(The author is a Reuters columnist and the opinions expressed are his own.)
CHICAGO (Reuters) - Market volatility has terrified investors to such an extent that they are avoiding stocks like the bubonic plague. But as cash becomes king, it bears a leaden crown.
There's significant evidence to show that there are better places to grow diversified portfolios. However, instead of focusing on overall portfolio performance based on risk-adjusted returns, most people think monolithically. Should I be in or out of the stock market? Should I be completely out of big stocks and into bonds and cash? This risk on/risk off approach is not only disconcerting, it leaves you open to bad market-timing decisions.
Fear is currently ruling mass investor behavior. Cash inflows into checking and savings accounts - which are posting negative returns after inflation and taxes - outpaced all other investments in the first half of the year, according to TrimTabs Investment Research. More than one-third of a trillion dollars went into these safe-but-sorry vehicles, compared to a $26 billion exodus from U.S. stock exchange-traded funds.
Mega-manager Bill Gross, co-founder of PIMCO, has declared "the cult of equity is dying," and the 6.6-percent return of stocks over the last 100 years is "a historical freak, a mutation likely never to be seen again." Millions have already taken that to heart, beating a steady retreat from stocks since 2008.
While Gross is probably right that stock returns will be less than half of the historical performance, there's little reason to abandon stocks completely for cash or bonds. It seems reasonable that a new average performance for U.S. stocks will be around 4 percent. That's a 2 percent for dividends and 2 percent for capital gains, according to Peng Chen, who wrote a paper on expected returns earlier this year for Ibbotson Associates.
Chen may be on the low side if robust growth returns to the U.S. and abroad. Adds Seth Masters, chief investment officer for Bernstein Global Wealth Management, "with reasonable assumptions, we can get returns in the 6 percent to 7 percent range."
Part of the "stocks are not quite dead yet" argument rests on looking at smaller stock sectors and not just the largest, most popular U.S. stocks. In a paper to be published in the Journal of Indexes, Craig Israelsen, who teaches finance at the University of Utah, found higher historical returns when examining indexes of non-blue chips.
True, the much-followed S&P 500 stock index, he found, returned a lackluster 2.92 percent from 2002-2011 and lost 0.25 percent in the last three years. Projecting those returns forward, which is always dangerous, gets you into Gross's "dying equity" zone.
Yet when you look at other sectors, the picture brightens considerably. The MSCI U.S. Mid-Cap Value Index returned almost 8 percent in the near decade. The Dow Jones US Small Cap Value Index was up 7.7 percent. The S&P SmallCap 600 Index rose 7.5 percent.
The monolithic view dominated by only looking at brand-name U.S. stocks suffers in a finer analysis. You need to consider a well-rounded portfolio of all sizes of growth and bargain-priced value stocks - and more. Nothing is guaranteed going forward, of course. The point is to take a more global view of different asset classes.
"What is important is how the overall portfolio performs," Israelsen notes, "rather than over-focusing on how an individual `single-asset-class' behaves…the sum is more important than the parts."
By covering all sizes and styles of U.S. stocks; non-U.S. developed and emerging stocks; real estate investment trusts (REITs); natural resources/commodities; U.S. and international bonds; inflation-protected bonds and cash, Israelsen figures you could have achieved a 7.73-percent return over the past 14 years (through 2011), compared to 3.55 percent for an all-U.S. stock mix or 5.12 percent for a 60-percent stocks/40-percent bonds portfolio. What about 100-percent cash? A sure loser at 2.9 percent. That's before you subtract inflation. This "7-12" strategy places 8.33 percent in each of 12 asset classes.
Instead of beating a hasty retreat to cash every time a sour headline emerges on the U.S., European or Chinese economy, if you're a long-term investor focused on inflation-beating growth, you could avoid the opportunity risk trap. Then you wouldn't have to worry whether the current rally or sell-off will last or how to best time your move. You'd be strategically situated to capture some growth and income throughout the world no matter how much stocks were gyrating.
Follow us @ReutersMoney or here. Editing by Beth Pinsker Gladstone and Alden Bentley