With economic upheaval and market gyrations causing quite a bit of investor angst, it seems appropriate to review some investing and psychology fundamentals. The goal is to address (and hopefully ease) your current concerns, put current issues in context and help you keep your eye on your long term goals. The market has seen quite a bit of volatility this year and to date (through 7/15/08) the S&P 500 Index is down about 17%. Your portfolios have held up better than this due to our diversification strategy and generally defensive posture.
The stock market by its nature is volatile. In any given year, returns will be positive or negative by varying degrees, depending on underlying economic activity and outlook, consumer confidence, prevailing interest rates, and inflationary concerns, among other things. Since 1970, large company stocks have returned about 11% per year, on average. The volatility around that average return is about 16.5% and is known as the standard deviation. Looking ahead, returns are forecast at about 9% with a standard deviation of about 18%, so slightly less return and slightly more volatility.
Statistically, this means that in a given year large company returns are expected to be between -9.0% and +27% 68% of the time (9% +/- one standard deviation), and between -27% and +45% 95% of the time (9% +/- two standard deviations.) Smaller company stocks tend to return about 2% more on average than large company stocks, but interim volatility is also greater. Fixed income returns are forecast at about 5.5% with a standard deviation of 4.5%. It is easy to forget that to get more return you have to take more risk.
While experiencing the downside volatility is always painful, it is important to recognize that it is a normal part of investing. Interim volatility is the price we pay for above average returns over time. Without uncertainty around shorter term returns, you should not expect to receive longer term average returns in the 9%-10% range. Importantly, the predictability of returns dramatically improves over time until they eventually converge around the average. The longer the holding period, the more likely you will achieve predicted returns. This is known as "reversion to the average" in statistics. What this means for investors is that periods of underperformance are always followed by periods of out performance. That is the only way to get to the average 9% market return. Given the lousy market these last 9 months, probabilities are good that forward returns will be healthy. In fact, it is a mathematical certainty over time.
Given the short term volatility of equities, but the relative predictability of longer term returns, equities are suitable only as a long term investment. Equities are an essential component of portfolios to enable growth above the rate of inflation so as to sustain a particular lifestyle well into the future. The risk of running out of money in the long term, due to an under allocation of equities, is much greater than the risk of running out of money due a temporary decline in portfolio values. As humans, we want to cut and run to stop the losses, but if done after the fact, this strategy merely works to turn a temporary decline into a permanent one. We must balance reason with emotion to achieve our goals.
The inherent above average return of equities, coupled with attendant volatility, gives rise to our investment strategy, which provides for adequate cash flow in the short term and the longer term. First, we diversify portfolios across asset classes – stocks (equities), bonds (fixed income), cash (money market), and so called "alternative" assets. Cash provides liquidity for spending. We advocate holding 6 months to 1 year of spending cash in a money market fund. Next, based on risk tolerance, hold three to five or so years of spending needs in fixed income. A fixed income allocation provides interest income to supplement the cash bucket and acts as a source of cash when needed. Fixed income also acts as a volatility buffer to equities as they tend to counter balance one another. When equities decline, fixed income often rises, and vice versa.
If you are still working and adding to your retirement accounts, your need for fixed income and/or cash declines accordingly, however it is still a good diversification tool. The remainder of the portfolio belongs in various equity and alternative asset classes to allow for long term growth and to offset the impact of inflation on future spending levels. A typical "growth" portfolio would consist of 55% equities, 15% alternative, 20% fixed income and 10% cash. With this asset allocation, you should never have to sell equities at inopportune times to meet spending needs and allow time for the long term performance benefits of holding equities to occur. Within equities, we advocate diversification across size (large or small company), style (growth or value), location (domestic or international) and sector (energy, real estate, etc.), leaning into those parts of the market working best. Alternative assets are less correlated to equities yet provide equity like returns and so provide further diversification opportunities.
As a result of market conditions and extensive analysis, we have substantially rebalanced your portfolio(s) this past quarter. We have reduced exposure to Exchange Traded Funds in favor of actively managed mutual funds. This is a stock pickers market and we have identified best in class managers that have long term track records of navigating successfully through various market cycles. We have combined the funds together in a way that we believe optimizes the risk/return characteristics of your portfolio as a whole.
Included with this letter is a new Morningstar report that provides a tremendous amount of information about your portfolio (total household if more than one portfolio.) Please take time to peruse this report, paying special attention to the risk return characteristics of the portfolio. I am confident you will be pleased with our efforts on your behalf. Of note, the historical returns are of the current portfolio holdings, not your actual returns. I wanted you to see how these managers have done over time, through various market cycles.
In looking at the current state of affairs, a couple of thoughts come to mind. The market is a leading economic indicator. It moves in advance of economic reality and already discounts quite a bit of bad news. Everyone knows there is a credit crisis; residential real estate values are in decline; unemployment rates are rising; gas prices are at record levels; consumer confidence is in the dumps; our trade and fiscal deficits are unsustainable; the U.S. dollar has lost its luster; and recession talk is on every news channel. Bad news is everywhere and the market has declined considerably from last year’s top.
We don’t know how far down this cycle will take the market, but I believe we are much closer to the bottom than not. Average bear markets last 9 months to 15 months and this one has been underway for 9 months now. There has never been a major decline after expectations get this low. Rather, they tend to make for market bottoms. According to Mark Hulbert of MarketWatch.com, during the second halves of all presidential election years over the past 110 years, the Dow has gained an average of 9.7%. In the second halves of all other years, in contrast, the Dow's second-half gain has been 2.7%, or barely more than a quarter as much. While this year could be an outlier, the odds are in our favor that we are at or near cycle lows.
Stimulus from the recent Federal Reserve rate cuts is still to be felt, core inflation remains in check, interest rates are low, aided by the weak dollar exports are booming, valuations are reasonable, and the next move in oil prices is likely down due to supply and demand considerations as well as increased congressional oversight of oil speculators. The Federal Reserve and U.S. Government are hard at work to keep the system working. I am confident they will succeed.
Our mission at BDA is to help people live inspired lives, free from worry about your money matters. Given market conditions, fear is certainly elevated. However, with a focus on proper asset allocation and an understanding of the long term benefits and performance characteristics of equities, hopefully fear can be reduced. We can’t change the markets, but we can adjust accordingly and keep things in perspective. We have adjusted your asset allocation to reflect current market conditions. Longer term, the world economy will grow and take the market with it. We encourage you to focus on what is in your control, such as your life goals. Inspiration often comes when times are tough.
