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Dennis Smith

I have just returned from a five-alarm fire in an art school I helped to create some years ago. While there, I spent time with the FDNY fire marshals who explained to me how this very damaging fire occurred. The blaze started in the flooring just below the kiln in the sculpture department, and since I am the only firefighter on the board of trustees of this school it is my responsibility to explain the cause and origin of the fire to those who are responsible for the school’s finances. The flooring below the kiln had begun a carbonization process over the 120 years since the building was built, reducing by small degrees its ignition point, and so the kiln operated safely for more than five years until suddenly it ignited the flooring. The fire had evidently burned unnoticed for a few hours, out of sight in the back of the building. The firefighters responded and did a superlative job in saving our art and our library. Of course, if the fire had been noticed earlier, we would have saved much more of the school’s property. It was the unseen that caused us the greatest harm.

I am thinking about this now in relation to my First Responder Finance column. I want to illustrate the different considerations in investing in stocks, bonds and cash equivalents, and because of this fire I began to think about what are the unseen elements that can determined the success or the failure of our investments.

Let’s look at stocks, which are certificates of ownership in public companies, and how a stock is valued. There is no easy answer to determine why a stock is selling at, say, $30 a share rather than at $20, but one prominent financial researcher, John Moffatt, says three factors go into pricing a stock: 25% is determined by the current economy; 25% is determined by the performance and management of the company itself; and, get this, 50% is determined by market influences. Ask any stockbroker what are the market influences going into the price of any particular stock and he or she will give you just part of an answer. The remaining part will go unnoticed and unseen like the fire below the kiln in my school.

For instance, analysts in many companies can make or break a stock by upgrading it or downgrading it – that is what we call a market influence. But, what do we know about those analysts? Do those analysts own the stock they are touting, or more importantly will they sell the stock immediately before downgrading it or just after touting it? Is the brokerage firm for whom the analyst works doing business with the company whose stock is being touted? These are the unseen influences in the price of a stock, and I think these analysts have a serious conflict of interest unless all these questions are answered about every stock they analyze.

Indeed, I don’t think analysts should work for brokerage firms at all. Instead, we should have independent financial analysts firms, financial think tanks, that brokerage firms can subscribe to for financial analysis. In the same way Consumer Reports magazine is distanced from manufacturers, I am saying that brokerage firms can be safely disconnected from the conflict of positively analyzing the stock of a company with whom it may be doing merger advisement and other business, and severed from the private investment accounts of the brokerage house analysts that now exist.

Also, independent analyst firms will not be prone to market frenzy. Did you know that in March 2000, when tech stocks and the bull market were at peak levels, fewer than 1% of all listed stocks were given the SELL rating by the analysts of the Wall Street firms each of us depends on for financial leadership? And, so, 99% of all listed stocks had a BUY, or HOLD, rating when the market collapsed. This is another reason brokerage firms should not have analysts working for them.

Still, for all of this, owning stocks remains one of the most profitable investments you can make, but you must determine if it’s better to own mutual funds or your own shares. And then you should determine what bonds you should own, and what cash equivalents.

Firefighters often ask questions in the firehouse kitchen that everyone has an answer for, and that’s why hanging around the firehouse is mostly a positive and sometimes hilarious experience. There is always something to learn when we are among firefighters, and there is usually something to make us laugh. And so the question I want to pose is one that most will have an answer for: What is the difference between stocks and bonds and cash equivalents? They are all good, one answer might be, if you buy low and sell high.

I am always advising that your ownership should be balanced between these three kinds of investments, and now I will tell you why I think this. Let’s also take a look at how you would have succeeded, if, in the past 30 years, you had been invested in these different financial choices.

According to a recent study by Barclays Capital, you would have gained just a 1.4% return on your money in the 1970s if you invested only in equities (an equity is a share, or stock, in a public company), and in the 1980s you happily would have enjoyed a 7.9% return. But, look at the 1990s, when we had a whopping 14.1% return on the same type of investment.

If your investment in the 1970s was in bonds – which essentially are time-determined loans you are making to governments or corporations – you would have lost 3.6%. In the 1980s, though, you would have made 8.8%, which was a higher return than you would have made in equities. And then, in the 1990s, you would have made 7.1%, which is just about half of what you would have made in equities.

These averages are impressive, but they don’t tell the full story of the risks involved in owning stocks and bonds. I know one hard-working professional (we’ll call him Bill) who carefully stashed money into a retirement plan throughout his career. He wisely invested in a balanced portfolio of stock and bond mutual funds, and planned to retire at the end of this year. In 1999, Bill gleefully watched his portfolio skyrocket from $350,000 to over $530,000 – a 52% increase that was not unusual for the period. Bill saw that he could have made even more money if his portfolio was 100% in stocks, and so he ignored the unseen risk, traded the bond portion for stocks in hopes of even greater returns and made plans for leaving his job. It isn’t hard to guess what happened next. His portfolio value declined by 56% over the next year, leaving him with just over $230,000. His retirement plans have been put on hold.

Many would-be retirees have suffered similar setbacks because they didn’t realize that stock ownership is advisable only for long-term investments that have time to recover from market setbacks. Bonds pay lower returns than stocks over the long term because they are safer; they don’t plummet or skyrocket the way stocks do and that makes them better investments for those who plan on using their savings within the next few years.

In Bill’s case, a sound strategy would have been to gradually move more and more of his savings from stocks to bonds as his retirement date approached. This would have required discipline in a time when stocks were soaring and it seemed that everyone in the country was getting rich. But it would have been wise. Bottom line: stocks are better for long-term investments, bonds are better for shorter terms or for those who just can’t stomach wild swings in their portfolios.

Cash equivalents, on the other hand, traditionally do not pay very much. These are very safe, very liquid investments, such as money market accounts and bank certificates. They do pay interest: (3%, 4%, even 5% or more, although the return is going down due to the Fed’s rate cuts) because cash equivalents essentially are ultra-short-term, low-risk bonds. In the 1970s you would have lost 1.1% in cash equivalents, in the 1980s you would have made 3.9%, and in the 1990s you would have made 1.9%. These may not be very impressive returns, but to have a small part of your portfolio in cash equivalents is important for several reasons.

First, cash equivalents are a perfect place to stash an emergency reserve. Firefighters know better than anyone the importance of being prepared for an emergency and financial emergencies are something that any of us could experience. Most financial planners advise that you keep from three to six months’ salary saved to weather unforseen events such as job loss, accident or illness. Cash equivalents are an excellent place to save your emergency fund because they pay interest and will be available at a moment’s notice. Some cash equivalents, such as interest-paying checking accounts, are insured by the federal government.

And, so, with a balanced investment portfolio, and a good sense of what are the seen and unseen factors determining the price of your holdings, you should feel comfortable that your future is prudently protected. I think the future continues to be rocky, at least through the traditionally slow summer months, but our economy has seemed to weather a recession. Things will begin to get better in October, and until then there will be some low-priced good values in the stock and mutual fund markets.

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