Lummer's Logic

The Empires Strike Back

By Scott Lummer
401k Forum Chief Investment Officer

Do you suggest a heavier contribution to the S&P 500 over the next 9 months, or to the Russell 2000?

The quick answer to your question is the S&P 500. But that will always be my answer.

First of all, let's cover the basics

You shouldn't put all of your domestic equity in either large-capitalization stocks (the S&P 500) or small-capitalization stocks (the Russell 2000). Though it is common for large and small company stocks to move in tandem, there are times when they diverge. When they diverge you don't want all of your money solely in large company or small company stocks, because your timing may be off ý you may have chosen the wrong one.

For example, in "How Now Down Dow," Click Here. I advised that investors should never put all their money into large company stocks. Three weeks ago the Dow had fallen by 14% for the year and small-capitalization stocks were up by 10%. Many of you wrote in that you fully agreed with my advice, and had none of your investments in large-company equities. But I also pointed out in that column that investors should "not completely eschew investing in larger companies."

The "new paradigm" theory

It was my advice to recommend allocating some investment to larger companies. However, many pundits are talking about a "new paradigm" (which is fancy talk for saying they have a new system that can beat the market). The theory's latest incarnation supposes that the Dow, and most of the S&P 500, represent decaying "old" economy stocks, whereas the real excitement is in the smaller company, high-tech "new" economy stocks. In this view, the old economy stocks are representative of a dying empire -- with products and services not entirely conducive to a web environment. These companies are "soooooooo 20th Century."

Here's a good rule of thumb. When you read an economic analysis telling you that a type of investment that has been popular is dead, consider which has existed longer: the author or the investment that he or she is writing about. If the investment has outlived the author by, oh, say, 100 years, don't make plans to attend the investment's funeral just yet. Large-capitalization stocks -- the empires -- have been the backbone of our economy since the industrial revolution of the mid-1800s. It's a bit too soon to write them off because of two months of weak performance.

Look, I like the Internet as much as the next analyst. You're not reading this column on a stone tablet, are you? But it is naýve to think that only small, "dot-com" companies are going to participate in the next wave of economic growth. Many of those larger firms have extensive e-businesses themselves -- as well as a significant amount of off-line revenue. Even after every family is wired, they will still get dressed to go out and buy gasoline to put in their cars, or go to the grocery store to buy detergent. So don't completely ignore the textile, energy, automotive, retail, and product companies.

Since I wrote "How Now Down Dow" the Dow has risen 13%, almost returning to its record high level. Meanwhile, the Russell 2000 has only gained 3%. Those of you who bought completely into the new economy story are about 10% behind those of us who kept some money in the old economy. Will that happen every month? Of course not. Sometimes the smaller company stocks will perform better. But this fluctuation proves that it was certainly too early to sound the death knell for the Dow.

Rejecting the old empires is risky

Moreover, one has to consider the risk. Having no large-capitalization stocks in your portfolio is more dangerous than having all large-capitalization stocks. The reason? Small companies are riskier and more volatile than are larger, established firms. There is a much greater potential of a disastrous loss with a portfolio comprised of only small-cap stocks than with one comprised of only large-cap stocks.

So what strategy should you use? Long-time readers of this column (yeah, both of you) know what's coming. The D-word.

Diversify!

Put some of your money in both large- and small-company stocks. As a rule of thumb, I would put about 3/4 of domestic equity in large stocks and 1/4 in small stocks -- due to the additional risk of the small-capitalization sector.

Oh, there is one group of investments you can ignore. Don't buy any stocks of publishing companies whose writers tell you to avoid all old economy businesses. Those publishing stocks are representative of the old, old economy -- the group of pundits who feel you can get rich quick by using simplistic investment rules. Those stocks died out in the 1920s.

I get a lot of "get-rich-quick" ideas e-mailed to me ...

… but I have a special request. What I would like is to hear from a few of you who have gotten rich slow. Specifically, please e-mail me if you satisfy the following criteria:

1. I have been investing in a 401(k) plan or other deferred retirement plan, like a 403(b) for at least 10 years -- sorry, no newbies.

2. I believe I have been a successful investor.

3. I am willing to share specifics (funds I've used, dollar amounts invested, current plan balance).

What I'd like to do is share with our readers some successful investor stories. I won't use names unless you approve, and I will show you the reference first.

And if you do choose to respond, what's in it for you? The person with the best story gets a Ricky Martin CD in almost mint condition. It will be sent to you as soon as I can sneak it out of my daughter's room.

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Scott L. Lummer, Ph.D., CFA, 401k Forum's Chief Investment Officer, is a recognized expert in the investment field. He has conducted extensive research on asset allocation, international investing, risk management, mutual fund analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook.