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What Investors Should Learn From 2011

The year 2011 will go down as one of the most volatile ever.  We witnessed political upheaval and wide swings in market prices.  Everything seemed to conspire to undermine investors’ composure.

Yet, the major U.S. stock market indices avoided a downturn in 2011 after two strong recovery years.  Those who bailed out after any one of the market  tumbles would have missed the year’s many improbable, unpredictable recoveries. 

So, what lessons can we learn from such a volatile year? 

1.  Be humble about making predictions. Even the experts can get it wrong – just ask Pimco’s Bill Gross.

2.  Don’t even try to time the market. That’s difficult even in the best of times and these aren’t those. 

3.  Stay diversified and disciplined; that’s always the best course, regardless of volatility.

4.  Don’t buy into the crisis du jour mentality of the media.  Shock and awe sells; judicious analysis does not.

Weston Wellington, Vice President of Dimensional Fund Advisors, does an excellent job of summarizing the year’s events and the lessons we can learn from 2011.

 

Year-End Review

Equity investors around the world had a disappointing year in 2011 as thirty-seven out of forty-five markets tracked by MSCI posted negative returns. The US did well on a relative basis and was the only major market to achieve a positive total return, although the margin of victory was slim. Total return for the S&P 500 Index was 2.11%, and the positive result was a function of reinvested dividends—the index itself finished the year slightly below where it started.

Throughout the year, investors seeking clues regarding the strength of business conditions or the prospects for stock prices were confronted with ample reason to rejoice or despair. Optimists could cite the strong recovery in corporate profits and dividends, the substantial levels of cash on corporate balance sheets, low interest rates and inflation, a booming domestic energy sector, continuing strength in auto sales, and record-high share prices for leading multinationals such as Apple, IBM, and McDonald’s. Pessimists could point to persistently high unemployment, slumping home prices, tepid growth in retail sales, worrisome levels of government debt at home and abroad, and political gridlock in both Congress and various state legislatures.

Although the broad market indices showed little change for the year, there were opportunities to make a bundle—or lose one. Among the thirty constituents of the Dow Jones Industrial Average, thirteen had double-digit total returns, including McDonald’s (34.0%), Pfizer (28.6%), and IBM (27.3%). But losing money was just as easy: The three worst performers in the Dow were Hewlett-Packard (–37.8%), Alcoa (–43.0%), and Bank of America (–58.0%). If nothing else, the substantial spread between these winners and losers discredits the argument we often hear that all stocks are now marching in lockstep and that diversification is ineffective.

Achieving even modest results in the US market required more discipline than many investors could muster, since investor sentiment fluctuated dramatically throughout the year and the temptation to enhance returns through judicious market timing often proved irresistible.

For fans of the “January Indicator,” the year got off to a promising start as stock prices jumped higher on the first trading day, pushing the Dow Jones Industrial Average to a twenty-eight-month high. Bank of America shares jumped 6.4% that day, the top performer among Dow constituents. With copper prices setting new records and factory activity worldwide perking up, the biggest worry for some was the potential for rising prices and higher interest rates that might choke off the recovery. “Overheating is the biggest worry,” one chief investment strategist observed. By April 30, the S&P 500 was up 8.4%, reaching a new high for the year.

Stocks wobbled through May and June but strengthened again in July. On July 19, the Dow Jones Industrial Average had its sharpest one-day increase of the year, jumping over 200 points, paced by strong performance in technology stocks. Just a few days later, however, stocks began a precipitous decline that took the S&P 500 down nearly 17% in just eleven trading sessions. The century-old Dow Theory—a sentimental favorite among market timers—flashed a “sell” signal on August 3, and on August 5, Standard & Poor’s downgraded US government debt from AAA to AA+. As investors sought to assess the implications of sovereign debt problems in both the US and Europe, stock prices fluctuated dramatically, with the S&P 500 rising or falling over 4% on five out of six consecutive trading days in early August. Rattled by the sharp day-to-day price swings, many investors sought the relative safety of US Treasury obligations in spite of the rating downgrade, pushing the yield on ten-year Treasury notes to a record low. Stock prices hit bottom for the year on October 3 as some market participants apparently lost all confidence in equity investing. A Wall Street Journal article cited a number of individual investors as well as professional advisors who had recently sold all their stocks and did not expect to repurchase them anytime soon. “I feel like a deer in the headlights,” said one.

As it turned out, the article appeared in print on the second day of a powerful rally that sent the Dow Industrial Average surging over 1,500 points during the next 19 trading days, putting it back into positive territory for the year.

What can we learn from a difficult year like 2011? As Dimensional founder David Booth is fond of saying, the most important thing about an investment philosophy is that you have one. Many investors (as well as some allegedly professional advisors) apparently decided to switch from a buy-and-hold philosophy to a market timing strategy in the midst of an unusually stressful period in the financial markets. We suspect few of those adopting the change would have been able to clearly articulate their investing beliefs and why they had shifted.

Legendary investor Benjamin Graham offered the following observation nearly forty years ago: “There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he himself is a part.”

Good advice then, good advice now.

By Weston Wellington, Vice President of Dimensional Fund Advisors

Sources

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Mark Gongloff, “Investors’ Forecast: Sunny With a Chance of Overheating,” Wall Street Journal, January 3, 2011.

Jonathan Cheng and Sara Murray, “Stock Surge Rings in Year,” Wall Street Journal, January 4, 2011.

Matt Phillips and E.S. Browning, “Tech Sends Stocks Soaring,” Wall Street Journal, July 20, 2011.

Steven Russsolillo, “‘Dow Theory’ Confirms It’s an Official Swoon,” Wall Street Journal, August 4, 2011.

Damian Paletta, “U.S. Loses Triple-A Credit Rating,” Wall Street Journal, August 6, 2011.

Tom Petruno, “Investors Stampede to Safety,” Los Angeles Times, August 19, 2011.

Kelly Greene and Joe Light, “Tired of Ups and Downs, Investors Say ‘Let Me Out’,” Wall Street Journal, October 5, 2011.

Benjamin Graham, The Intelligent Investor (New York: HarperCollins 1949).

The S&P data are provided by Standard & Poor’s Index Services Group.

MSCI data copyright MSCI 2011, all rights reserved.

Yahoo! Finance, www.yahoo.com, accessed January 3, 2012.

 

Confessions of an Investment Manager

When I studied Economics and Finance in business school, I learned many useful things about investing, but over time I have discovered that they were not nearly enough.  Here are the exceptions to what I learned in graduate school, as well as some new realizations.  Sometimes, what you think you know is incomplete or just plain wrong.  And sometimes, you learn things you never knew you never knew.

Yes, Virginia, bubbles do exist.  Years ago my professors downplayed the importance of speculative bubbles, but I think the evidence is clear.  In the last 15 years I would argue that we have had (at least) four separate bubbles.  Two of those bubbles have already popped, and of those I am sure there will be no disagreement.  Bubble #1 was technology stocks (remember all of the dot-com companies?) of the 1990s and bubble #2, housing prices, which from 2001 – 2006 went sky high, simply because people fell in love with the sure-fire benefits of owning them. 

Now, I cannot prove it yet, because prices are still high, but I believe we have had a bubble in gold, and to some extent, silver prices.  (I wrote about this last November.)  The phrase “as good as gold” has a long history and a certain charm, but I would not bet my own money, nor my clients’ money for that matter, on whether gold will continue to do so well. 

A Bond Bubble?

I believe that we have also had a bubble in bonds.  Admittedly, bonds have done extremely well in the past, but you don’t win a race by looking backwards.  Are too many people flocking to the supposed “safety” of bonds?  We will see.

Diversification works, but not always.  It is foolish to concentrate your investments in a narrow selection of securities.  Because we cannot predict the future, we diversify.  But in a crisis, when investors are panicking, most assets fall, in lock step.  

There have been some exceptions; we can count on cash to be stable, and money market funds have been a safe, if not very profitable, bet.  U.S. Treasury bonds usually rise when other riskier assets are falling, but even this may change at some point in time.

A fairly quick recovery of the economy usually follows a recession, but not if it is caused by a financial crisis. This is something Carmen Reinhart and Kenneth Rogoff demonstrate in their book: This Time Is Different: Eight Centuries of Financial Folly. We are living through a very slow recovery, which should not surprise us, given the financial crisis that started the Great Recession.

Decisions by the Federal Reserve are very important but not a sure thing and, certainly, not always the right thing.  The Fed can influence interest rates, the economy and people’s expectations.  They can slow the economy down when it is overheated, and they can give it a boost when the economy is not growing, but there are limits to just how much they can accomplish. We will learn more about this in the next few years, as events are still unfolding and history is still being written. And, speaking of history, it has shown us (witness the Great Depression) that the Fed’s decisions are not always the right ones. The hope of course, is that they, and other central banks, have learned from past mistakes.

Those in the know, don’t always know.  Economists are not very good at predicting anything useful: the growth in the economy, interest rates, exchange rates, stock prices.  Top management of a publicly traded stock may be buying their company’s shares like there is no tomorrow, but they can be wrong.  Hedge fund managers who have had spectacular results can make bets that turn out spectacularly wrong.  Investment “experts” are right some of the time, but are wrong frequently.  (See this post.)

Investor behavior is more important than investment returns.  To get the long term returns that stocks have delivered over time, you cannot periodically panic, sell your stock investments, and “go to cash.” If your strategy is to “get back in” at a safer time, you will undoubtedly miss the rebound in stock prices. (If you were out of the stock market in 2003 or 2009, you cannot get those large returns back.)  Just because the media and your friends are telling you how terrible things are, don’t go along with the “end of the world” story.  (See this post.)  If you do panic, you will almost certainly hurt your results. 

Conclusion

I am thankful that I learned Micro Economics, Macro Economics and Monetary Economics from some wonderful professors.  Knowing what incentives drive producers and consumers and how markets work is very helpful. But it is not enough. 

In graduate school, I loved studying Modern Portfolio Theory.  MPT was so new that we read the original groundbreaking work, before it was even in textbooks.  But I am always looking for practical ways to implement it. 

Understanding risk premiums and historical returns of various investments is useful, but it is not sufficient.  Mathematical models are helpful, but they are not foolproof.  To me Portfolio Optimization is a useful framework in theory, but not very practical in application.

We should always remember that people and events are not as predictable as we would like to think.  Economics is a social science not a physical science. Psychology frequently plays an important and changeable role.  We should not forget that our crystal ball is always cloudy.  

 

Personal Finance Challenges

The following guest post is a personal story written by an intelligent, conscious friend, who wishes to be anonymous.   I post it here, because all couples need to work on their communication regarding money issues.  And all individuals and couples need to be aware of why they make the decisions they do.

I believe that individuals and couples will learn something from the experience Anonymous shares, his honest assessment and changed behavior.

Money Challenges for a Conscious Couple

Like Roger, I am a Certified Financial Planner (now retired, however) and have an MBA in Finance.  For several years, I have been very involved in The Mankind Project, a men’s organization which is dedicated to improving the world by helping each man achieve his full potential.  My wife is a therapist who counsels people on developing effective communication, especially with their primary partners and family members, and learning to live life to the fullest. 

You might imagine, then, that we, a happily married couple, would be very effective at communicating with each other about any and all matters that arise in a marriage, including those issues with a financial aspect.  Unfortunately, that is not the case; the issue of managing our finances has been far and away the major point of contention in our marriage.  Embarrassing as they may be, I will relate our struggles with the hope that, by sharing this, you can learn from our mistakes.

One thing that we have never had to worry about, fortunately, is having enough money.  I was an executive at several different banks; I earned a good salary, received stock options, had a 401k, and I now receive a small, but entirely adequate, pension.  Just as important, I did not marry until I was in my 50’s, and my then wife-to-be had no children.  Thus, as a childless mature couple, we avoided the major expenses of child rearing and college.

When we got married, my wife was an independent, intelligent businesswoman from New York City who made good money in a commission-based job.  I moved into her NYC apartment afterward, and was, I admit, pretty unhappy.  Having lived in that apartment for over 20 years, my wife essentially “owned” it; The apartment was filled with “her” things, top to bottom, and I missed having my own stuff around me. 

Life Events Caused a Re-evaluation

I got laid off from my bank job in 2001- the fourth lay-off in ten years, as banks went through one round of layoffs after another.  That was the last straw; I examined my life hard and decided that, in order for me to be happy, I had to quit the corporate game, and move back “home” to the Washington, DC area.  I had enough money saved so that both of us could stop working full-time, if we so chose.  My wife, understanding that I was just not happy in NYC and open to a change, agreed to give up her established career and move to the DC area.

Once settled back in the DC area, my wife attempted to re-create the success she had had in NYC by doing the same type of work—helping people find jobs (attempted being the operative word.)  For whatever reason, and in spite of her incredible work ethic and outgoing, buoyant personality, she just could not replicate her NYC success.  (And with all due respect to Frank Sinatra and the lyricist who wrote the words to that wonderful old song, New York, NY, “If you can make it there, you can make it anywhere” simply did not apply in my wife’s case.)  So, she became dependent upon me and my savings to live.  Of course, I didn’t mind her being financially dependent on me, but I also didn’t think it unreasonable for me to assume that I would be the one who would control our finances.  In my mind, it made perfect sense; I was the financial expert, after all.  I believed that she should be grateful, not just for my generosity but for enabling us both to retire at relatively young ages, and for my willingness to take control of the finances.  I truly thought she would not mind relinquishing financial control to me. 

Our Background and Baggage

Both my wife and I had come from homes where money was tight, thus a constant issue between our respective sets of parents.  That was the baggage we each carried into the marriage; we both viewed money, not as a tool for enjoyment, but rather as security. 

It’s often been said that money is power, and I recognize that implicitly.  But here is what I failed to recognize:  that the person in power does not have the same “sense” of a power imbalance as does the person out of power. 

I enjoy working with numbers and have more experience with and knowledge of money management than my wife.  So, it was only natural for me to take on the role of Chief Financial Officer for our family, and for many years, my wife had no objections to it.  I paid all the bills and made all the investment decisions and we did just fine. 

Having gotten married for the first time when I was 54, I was used to making decisions on my own, without consulting anybody else.  Even after getting married, I didn’t really see the need to change my behavior and consult with my wife, especially in areas where I felt supremely confident, namely with respect to money management.  After all, she couldn’t possibly add any value to the decision making process, given her lack of knowledge.  I didn’t know it then, but my wife was very hurt at how easily I could make financial decisions on our behalf, but without consulting her. 

Mauled by the Bear Market

The Great Recession of 2008-2009 presented us with a particularly challenging time.  As with so many others, our nest egg suffered a major hit, and we lost over 25 % of our savings.  One major bone of contention was my investment philosophy; I was (am) basically a “buy and hold” kind of investor and was more than willing to leave our asset allocation alone.  My wife, on the other hand, had told me, even prior to the downturn, that we should get out of the stock market, because she “did not have a good feeling.”  I was the financial expert so I dismissed her “feeling” and overruled her. 

We stood pat and watched our net worth go down, and down again.  Never giving up, my wife would regularly lobby for us to get out of the stock market and, as usual, I would resist.  It wasn’t until near the absolute bottom of the market, that my wife’s constant lobbying (and I admit now, grudgingly, my own annoyance for not having listened to her in the first place much earlier), persuaded me to finally really listen.  She wanted the mortgage on our house paid off, so I sold off enough stock from our portfolio to pay off the loan balance.  In truth, to me, paying the mortgage off didn’t make sense – smart investors buy low and sell high!  But the majority of people do the opposite.  Much to my chagrin, we later joined the masses in buying high and selling low.

Preparing to be a Widow

A couple of years ago, the husband of one of my wife’s dear friends died after a long bout with cancer, and his wife had to learn how to handle the family’s financial affairs.  Unfortunately, she was not well-prepared to take on this task, and struggled with the burden of it, in spite of her husband’s well-detailed instructions on what to do with each account.  It was my wife’s observance of her friend’s struggle that was the wake-up call that she, too, should become more knowledgeable about our finances. Now.

My wife insisted that I make no financial decisions without consulting her first.  I hated the idea, but acquiesced once I realized how strongly she felt about it.  It took me some time to get used to the idea of it, but now we have regular meetings to discuss how our finances look and what we should do or changes we should make.  My wife has assumed responsibility for monitoring our expenses, using the free on-line tool, Mint.com.  She has become disciplined in reviewing each and every expenditure on that system and assuring that it is correctly categorized.  I calculate our net worth on a monthly basis and evaluate our asset allocation.  As a result of our most recent look at our asset allocation, we decided to change our portfolio allocation, together.

My Advice for Couples

To those couples who argue over money (and really, who doesn’t nowadays!), I suggest the following:

• Understand that both money and knowledge are power. 
• Share the three major tasks of managing your money, i.e., paying bills, monitoring expenses and investing.
• Monitor your expenses on a monthly basis.  The free on-line tool, mint.com, is a wonderful way to understand what you are spending money on and how much by category.
• Determine what asset allocation you are comfortable with and rebalance your portfolio so that you stick to your target.  Take on only the amount of risk that you are comfortable with and that you need to achieve your goals.
• Monitor your net worth on a quarterly basis. 
• Have regular financial meetings to discuss expenses and investments.

And most importantly, never assume anything with respect to your partner’s feelings about money management- have the tough discussions early on to make certain you are both on the same page.

- Anonymous

Postscript by Roger Streit

Many people are not motivated, or do not have the time, to analyze and monitor their financial situation.  A good financial advisor should be able to help you assess your goals, discuss your risk tolerance, set up a sensible portfolio, and even help you unpack your feelings about money.  Do-It-Yourself is not right for many people.