The world’s major stock markets have been on the decline over the past twelve months and volatility has been on the rise. The NASDAQ and Standard & Poor’s 500 stock index are back to their 1997 levels, wiping out $7 trillion in value from the market’s peak. The Dow Jones Industrial Average is down 14 percent so far this year, S&P 500 down 20 percent and NASDAQ down 30 percent. The European markets have fared even worse. If the American stock market ends 2002 in negative territories, it would be the first time since the end of World War II that the market falls for three consecutive years.
The reasons for the decline in share prices are now well known. Impact of Sept. 11, corporate scandals and weak economic recovery. GDP growth in the US for the second quarter was 1.1 percent, down considerably from the 5 percent growth of the first quarter. Deception of WorldCom, Enron, Tyco and the rest, as well as, huge write offs of companies in telecoms and other sectors have raised concern over corporate profits. According to Business Week of July 29, 2002, if all S&P 500 companies accounted for the stock options they gave their employees in their operating expenses, average earnings would have been 24 percent lower in 2001 and will be an estimated 17 percent less this year. Average price earning ratio for S&P is currently around 21, compared with an historic average of 15. Foreign investors, who had about $1,700 billion invested in US stocks at the end of last year had reduced their investment by around 25 percent by the end of the second quarter.
No one knows when the bear market will come to an end. Since 1931, S&P 500 index never lost money in any overlapping 10 year period (i.e. 1931–41, 1932–42, etc.) and since 1938, the market has lost money only three times in five-year periods. Current monetary policy is quite supportive with short-term interest rates at their lowest level in 40 years and are unlikely to rise anytime soon. Inflation is at 1 percent going down to zero, fiscal policy is expansionary and companies are recording strong productivity gains. According to Ibbotson Associates, over the past five bear markets, the Dow and the S&P 500 lost an average of 20 percent and 30 percent respectively from previous peaks, so far the Dow is way down by 20 percent and the S&P by 30 percent from their peaks.
How can investors cope with the turmoil in the international stock markets? The answer lies in one word: Diversification. Of all the decisions one makes in his investing life, the choice of how to divide up his money among financial categories i.e. asset allocation, is by far the most important.
A good financial adviser could help you set a serious, simple asset allocation strategy, which should hold irrespective of market conditions. Stocks produce the highest returns but they are the most risky, cash generates the lowest returns and it is the least risky, bonds fall in between. Over longer periods, however, the riskiness of stocks decline. Over a 20-year holding periods, the risk is about the same for the three assets but the returns are considerably higher for stocks. It would be great if one could pull his money out of stocks just before the market tumbles and puts it back just before the market booms. But rarely have investors been successful in timing the market.
Asset allocation depends on one’s appetite for risk. If the investor is risk averse and cannot sleep at night because he is worried about his stocks, then he should stay out of the stock market. If one is saving to pay tuition fees for his children or to make a down payment on a house two to three years off, then he should stick to bonds. Capital guaranteed funds have been around for a while, but increasingly more investors are seeking them. Any investment that guarantees to protect your capital on top of a minimum return sounds like a blessing. But remember there are no guarantees when it comes to investing, and low risk always means low return. Furthermore, protection from market volatility means high fees and often you are required to tie up your money anywhere from three to ten years. But if you are willing to consider such a time horizon for your investments, you are better off having a portfolio of stocks and bonds rather than investing in a capital guaranteed fund.
A simple asset-allocation formula would work like this. Keep an emergency amount of cash that might represent a few months’ expenses. All of the rest, if you are in your 20s, should go into a diversified portfolio of stocks. In your 30s, the allocation should be 90 percent stocks, 10 percent bonds. In your 40s, move to 75 percent stocks, 25 percent bonds. In your early 50s, your portfolio should be 60 percent stocks, 40 percent bonds. By the age of 65, a good mix for most people who can also count on Social Security and some pension money form another source is 50 percent bonds, 30 percent cash and 20 percent stocks. And remember to diversify within those categories as well.
The present value of one’s portfolio is the level at which it is trading at today. One should stop thinking of the high levels his shares used to trade at before. Studies in behavioral finance show that people tend to hold on to their losing shares and to sell their winning ones. The motivation is the need to minimize the regret of making a mistake. As long as there is some hope a stock will bounce back, people will hold on to it. Then once a stock starts to come back a substantial way — although not necessarily all the way — investors frequently sell.
The recent performances of the region’s stock markets compared with their international counterparts together with exchange rate stability of the Jordanian dinar and the Gulf currencies on the dollar have convinced investors to put more money in their home stock markets. For example, the Jordanian stock market is up around 1 percent so far this year, on top of the 30 percent increase recorded in 2001. Kuwait’s market up 12 percent on top of last year’s increase of 28 percent. Saudi Arabia’s stock market index surged 9 percent year to date, following an increase of 8 percent last year. Qatar’s stock market has recorded the best performance, up 40 percent so far this year on top of 37 percent last year. We are witnessing local investors adjusting their asset allocation, directing a higher percentage of their portfolio to their local stock markets. However, because of lack of a variety of investment products, the limited liquidity of these markets and their extreme volatility as witnessed in the past few days, there is no doubt that the international stock and bond markets will continue to attract the bulk of local money. Domestic stock and bond markets provide a diversification outlet but are not large enough to absorb the estimated $1,000 billion of Arab money invested overseas.
If the investor does not have the time or the knowhow or does not have access to company information, or the amount he is investing is relatively small, he should invest through specialized mutual funds. These funds offer economies of scale, risk diversification and professional management. The choice of the fund is dictated by its track record and the asset class it specializes in. An example of such funds is Jordinvest First Trust Fund which provides both diversification in bonds and stocks and by markets in Jordan and other Arab markets. The Fund was up 27 percent in 2001 and 9 percent in the first half of 2002.
(Henry Azzam is chief executive officer at Jordinvest.)