After 40 years of experience, I know that clients hate uncertainty and the older we get the tougher it is to stomach the ups and downs in account values. I also understand that even with well-designed plans clients react to the fear that uncertainty creates. More often than not their fear lets their emotions and stomachs take over. And stomachs don’t make good financial decisions.
Unfortunately, we can’t remove the uncertainty that may have your stomach rumbling. We completely understand the “all-too-human need” to believe that there’s someone who can protect us from bear markets in stocks, inflation, rising interest rates, or global political discord. Truthfully, in earlier days, I thought I was that person. Over time, I recognized that I had mistaken skill for luck and a crystal ball for market inefficiencies. As the information-driven internet age arrived, the market inefficiencies that I was exploiting vanished. I had to acknowledge that the evidence from academic research clearly demonstrated that no such person exists. All crystal balls are cloudy, including mine.
The Need to Embrace Risk
We believe that clients should only take as much risk as they need to attain their financial goals. If you had a bank account that looked like Warren Buffet, you could leave your money in a bank and forget about the stock and bond markets. Unfortunately, that is not a luxury that most of us have.
We know, given our life expectancy, that most us of will need to take more risk than is comfortable. Finding the balance between your comfort zone and the amount of risk that you need to take to assure that your money lasts as long as you do is a process that will go on for the rest of your life. Risk implies volatility and uncertainty. Volatility and uncertainty create fear of loss. The antidote for the emotions is education.
Education is the key to coping with your fear of loss. We can’t protect your money from the ups and downs of the financial markets but we can educate you. Knowledge can be your shield. We can teach you enough of what we know so that you can cope with the fear. We can provide you with an investment discipline that will profit from the volatility by rebalancing your asset allocation. Rebalancing controls the risk in your portfolio and presents periodic investment opportunities. During the retirement distribution phase, we use rebalancing to systematically move money from the “risk zone” to the “safe zone” to provide cash to supplement your retirement income.
Due to the volatility that you see today, money that you plan to spend in 5-10 years should not be invested in stocks. . The best defense against the loss of principal in the stock market is broad diversification and global exposure combined with low costs and a 10+ year investment horizon. This time horizon provides us the opportunity to obtain a higher return but volatility is the price that must be paid to get that return.
Your money is not going to vanish because when you own stock markets not individual stocks. When you own bond markets not individual bonds. Stock and bond markets will not go to zero. The stock and bond markets are a survival of the fittest. Over time, individual companies and their stock or bonds can disappear. This is called “company specific risk”. We can eliminate that risk from your portfolio by owning global stock markets giving you ownership of over 12,000 stocks. In the bond market, we own mutual funds or ETFs that are well-diversified. The return that you can expect to receive is the return associated with formation of successful businesses that bring value to the world. It is the return associated with the spread of capitalism across the world. The return is the product of rising human expectations about making a better life for their families.
Perspective on Certainty
Certainty doesn’t exist in the investment world because so much of short term performance is affected by unforeseen events such as Mideast revolutions, Japanese earthquakes, tsunamis and the attack on the World Trade Center buildings. If certainty existed in the investment world, there would be very little reason to pay investors a higher return for taking a risk. The higher return exists because there is uncertainty. Our job is to make sure that you get paid for taking the risk that is the product of this uncertainty. Many investors are unknowingly taking risks that they will produce no long-term reward. Market timing and stock selection are proven to be two uncompensated risks. For that reason, we do not advocate either of them for our clients. Nevertheless, some clients insist. Academic research on forecasting clearly demonstrates that as much as we would like to believe there are those who can consistently predict the future, forecasting is folly.
Stage One Thinking & Waiting for the Green Light
When there are crises, investors focus on the negative news and conclude that whatever is happening will never go away. They fail to consider the likelihood that government, Central Banks, businesses, or people will act to try to resolve the crises and restore their economies to a healthy state. Those who engage in “stage two” thinking understand that crises lead to actions to counter the problem. For example, faced with crises, governments typically enact fiscal policies, and central banks implement monetary policies to stimulate the economy. Companies that are not profitable become more productive or cut costs. Those policies often take time to produce results, but financial markets will react almost immediately to any action intended to address the problem. That means that well-designed policies will typically lead to the financial markets recovery long before the actual economic recovery. Financial markets are forward-looking.
The stock market is one of the government’s nine components of the index of leading economic indicators because it anticipates the future. The failure to not think beyond stage one causes panicked selling and the resulting sell-low/buy-high outcomes most investors experience. Today, it often takes a crisis to get the action. Unfortunately, crisis implies that investors are more likely to think with their stomachs and therefore more likely to sell just before some action is taken. As a consequence, they miss the market recovery.
Other investors exit the markets to “sit on the sidelines” until the “green light” comes back on, indicating that it’s once again safe to invest in stocks. This is an illusion because there’s never a green light when it comes to equity investing. It’s never safe to invest. There’s always a high degree of risk. For example, if you had sold in March of 2009, when would have it been “safe” to again invest in stocks?
- The unemployment rate continued to rise and stay at very high levels.
- We had a series of mid-East revolutions.
- North Korea launched an attack on South Korea.
- Our budget deficit problems have not been solved in any way.
- The U.S’s credit rating was downgraded.
- Oil soared from below 50 to well over 100.
- We had the PIGS crisis.
- We had a flash crash.
- Housing prices continued to fall.
- Hundreds of banks failed.
- Let’s not forget Meredith Whitney’s dire forecast for municipal bonds.
There never was a green light, which was why most investors that sold in late 2008 and early 2009, missed the rally. Nervous investors did not begin talking about getting back into stock until the first quarter of 2011. The stock market peaked 60 days later. There never is a green light.
If investors decide to sell, you must have a plan to get back in. The problem is there is no effective way to design such a plan, because history is likely to repeat itself, and you’ll be trapped in a vicious circle of buying high and selling low.
There are very few investors who can avoid all risks and still achieve their life and financial goals. The strategy most likely to allow you to achieve your goals is to aband focus on the things you can control:
- The amount of risk you take
- Diversifying the risks you take as much as possible
- Keeping costs low and tax efficiency high
In other words, while the advice to arrive at a target asset allocation may not seem to be the most satisfying of answers, we believe the evidence demonstrates that it’s the right one. The last thing investors should do in response to a crisis, or any period of volatility and uncertainty is to let their stomachs take over.
The Need for Global Diversification
Some investors believe the U.S. is the safest place to invest. That is probably a result of the S&P 500 Index outperforming the MSCI EAFE and MSCI Emerging Markets International Indexes. It was only a few years ago that everyone was flaunting investment success in these same overseas markets. Other people talk about the lost decade in stocks. The truth is the S&P 500 stock market did not produce a gain over the most recent decade. However, international, small cap US stocks, and emerging markets stocks were very profitable. Today, the US stock market accounts for less than 50% of the global stock market. Looking forward, we feel that the best opportunities for the growth of capitalism and the subsequent return in stocks are outside of our borders.
Bottom Line
The key to successful investing is to understand what Napoleon knew — most battles are won in the preparatory stage. For investors that means having a plan that incorporates the certainty that they’ll have to face many crises over their investment careers. Therefore, it’s critical to not take more risk than you have the ability, willingness or need to take. If your stomach is roiling now, let’s check to see if you are able to lower your equity allocation and still be able to achieve your goals. If we find that is not the case, then we should at least consider lowering your goals, spending less now (saving more so don’t have to take as much risk), or planning on working longer.
Before closing, I offer these words of wisdom. It’s critical to remember that once something bad has happened, and we know the outcome, it’s too late to act because markets have already done so. You have already taken the risks and incurred the loss. Any reaction, after the damage has been done, is likely to be an overreaction, caused by panicked selling.
And finally, I would like to share an amusing irony. While most investors revere Warren Buffett, they ignore virtually all of his advice, including his advice to ignore all market forecasts and avoid trying to time the market. His sage advice is – buy when others are panicking and sell when others are getting greedy. We agree. The diversification of asset classes in your account combined with periodic rebalancing of your account will you have buying and selling according to Buffet’s advice.
Sincerely,
Rob Grey for the Denver Money Manager Team
