Saturday, May 20, 2000
The Sophisticated Investor
Asset allocation fund offers peace in uncertain times
By John Waggoner
USA Today
Sometimes the investment outlook is so clear that you can plunk your money down with confidence, knowing that all will be well.
Unfortunately, this is not one of those times. The Federal Reserve Board is raising interest rates, and Wall Street is as nervous as a snail in a French restaurant. And if you're going crazy trying to figure out where to put your money now, perhaps this is a good time to let someone else do the job for you by investing in an asset allocation fund.
What makes this such a difficult time? The Fed is trying to thwart inflation and slow the economy by raising short-term interest rates. This week, the Fed raised its key federal funds rate — the rate at which large banks make overnight loans to one another — to 6.5 percent from 6.0 percent. There are two simple reasons why this hurts the stock market, and one complicated one.
First, the simple reasons:
• Competition from other investments. When bank CDs yielded 3 percent, investors shunned them. But now, the average one-year CD yields 6.25 percent. And the highest CD tracked by 100 Highest Yields has a 7.52 percent yield. That's high enough to make conservative investors consider putting money into a CD, especially when the stock market looks shaky.
• Lower earnings. When rates rise, it becomes more expensive for businesses to borrow and expand. Companies with adjustable-rate debt have to make higher interest payments, which cuts into a company's earnings. Stock prices tend to follow earnings, so unless the company can boost its earnings more than it would otherwise, the stock's price will probably fall.
But the more complicated reason is more compelling. Basically, when rates rise, investors are less willing to pay high prices for stocks. Here's why.
Suppose you're a lucky devil and win $1 million in the Whole Lotta Bucks Lottery. But you're not quite as lucky a devil as you thought. You'll get 20 payments of $50,000 a year, not $1 million in one lump sum.
A banker offers to give you $573,496 if you sign over the 20 payments to him. Deposit that amount at 6 percent, he says, and you'll be able to withdraw $50,000 a year for 20 years before the money runs out.
Now suppose that prevailing interest rates were 8 percent. In that case, the banker would have offered you substantially less — $490,907. Why? Because you could have earned more on your money while it was on deposit. In fact, the higher the current interest rate, the less your banker
would have offered you for your series of $50,000 payments.
So how does this relate to stocks? Most large investors use something called a dividend discount model to figure out how much to pay for a stock. It works much the same as the lottery example above.
After all, when you buy a stock, you're essentially buying a stream of payments — in this case, your share of the company's earnings. As interest rates rise, investors typically bid lower prices for stocks. Stocks priced highest relative to earnings get hurt the worst.
So if you're investing now, you want a fund that's born to be mild. You could look for solid growth funds that specialize in low-priced stocks, such as American Century Equity Income — (800) 345-2021 — which has risen 1 percent this year vs. a 1 percent loss for the average stock fund. The fund's average price-earnings ratio is 16.5 vs. 27 for the Standard and Poor's 500 index.
You could also park your money in a money fund until you think the danger is over. But then you run the risk of never getting back into the market. If you're torn between stocks and other, safer investments, consider an asset allocation fund, which moves among stocks, bonds and money market securities, depending on which the manager feels is most attrac tive.
These funds are like a good compromise: They won't make anyone entirely happy. In a raging bull market, you won't make as much money in an asset allocation fund as you would in, say, a technology fund.
And in a bear market, you won't avoid losses altogether. But in time, you should be able to get good performance and good sleep.
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