Take long-term view with mutual funds


January 03, 1993|By WERNER RENBERG

With the Dow Jones industrial average at 2,930 on Dec. 3, 1991 -- 17 days before a Federal Reserve interest rate cut that triggered a 9 percent year-end surge in stocks -- Oppenheimer Management Chairman Jon S. Fossel predicted the Dow would reach 3,600 by the end of 1992.

A month ago, as it appeared that the average would not top June's high of 3,413 in the absence of another strong year-end rally, Fossell gave his 1992 call a C+ grade --even though broader market averages were at record levels -- and bravely issued a 1993 forecast. Finding "a new sense of confidence" in the country, he predicted the Dow would rise to 3,700 this year and to 4,800 by the end of 1995.

Other experts also have made their 1993 predictions for stocks as well as for interest rates, inflation, and so on.

They can't all be right. So, how do you decide whose short-term market outlook to follow as you consider whether to revise your strategy for your mutual fund portfolio in 1993? You don't.

Mutual fund investing is -- or should be -- a long-term proposition. Planning how to divide your money among money market, bond, and equity funds, therefore, calls for taking a long-term view.

Among other things, this means incorporating into your strategy some assumptions about expected rates of return over the years that you plan to be invested, as well as the risks of interim losses.

To make such assumptions, you'll want to reflect historic long-term returns for the major classes of securities in which your funds invest. And you'll need to consider market prospects, taking into account how major factors may differ in the years to come.

Still, you face a fundamental question: Which period's investment results are more likely to be repeated in the future? The last 10 years? 15 years? A longer span?

It's not a trivial question, because portfolio returns have varied over time. For the last 5, 10, and 15 years, for example, average annual returns on common stocks have been around 15 percent. Over the last 65 years, they have averaged around 10 percent.

Many students of markets feel that the extraordinary returns on securities in recent years -- such as those shown in the table -- can't be sustained. They believe that returns on stocks might drop to about 10 percent for this decade. Treasury bill rates have already plunged, thanks to lower inflation.

How one can come up with the lower rate for stocks is illustrated in an analysis by Chairman John C. Bogle of the Vanguard Group. He broke total return on the Standard & Poor's 500 Index into three components: an initial yield, earnings growth, and the impact of a change in the index's average price-earnings (P/E) ratio.

Applying this technique, Bogle projected an average return of 8.6 percent for stocks in the 1990s. He started with the entry yield of 3.1 percent. For earnings growth, he used 7.2 percent, the average of the last 25 years. And he figured that a drop in the P/E ratio from 15.5 at the start of the 1990s to a 25-year average of 13.1 would reduce annual total return by 1.7 percent.

"It need not be so," he said, "but to expect higher returns is to expect higher-than-normal earnings growth [it could easily happen], accompanied by much higher than normal price-earnings ratios."

To estimate returns for long-term U.S. Treasury bonds, which have averaged 4 percent for 65 years, Bogle also looked at three elements: initial and end-of-the-period yields and interest reinvestment rate.

He developed two scenarios, in both of which he anticipated no impact from the reinvestment rate. In one, assuming no change from the initial yield of 8.2 percent, he projected an average return of 8.2 percent for the decade. In the other, he projected a small drop in rates, raising total return to 9 percent.

If you have assumed higher interest returns but now suppose Bogle could be right -- that stocks and bonds will have similar average rates of total return in this decade, as they did, ironically, in 1992, and that rates will be about 9 percent -- how could you change your strategy?

By reducing your expectation of the amount of capital you may accumulate over your planned investment period, remaining invested longer than you had planned, and/or investing more money.

You also might consider investing more in bond funds, partly to reduce the volatility of a growth-oriented portfolio.

Whether you reinvest or take your dividends, pay attention to how funds' total returns are divided between income and capital returns. Because income returns tend to be more stable, funds that rely more heavily on dividends or interest tend to be more stable, too.

As the table indicates, funds concentrated in value stocks generate more income -- taxable unless you're in tax-deferred retirement accounts -- than those committed to growth stocks.



Average annual rates

For 15 years ended Oct. 31, 1992

.. .. .. .. .. .. ..Capital.. .. .. ..Income.. .. ...Total

.. .. .. .. .. . ...Return.. .. .. ...Return.. .. ..Return

Standard & Poor's

500 Stock Index.. .. 10.6%.. .. .. .. .4.8%.. .. .. .15.4%

Standard & Poor's

Value Stock Index.. ..9.7%.. .. .. .. .5.8%.. .. .. .15.5%

Standard & Poor's

Growth Stock Index.. 11.6%.. .. .. .. .3.3%.. .. .. .14.9%

Salomon Bros.

High-Grade Bond Index 4.3%.. .. .. .. .6.1%.. .. .. .10.4%

U.S. Treasury Bills.. .._.. .. .. .. ..8.3%.. .. ... .8.3%

Consumer Price Index.. ._.. .. .. .. .. ._ .. .. .. ..5.7%

Sources: Returns, Vanguard Group; CPI, Bureau of Labor Statistics.

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