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Investing Defensivley Does Not Mean Deserting Stocks

For investors, these are baffling times. The outlook for the economy and financial markets is so opaque that everyone seems to be predicting a different best- or worst-case scenario, and there are so many conflicting indicators that one notion may sound just as convincing—or as full of holes—as the next. But one thing isclear—individual investors really don’t like stocks. During the first seven months of 2010, a net $33.12 billion came out of stock mutual funds, according to the Investment Company Institute, while a net $185.31 billion surged into bond funds. And whereas two years ago, 401(k) investors had 70% of their assets in stocks, now the percentage is 57% and dropping, according to benefits consultant Hewitt Associates. 

There are plenty of reasons for this obvious distaste. An investment in stocks 10 years ago would be worth less now than when you made it, and if you had been prescient enough to get out of the market at its peak in 2007, you’d still be well ahead of the game, even after 2009’s historic rally. In mid-September 2010, the Standard & Poor’s 500 stock index was nearly 30% below where it had been three years earlier. And the stocks of solid, dividend-paying companies—which many analysts have praised as a relatively low-risk, income-producing alternative to bonds—could suffer if dividends are again taxed at rates for ordinary income (as high as almost 40% for top earners) rather than at the 15% rate that has applied to most payouts to shareholders for the past several years. That will happen in January 2011 unless Congress votes to change the law.

What the government does or doesn’t do during the next several months could help determine whether the shaky economy falls again into recession—and, by extension, whether the stock market goes into another tailspin. Unemployment remains stubbornly high, real estate values may be falling again after a short-lived, very tentative recovery, and consumers, whose spending accounts for the lion’s share of economic growth, are saving more as they begin to repay a mountain of debt. Additional government stimulus might help create jobs and spur spending, but most politicians, stung by the popular backlash against bank bailouts and the 2009 stimulus bill, seem much more focused on reducing the federal budget deficit. If tax increases and cutbacks in government spending result, strong economic growth may be almost impossible.

Perhaps the most likely scenario for the near future is that the economy and stock markets will muddle along, neither moving into full-fledged recovery mode nor collapsing again. And even amid the uncertainty, all of the time-tested reasons for owning equities still make sense. Corporate earnings have posted a brisk recovery during the past few quarters, and there’s a likelihood that the best companies will gain value over the long haul—just as they’ve always done. And putting too much faith—and money—into bonds or cash carries its own risks. Though bonds have done extraordinarily well the past few years, there’s now talk of a bond “bubble,” with an increasing possibility of sharp declines when the economy eventually picks up steam. Just as diversified portfolios fared better than those concentrated in stocks during the market crash in late 2008 and early 2009, having a substantial portion of your holdings in stocks now will help when bond returns inevitably retreat toward their historical averages.

Yet there’s a difference between knowing you should own stocks and feeling comfortable doing it, and unless you have several decades to go until you’ll need to tap your investments, just sitting tight and waiting out stocks’ rough patches isn’t necessarily the best strategy. So the real question may not be whether to hold equities but rather which ones to hold, how much of your portfolio to allocate to stocks, and how to minimize the damage if another bear market takes hold.
Even if tax rates on dividends rise, large companies with long records of maintaining or increasing payouts to shareholders—even during the stress test of the economic crisis—could continue to outperform many of their competitors. Meanwhile, economic growth in developing countries seems likely to keep outpacing the expansion in the United States and the rest of the developed world, though the volatility of investments in emerging markets may put off many risk-averse investors.

If you have questions about the economic and market outlooks—and about what defensive measures you could take to insulate your investments from ongoing turbulence—please call to set up an appointment.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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