Guest Author - Guido Deboeck

Remember the Limbo dance? Quite popular in the 60’s, sometimes still performed at weddings, was a unique dance originally performed in Trinidad. Today limbo refers to a dance whereby a dancer moves on rhythmic music and dances under a stick, held up by a person on each end (or a stand), without knocking or touching the stick. If the dancer is successful she or he must repeat this again and again with the bar being lowered another "notch" each time.

Lots of people who invest in the financial markets dance the limbo: they acclaim success by lowering the bar. If today you can get an annual rate of 4.5% on 30 to 90 day deposits, or 4.9% on six months CD, or 5.20% on US Treasury Notes up to 10 years, why bother learning more about investments? (Actual rates can be found in the related links.)

A young Vietnamese lady who approached me recently for advice on investing her pension money, felt like that. She was offered the choice between investing in the S&P 500 index, the Lehman Brothers Government/Credit Index, the Morgan Stanley Capital International EAFE Index, or a money market fund that produced a real rate of return of 3%. She felt quite comfortable with the latter and put all of her money into it, although she is just a notch over 30… Fortunately, she recognized she didn’t know too much about all this and left the door open for better alternatives.

Remember just the following three points, I wrote her:

1/ money market investments do NOT keep track with inflation over long periods of time based on evidence of the last 60+ years.

2/ fixed income investments, Treasury notes or bond investments, show over long periods of time to just barely keep track of inflation. For example, the last ten years the total bond index shows that bond investments produced merely 6% per year. Hence when inflation averages 3%-4% over time (because inflation is not always as low as it is today) real return on these investments is very marginal.

3/ the only way to protect against inflation AND achieve a reasonable return is to be fully invested in equities. For example, in the past ten years a total stock market index for the US shows a return of 9.1%; a comparable index for equities around the world shows a return of 10-11.8%. Even if inflation averages 3-4%, these returns from investments in equity produce a real return of 5% or more. See the related links for two articles (Putting all your egges in on basket, and The 100% equity allocation) for more on this.

“Consider the implications”, I wrote her: “if you invest $10,000 today at 4.5% per year (which corresponds to the 3% real rate of return that she had chosen) for the next 30 years (without further additions.), you will get $37,453 when you retire; if you invest 10,000 today without further additions at 9.1% for 30 years, you will get $136,377, three and a half times as much.

A lot of advice you can get for free goes against this and will always talk about the risks of investing in equities, but even if you were to invest all your capital just before a major market crash (like in 2000-2002), you would still come out better over the long term with stocks than with bonds or money market funds.

My bottom line suggestion to her was: “take all of your pension money out of money market and put 2/3's in the Morgan Stanley Capital International EAFE Index and 1/3 in S&P500. Alternatively, if you do not like to be invested in the US market (because she is Vietnamese...) put 100% in MSCI EAFE and leave instructions that future deductions from your salary should follow the same allocation.” As an example I told her about a 401K plan that I am monitoring which is invested 48% in international growth (VWIGX), 29% in domestic value stocks (VWNFX) and 23% in US small cap stocks (FLPSX). It is up year-to-date by 11.2%.

Next segment, we’ll talk more about the inverse of limbo dancing, namely how to raise the bar to achieve better investment results.