Greg Miller & Darlene Murphy

How To Play And Not Get Burned!
by Greg Miller & Darlene Murphy

WHETHER YOU WERE just getting ready to set sail for Fiji, send your daughter to medical school (without the worry of daunting debt), sign a contract as the Red Sox's newest relief pitcher, or retire on a modest income, the stock market slump has put a crimp in your plans. This latest bear market, and all the bad news surrounding it, has everyone jittery. Even if you are just starting your career and have a lifetime of market fluctuations ahead of you, you still don't want to see half your principal vanish in a flash.

During these times, the temptation exists to turn to "safe investments" such as CDs and Treasury Bills, or beat yourself up for not having "gotten out of the market earlier." Unfortunately, meager returns from fixed income investments, together with inflation, will relentlessly erode assets over time. Don't be tough on yourself…even the best market timers cannot get it right all of the time.

It seems that only lately-driven by the current bear market-the idea of principal protection is gaining credence. It was a philosophy we developed in l991 when the market was soaring and we titled it Limited Risk Investing™, a concept that offers downside protection while simultaneously including participation in the upside potential of the stock market.

The most commonly known-and traditional-principal-protected investments are Convertible Bonds. Convertible Bonds, like simple corporate bonds, oblige the issuer to pay interest and full face value at maturity. Convertible bonds are a hybrid that may be traded in for, or "converted," to common stock whenever it benefits the investor.

Whether the market rises or falls, convertibles will do well and, barring default, will pay interest and face value at maturity. According to Value Line Guide to Convertibles Strategies, "Surprisingly, over long periods, convertibles typically provide better total returns than stocks." Yet, they received scant media attention during the dot.com boom.

Several variations on the convertible bond theme exist including Convertible Bond Mutual Funds, which we feel do the opposite of what bonds are supposed to achieve-protect principal.

Index Linked Securities

A more sophisticated investment category that has the financial pundits buzzing is Index Linked Securities. These securities are aggregate investments based on an index such as the S&P 500, Dow Jones Industrial Average, Russell 2000, Nikkei or specialized groupings of securities created by brokerage houses. Regardless of the index, the issuing brokerage firm guarantees principal on investments held to maturity.

The appeal of Index Linked Securities is that most are guaranteed by the largest financial institutions in the world. Although they may be structured in a variety of ways, here is one model: A major brokerage firm offers shares in a $100 million Index Linked Security fund at, say, $10 per unit. A benchmark price based on the Dow or other index, for example, is established at the time of the offer. When investors hold their shares to maturity, they are guaranteed the benchmark price of $10 per share. If the Ending Index Value is higher than the Benchmark-by a predetermined margin-investors receive a Supplemental Payment above the $10.

These investors share in the upside potential of the stock market over five or more years without having to worry about the market being down when they need money. Should investors wish to redeem their units prior to maturity, active markets exist for many Index Linked Securities, with the redemption value determined by how well the market is doing at the time of the trade.

Insured Mutual Funds

In addition, principal protected mutual funds are now becoming available. For example, ING Pilgrim Securities, Inc., one of the largest worldwide financial institutions, now offers such a fund. The fund, which seeks to outdo the Standard & Poor's 500 Index, has a five-year "Guarantee Period."

At the end of the 5-year period, investors are guaranteed 100% of their principal. The guarantee is backed by an insurance policy issued by AAA-rated MBIA Insurance Corporation. Investors seeking to redeem their shares prior to the end of the Guarantee Period may do so, but may be subject to fluctuations in fund value. However, investors who hold it for five years are assured protection of their principal. The fund, titled Pilgrim Principal Protection Fund, will be available to investors until October 4.

According to Michael Santoli, a reporter we follow from Barron's: "For the nervous investor, [a principal protected mutual fund] removes the danger that he or she will choose a horrifically inopportune moment to initiate or deepen a commitment to stocks, thereby potentially insulating shareholders from years of embarrassment for throwing money into a sinking market."

No matter which investment instrument is used to protect principal - principal protected mutual funds, Index Linked Securities or Convertible Bonds-we urge every investor to adhere to one overriding precept during both bear or bull markets: avoid trendy stocks and invest in good businesses priced at a discount from their long-term intrinsic value.

Greg Miller and Darlene Murphy, principals of Wellesley Investment Advisors, are CPAs with a total of 40 years of experience, and are Registered Investment Advisors. The firm they founded in l991 manages the assets of high net-worth individuals and both qualified and non-qualified pension plans. They may be reached at inquiries@wellesleyinvestment.com.