Sometimes you get the Bear, sometimes the Bear gets you

This could be titled "Musings on Bear Stearns," but my editor likes (occasionally) catchy headlines.

GOVERNMENT WELFARE
It is ironic that the most free-market oriented administration since Herbert Hoover would ride to the rescue of Bear Stearns. After all, the free-market works just fine for health care. The rationale behind the bailout of Bear Stearns is logical - preventing unwinding of complex financial products. That still doesn't mean this handout is a good idea. 
At the risk of oversimplification the Federal Reserve essentially has guaranteed roughly $29 billion worth of Bear Stearns investments to entice J.P. Morgan Chase to buy Bear Stearns for $10 per share. Before the Fed pledges any more of my money I wish they could read a balance sheet. The Bear Stearns building in Manhattan is worth approximately $8 per share by itself.
Despite the Fed's good intention this bailout is not the same as FDIC insurance at a commercial bank. Rather this bit of charity is more like the Fed saving Enron or WorldCom. Investment banks traditionally worked like partnerships. When they gave good advice - which they did most of the time -the partners were rewarded handsomely.
When they stumped their toe with sub-par counsel, profits suffered.  Now the Fed is essentially making up rules as they go. Since risk has been banished the result is "heads I win, tails you lose." 
Don't take it from me.  Bloomberg.com reported that each "top executive at the 16 financial firms potentially facing sub-prime mortgage losses have severance packages averaging $66.4 million."

OWNING INDIVIDUAL STOCKS
Doesn't this mystery company sound like a sure-fire winner most investors would like as a bulwark of their retirement portfolio? From its IPO during the 80s through 1999 it had an annualized return of almost 25 percent versus the S&P 500's 18.04 percent return.
It blew through the 2000 - 2002 bear market (44 percent total return) trouncing the moribund S&P 500's negative 37 percent. Get out of the way Warren Buffet - over a 20 year period ending in December 2006 our mystery company bested Berkshire Hathaway 4.5 percent annually. 
You could guess by now the identity of our anonymous company is Bear Stearns. Over 30 percent of Bear Stearns stock was held by employees who thought they were on the way to Easy Street. Owning this stock was a no-brainer. Bear Stearns made the cover of Barron's magazine, which glowingly noted in 2004 that Bear Stearns' investors "can sleep well, knowing a full-blown financial crisis is unlikely to cripple the firm."  Even the CEO of Bear Stearns drank the Kool-Aid stating that the firm's balance sheet, liquidity and capital "remained strong" a mere one week before it faced the prospect of bankruptcy.
Maybe investors should have listened to the Grateful Dead: "When life looks like easy street there is danger at the door." Owning individual stocks -particularly highly concentrated positions - carries an enormous amount of risk.  Mutual funds are a far better choice.

ACTIVE VERSUS PASSIVE INVESTING
The Bear Stearns debacle points out with brilliant acuity the benefit of passive investing using mutual funds from Vanguard or DFA. The Friday before the Bear Stearns collapse, noted stock-picker Bill Miller was speaking to over 200 top-tier Deutsche BanBank clients touting financial stocks including Bear Stearns.  During a Q&A session after his presentation Mr. Miller was shocked when an audience member pointed out that Bear Stearns was down over 15 percent that day. 
Mr. Miller was the poster boy for active management since his mutual fund (Legg Mason Value Trust) bested the S&P for 15 straight years ending in 2006.  Since then his performance has gone from bad to abysmal. Currently Value Trust is ranked at the bottom of its peer group with a 20 percent decline for 2008.   
In a Money magazine interview Mr. Miller stated, "first of all let me say that I think index funds ought to constitute ...a significant portion of one's assets in equities. Because you know, the evidence is that over any substantial period of time - 10 years, 15 years, 20 years - the odds that you will get a money manager who can outperform that period of time are about one in four."
Batting .250 in big leagues might make you a lot of money but in the investing world it is not a good idea.

Buz Livingston is a certified financial planner. He operates Livingston Financial Planning Inc. focusing on hourly financial planning and investment management. Listen to his radio program, Money and Music, every Wednesday at 8 a.m. on 107.1FM, 30A Radio or www.30Aradio.org. Contact him directly at (850) 267-1068 or at LivingstonFinancial.net.