Courage overrated in current stock market

Now that the stock market has reached all-time highs, you may be thinking yourself a coward for being reluctant to invest now.

But as a great man — OK, the Wizard of Oz — once said, you may be a victim of disorganized thinking. You are under the unfortunate impression that just because you run away, you have no courage. You’re confusing courage with wisdom.

Cowardice can be a good thing, especially when the stock market is at record levels. If you’re really worried, you might consider the Cowardly Portfolio, first introduced here more than a decade ago. But it’s time to make a few changes to the Cowardly Portfolio. It’s OK. You’ll be fine.

The Cowardly Portfolio simply introduces the notion that investing in stocks is not an all-or-nothing proposition. In its original formulation, it consisted of 50 percent in conservative stock funds, 30 percent intermediateterm government bonds, and 20 percent in money-market funds. You won’t get rich, because widely diversified people don’t get rich, or at least rich quickly.

You will be somewhat shielded from short-term stock market fluctuations, however. When the Cowardly Portfolio made its last appearance, in September 2011, the portfolio had gained 41 percent over 10 years, vs. 31 percent for the Standard & Poor’s 500-stock index. The period included at least part of the 2000-2002 bear market, and all of the 2007-2009 bear.

The past 10 years, the Cowardly Portfolio is up 71 percent, vs. 116 percent for the S&P 500 with reinvested dividends. The10-year record for both has improved because the tech wreck is now off the books. The S&P 500 is beating the Cowardly Portfolio because it always will in a bull market.

The Cowardly Portfolio has worked well because bonds tend to rise in value when stocks fall, and cash acts as a cushion to both. But as we look around today’s landscape, we see that the 10year Treasury note yields about 2.73 percent.

William Bernstein, market adviser, neurologist and author of “Deep Risk,” suggests buying bonds at these levels could be an even bigger problem than buying stocks, at least over the long term. That’s because interest rates tend to rise and fall in long cycles, and when interest rates rise, bond prices fall. “From 1941 to 1981, the total return from U.S. and U.K. bonds was —70 percent,” Bernstein says. “Stocks have never done that badly.”

Analysts use a term called duration to measure the effects of interest-rate risk. A bond fund with duration of 10 years will fall 10 percent in value if interest rates rise 1 percent, and vice versa. The 10-year T-note has averaged a 6.6 percent yield since 1962. Clearly, there’s interest-rate risk in a 10-year T-note, especially if rates pop up beyond the long-term average.

Your best bet: “Hold your nose and go short,” Bernstein says. “If I buy a bank CD with a1 percent, 2-year yield, I’ll come out almost flat against inflation, and not be that badly hurt.” But buy a bond fund with a 10-year duration, and you’ll get your head handed to you when interest rates rise.

If you’re a true coward, then, you might consider eliminating your 30 percent bond position for a series of staggered bank CDs. You won’t earn much now, but as interest rates begin to rise in 2014 and 2015, you’ll get higher yields and dodge the losses you’ll take from a bond fund.

Changing from 20 percent cash and 30 percent bonds to 50 percent cash is so cowardly, it borders on the craven. You could probably bump up your stock holdings to 60 percent and reduce cash to 40 percent without too much damage. Were stocks to fall 50 percent, your portfolio would fall 30 percent, which is survivable, and you’d have plenty of buying power if stocks became incredibly cheap.

The older you get, the more you should worry about short-term risks, and the more a cowardly portfolio makes sense. If you’re 70 and have no further source of income, market risk from stocks can be “Three-Mile-Island toxic,” Bernstein says.

But for young investors, particularly for those investing at regular intervals, worrying about short-term market risks is foolish. “Young people should embrace shallow risks,” Bernstein says. If the market falls 50 percent and you’re investing regularly through a 401(k), you’ll get the chance to invest at bargain prices.

Worry about other things, like winged monkeys.