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In reflecting on '04, avoid 'rear mirror' investing

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By Ernie Ankrim

January 10, 2005 6:01 am ET

Investors spent much of 2004 on the sidelines of the stock market, playing a waiting game and investing in bonds and real estate - areas of the market that they thought would deliver a high yield with a lower risk than stocks.

In the past couple of months, however, with the easing of the tensions that caused them to wait, some have moved back into growth stocks.

The question for 2005 is, will this move prove to be the start of a trend that will continue during this year or will it turn out to have been a temporary phenomenon?

Part of the answer might lie in what prompted investors to seek relatively-high-yield-bearing investments in the first place.

Awaiting a clearer picture

During the first 10 months of 2004, investors - troubled by rising oil prices, the uncertain outcome of a closely fought presidential election, fears of terrorism and inflation - pulled back from stocks. They preferred to wait for a clearer picture of world events, afraid that a sudden geopolitical event could send stocks tumbling.

At the same time, they sought out investments that would provide them with a relatively high yield, settling in particular on real estate investment trusts and lower-credit-rated bonds.

The result was that bonds grew from Jan. 1 to Dec. 20 by 4.8%, as measured by the Lehman Brothers Universal Index. What surprised analysts most, however, was the continued strong performance of real estate securities, which resumed their strong upward climb after a sharp but short dip earlier in the year - so much so that over the four years through Nov. 30, the Bloomberg REIT Index returned an astounding 20% on an annualized basis. Over the same time, the Russell 1000 Index, which tracks large-company growth stocks, was virtually flat, losing an average 0.72% a year.

The good news was that if you had a well-diversified portfolio divided among stocks, bonds, real estate and international stocks, you stood a good chance of enjoying returns that were in line with historical patterns of about 10% a year, or even higher.

If you bet the farm on the wrong sector of the market, however, your portfolio may have looked a lot less impressive, and of course, if you bet the farm on the right sectors of the market, you would have done really well.

But be warned: It doesn't necessarily follow that yield-bearing investments will do well again in 2005. Just as some were surprised during 2004 with how well bonds and real estate investments performed, so others might be surprised during 2005 at how badly they may perform.

As we move into a new year, we note that some of the concerns that drove investors to yield-bearing assets have lessened or gone away. The presidential election is over, the price of oil has fallen from its record highs, and fears of another terrorist attack on U.S. soil are easing.

As a result, investors are paying increasing attention to corporate earnings and interest rates - indicators that they had almost glossed over during the waiting period.

Such attention may lead them in 2005 to growth stocks, which have been neglected for so long that their prices look attractive, and they have room to grow.

Of course, anything could happen. Few analysts accurately predicted the events of 2004 and in particular the strong performance by real estate securities and high-yield bonds; most underestimated the length of the period investors were prepared to wait.

Nothing is static

What we do know, however, is that if historical precedents hold, investors are likely once again to be best served if they diversify their investments among large-cap as well as small-cap stocks, bonds, real estate and international equities. To be truly diversified, they shouldn't reduce their investments in stocks below an acceptable level for their risk tolerance.

Nor should they boost their allocations to bonds or real estate securities beyond those levels just because those assets did well in 2004.

Doing so would be akin to "rear mirror" investing, in which investors base their allocations on recent events instead of realizing that nothing in the markets is static and that historically few years have followed exactly the same pattern as those preceding them.

By being effectively diversified, they won't score huge gains if one or two sectors take off, but they are unlikely to suffer large losses if one or two sectors collapse.

Ernie Ankrim is chief investment strategist at Russell Investment Group in Tacoma, Wash., which has $120 billion in assets under management.

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