard. Rather than blow up that approach and start from scratch, consider investing 55% in the stock funds described below, 35% in bond funds, and 10% in alternative assets. If the dumb money is indeed signaling the end of this bull run, you’ll own assets that zig when other investments zag.
I like Vanguard Total Stock Market Index Fund (VTSAX) and Total International Stock Index Fund (VTIAX). Own just these two funds and you have exposure to virtually every single stock market in the world. The fees are about one-tenth of one percentage point, far less than the average mutual fund. “When it comes to mutual funds, expense ratios are much more important than past returns,” Frazzini says.
Also, get in on the FPA Crescent Fund (FPACX). Few fund managers earn their fees, but Steve Romick is an exception. This fund has risen about 145% since 2000, crushing not only stocks but also most other “balanced” funds that hold a mix of stocks and bonds. Right now Romick is concerned that stocks are expensive, and he has more than a third of the fund in cash.
Make the core of your bond holdings part of Vanguard Total Bond Market Index Fund (VBMFX), a dirt-cheap index fund that owns the whole U.S. bond market. In 2008, when nearly every investment got clobbered, Treasury bonds were up. Look into Harbor Bond Fund (HABDX) as well. It’s managed by Bill Gross, known as the “bond king” because of his fantastic record running the largest mutual fund in the world, PIMCO Total Return. You’ll get the same expertise for less with Harbor Bond.
Harbor Commodity Real Return Strategy (HACMX) exposes you to “hard assets,” from gold and corn to cattle and coffee. Over the long term it should help buffer you from inflation, and will also move differently from stocks and bonds. Just be prepared: If China, which is responsible for consuming half the plan- et’s supply of some commodities, hits a wall, prices will fall.
Then, of course, there’s the Vanguard REIT (real estate investment trust ) Index Fund (VGSIX). If you own your house or other property, skip this one—you have enough exposure to real estate prices. But if you rent, it’s a good way to keep up if real estate prices go on another bender; and REITs’ kickoff income is about 3% a year.
Last, consider the Kayne Anderson MLP Investment Company (KYN). Master limited partnerships, or MLPs, were once a little-known corner of the investment world. But they’ve become popular in recent years, so after dramatically outpacing the stock market over the past decade, returns may moderate. By law, they’re required to pass most of their income to shareholders, so they kick of a decent yield, currently 6%.