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97

To Sum Up

We have seen that stocks are a far better investment than most other financial altematives, particularly T-bills and bonds and other debt instmments you might own. The postwar period has entirely changed the investment environment. Retums on stocks adjusted for inflation or for inflation and taxes are higher relative to bonds and T-bills than at any time in the past.

Clearly, the conventional wisdom that fixed-income investments are safe is unsound. If you are saving to buy a house or a car or have another use for funds within a few years, then T-bills, money market funds, or short-term bonds are certainly reasonable. In a short period stocks are simply too unpredictable to depend on. However, once you push the window beyond four or five years, you should keep the large proportion of your assets in stocks or another investment, such as real estate, where there is a long-term record of outperforming both inflation and taxes. Be careful though. Real estate and other investments require a much higher level of expertise than do stocks. If you do not have it, Id suggest you stay with the excellent record of blue-chip equities.

Not only do stocks sharply outperform bonds and T-bills over time, they also have remarkable recuperative power from major disasters, whether from a market crash or from economic disintegration.

The lesson then is to buy blue-chip stocks with funds you can salt away for some time. Forget bonds and T-bills as investments over the long term. No, this advice is not the conventional wisdom of the day. It certainly wasnt the wisdom of some of the seers of value investing of markets past. Graham and Dodd with "their margin of safety" come to mind in particular. But we must remember that they were writing in a period of litde inflation, and in the early thirties, deflation. Astute observers that they were, Im convinced they would have been among the first to understand the new realities of todays investment world and would offer similar advice.

I am sure youll hear that this approach is "too aggressive," but inflation is the reality of our times. It is a reality that is difficult for many to perceive, because it goes against the advice of generations of intelligent

decades) I would be considered imprudent and irresponsible. I would have violated the basic tenet of conventional modem investing, Iceeping a significant portion of the funds in "safe investments," namely bonds, T-bills or their equivalents. And if the maricet dropped sharply, I might be successfully sued, even if I made the case presented in this chapter.



and conservative investment advisors and fiduciaries as to what was prudent.

Indeed, it goes against the principle we were taught fi-om child-hood-that the safest way to save was putting our money in the bank.

Contrarian strategies fit in well with this new advice. As we saw, we can get a higher-than-market retum by using any of the four primary methods that I discussed, low P/Es, low price-to-cash flow, low price-to-book value, or buying the lowest-priced stocks in an industry. Contrarian strategies work best over time, which ties in well with the plans of a long-term investor. Such strategies should be able to enhance inflation-adjusted retums by 1% to 2% annually over a period of years.

Next lets look at how risk affects your portfolio. Does the current universally employed risk measure-short term volatility-capture the inflationary aspects of a postwar economy? As the following chapter will show, we can develop more practical ways of identifying risk, and thus be able to protect ourselves from the major investment risks of our times-which will soon mean a brand new century.



What Is Risk?

all the evils the investor must face, the devil of risk is perhaps the most treacherous. At this point its time to step back and ask a basic question: are the risk measures you use effective? Or could they actually impede good investment decisions?

We saw in the last chapter how a new form of risk sprang full bom at the investor after the Second World War: the risk of loss of purchasing power though inflation and taxes. This risk is far more severe than financial risk, because it is universal. Its effects continuously erode the value of fixed-income securities, whether gilt-edged Treasury-bills and govemment bonds, or high-yielding junk bonds.

Cutting through the myths to a realistic assessment of the actual risks you face today will lead to dramatically different conclusions about the kinds and amounts of investments you should own.

It Seemed So Simple

What then is risk? To the academics who built the efficient market hypothesis (EMH) and modem portfolio theory (MPT) the answer is obvious. Risk is an A-B-C commodity. According to this theory, investors are risk-averse: they are willing to take more risk for higher payoffs and will accept lower retums if they take less risk. A simple but elegant theory.

How does one measure risk? That too is simple. As we saw in chapter 3, it was defined by Markowitz, $ , et al., as volatility: the greater the volatility of a stock or portfolio, whether measured by standard deviation or beta, the greater the risk. A mutual fund of common



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