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Summer 2002


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Taking Stock

 


Taking Stock
UMaine financial analyst Bob Strong says there may be a ‘whole different way of thinking' about investments in the post-Enron era

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Everyone wanted to talk to Bob Strong in the days following the Enron implosion last winter. Financial reporters and others sought his perspective on the scandal and the effects it might have on investor confidence.

Strong is University Foundation Professor of Investment Education and professor of finance at The University of Maine, and his stock market insights are widely respected.

Some of the questions people were asking immediately after the Enron scandal broke have been answered. (No, investors didn't flee the stock market in droves. Yes, some accounting reforms are needed.) But anxieties remain, and people still have questions, such as: Should investors be worried that other big companies — perhaps some in their own portfolios — are heading for an Enron-like collapse?

While there are no guarantees that it won't happen again, Strong says it is less likely that companies will be engaging in the sorts of questionable deal-making and hocus-pocus accounting practices that turned Enron into a house of cards.

"I think firms will be much less willing to push the envelope and do things in unusual ways," he says. "Accounting rules have always provided management with a certain amount of flexibility as to how they handle a particular transaction, but people are very sensitive to what happened in the Enron case."

Bob Strong
Bob Strong is University Foundation Professor of Investment Education and professor of finance at The University of Maine. He has been a visiting professor of finance at Maine Maritime Academy and Harvard University. A chartered financial analyst, Strong's consulting focuses on risk management and asset valuation. His current research interests center on investor asset allocation. His fourth book, Derivatives: An Introduction, was published last year.
 

In addition to new regulatory guidelines, he says, "I think we will see voluntary actions on the part of firms to make sure they avoid accounting scandals. From the investors' perspective, that is something positive that comes out of the Enron situation."

Another positive effect may be renewed respect for the traditional principles of investing, which Strong says were often ignored during the dot-com mania of the late 1990s. In those days, investors sometimes paid more attention to the flash and dazzle of new Internet-related companies than to what the companies were actually delivering, sending stock prices soaring. Even before Enron became front-page news, many of the dot-com darlings had failed.

"People were willing to pay huge sums on the basis of good ideas that they hoped would work," Strong says. "Valuations got very high, but a lot of these firms weren't making any money.

"Enron has reinforced the fact that you can't spend sales; you can only spend earnings. So, I think there is going to be a return to the notion of looking at the extent to which a company is realistically selling its products for more than it costs to make them."

Daily fluctuations in the price of a stock often are caused by psychological factors that have little or no direct bearing on the company or its industry. Alan Greenspan sneezes or a civil war heats up on the other side of the world, and stocks chase each other up or down.

"But in the long run, it's earnings that overwhelmingly contribute to shareholder value," Strong says. "If a company isn't making money, then where is the value going to come from?"

The stock market isn't the only place where people can invest their money, of course. There are corporate bonds, government bonds, real estate and savings plans of various kinds.

"How you distribute your money has always been the single most important decision an investor makes," says Strong, whose primary research interest currently is asset allocation.

Historically, stocks have earned a higher rate of return than other, less risky types of investments. However, Strong says it appears that the size of the difference between the returns of common stocks and government bonds, for example, is shrinking.

"There is increasing evidence that the historical size of the difference is not going to be sustainable in the future," he says. "It is not clear where money is going to come from to support the level of return in the stock market that we have had in the past."

Does that mean people should take their money out of stocks? Not necessarily. Stocks in general still outperform bonds and, according to most experts, will continue to do so. But they are not likely to outperform bonds and other investments to the same extent that people have come to expect.

"It suggests a whole different way of thinking about the investment business than we have been accustomed to for the last 50 years," Strong says. "It's quite thought-provoking, and it's going to make for some interesting headlines in the next year or two."

One thing that isn't likely to change is the biggest mistake people make when it comes to investing: They don't do it soon enough. The money lost in the Enron debacle is a pittance compared to the amount people lose to procrastination.

"People say they can't afford to start an investment program now because they've got to pay for a new washer and dryer or wait until a child finishes college," Strong says. "Any investment program is usually better than none at all, but a lot of people never get around to starting one."

Another common mistake, he says, is not fully understanding the concept of "risk" and, as a result, investing too conservatively. This is often true of people who begin investing through a 401(k) plan at work or an employer's pension plan.

"They think the stock market is too risky when, in fact, as a long-term investor, if you stay completely out of the stock market, you are taking a fairly substantial risk that your investment is not even going to earn the rate of inflation."

This finding is based, in part, on Strong's work with computer simulations of thousands of investment scenarios. He also found that putting as little as 10 or 12 percent of one's investments in stocks can dramatically increase the chance of at least keeping up with inflation.

"Adding more stocks than that doesn't really improve the likelihood very much," he says. But if the goal is to do better than simply match the rate of inflation, then putting a higher percentage of money in stocks is, for many investors, the best bet.

by Dick Broom
Summer 2002

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