The Right Investment Advice

While we only have a little more than two months under our proverbial belt, there’s no denying that it’s been a good run thus far in 2013.  Since January 2^nd the S&P 500 Index has returned 9%.

In addition, all of the major indexes, the DJIA, the S&P 500 Index and the NASDAQ, have more than doubled since the low of March 9, 2009. This is a great reminder why you shouldn’t abandon your well-designed plan just because others are panicking.

On the flip side, any day now we can expect to see articles about why this is a good time to buy stocks.  Why few people were saying that in the depths of 2009 is a good question you might ask.

When the news was bad and markets were tanking, I advised staying the course and adhering to your investment plan.  Now I advise not getting too optimistic, thinking the “coast is clear.”

While we can all enjoy the recent successes, I certainly cannot take any credit for predicting the stock market rally.  The truth is that rallies come along quite randomly, as do stock market routs.  And as I’ve said on numerous occasions, no one can predict short-term stock market returns.  Just a reminder, stocks can go down as well as up.  Of course, you know that, but you also know that the long-term trend has been up.

So let’s bring up a subject I feel is critical to safeguarding your long-term investment experience: In good times and bad, there is an art to making quality decisions, and it may not be what you think.

Among the many roles of your financial advisor, one is to remind you (repeatedly) that the quality of your financial decisions contributes as much or more to your investment success as do the fleeting outcomes of hot or cold markets. In Carl Richards’ book, Behavior Gap, we are reminded of an important related insight: 

“The outcomes of our decisions may vary. In fact, you can make a good decision and have a bad outcome. But sensible, reality-based choices are our best shot at reaching our goals.”

To illustrate, you could take your life savings toLas Vegas, bet it all on a single very lucky spin and strike it outrageously rich. That would be a great, albeit improbable, outcome … to a very horrendous decision. In contrast, you can maintain a low-cost, globally diversified portfolio that reflects your personal goals as well as the latest academic evidence on capturing market returns. Fantastic decision, even when market conditions deliver disappointing results.

This is where your financial advisor comes in especially handy. Whenever you may be tempted off-course by undesirable outcomes — or, on the flip side, by random bursts of success — you need to objectively assess what, if any, adjustments might be warranted within your plans and your investments.

As Larry Swedroe points out:

“If you have done a good job developing your plan, and it has anticipated the risks you are likely to face, you should ignore the noise of the market, not getting caught up in either the hype or the fear that bull and bear markets can cause. Just stick to your plan.”

Making confident, quality decisions toward achieving your long-term goals regardless of past-tense outcomes — that is good advice any time of year.

Health and Wealth Resolutions for 2013

If weight loss is one of your New Year’s resolutions (and it almost always is for quite a few of us after the triple whammy of the Thanksgiving, Christmas and New Year’s holidays), here’s a handy tip: A team of international scientists, analyzing recent health data from more than 25,600 U.S. survey participants, concluded that people who read food labels weigh less than those who don’t (this is especially true of women participants, who averaged nearly 9 pounds less).

I would argue that you need to know what to look for on a food label.  “Natural” “healthy” “cholesterol-free” are, in my opinion, meaningless.  Depending on your goals and specific diet, “wheat-free”  “soy-free” and “dairy-free” may be important.  And once again in my opinion, the amount of sugar (and the carbohydrates which convert to sugar in the body) in any food is extremely important. 

You’re probably asking yourself what has food got to do with finance?  The answer is all about information and interpretation.

What you need: Your investment experience is greatly improved by a sound philosophy and consistent exposure to meaningful facts. For example, in 2012 despite continued global economic uncertainty and political gridlock, stocks quietly rewarded patient investors with double-digit gains. Not too shabby after all for a stay-the-course investor, an approach we have consistently advocated.  Investors who believed the negative headlines and pulled their money out of equities into safer havens suffered accordingly.

What you get: Slick advertising showcases a product’s most appealing features. If they’re there at all, the blemishes and boring but very important details for the long-term investor are buried in the fine print.  Just as understanding metabolism is important for weight control, knowledge of how markets and investments work is key to a successful investing strategy.

What counts: There is a reason the Securities and Exchange Commission makes sellers of investments say that “Past performance is not a guarantee of future results.”  Why?  Because it is true.  Why then do so many investors pay attention to the Morningstar ratings of mutual funds?  Those much ballyhooed Morningstar Star ratings are based on past performance. 

What you must know: There’s no law in our free market system against promoting what’s popular, irrespective of how bad it might be for you. It’s up to you, not the product provider, to make informed choices that are in your best interests.  Understanding fee structures and tax implications are up to you (or your objective investment advisor).

How we help: We live in a world of up-and-down markets in which useful financial disclosures are often opaque to non-existent; and the next upset — the next fiscal cliff or its economy-busting equivalent — seems to forever threaten our best-laid plans. Our greatest role is to provide you with solid, steady, evidence-based advice. Like an objective nutritionist for your wealth, it is our privilege to champion your best financial interests alongside you, help you read wisely between the promotional lines, and chart out a healthy, happy lifestyle that suits your personal tastes.

We look forward to remaining at your side throughout 2013.

What’s Your Investment Philosophy?

“The important thing about an investment philosophy is that you have one.” - David Booth

Regardless of whether or not you are a fan of Capital One credit cards, you have to admit “What’s in your wallet?” is pretty catchy. Maybe that’s because it gets to the heart of the matter so quickly. At the heart of solid investing is a similar key question: “What’s your investment philosophy?” Let’s explore why that’s so important.

Step One: You Think, Therefore You Are

First, at the very least, you should have one.  As recommended by Dimensional Fund Advisors chairman and co-CEO David Booth, having any sort of investment philosophy is a critical first step in grounding you, and directing your decision-making toward your desired ends.

You’d think that would be a given, but many investors would be sorely put to articulate an overarching plan behind their individual trades.  In the absence of an “all-weather” philosophy to guide your way, you’ll struggle to make sense of the economic news you hear. You’ll react emotionally to short-term market fluctuations and the crises du jour proclaimed by the media.  You’ll spend too much money on unnecessary trades or lack the confidence to act boldly when it’s in your best interests.

Step Two: Make It a Good One

Even better than having any old investment philosophy is to have a good one. It should fit well with your personal goals and risk tolerances.  It also should be based on the wealth of academic evidence on how markets are expected to reward patient investors.

Read our evidence-based Investment Philosophy and see if it makes sense to you.   Contrast it with questions I hear from those who have not yet crafted their best-laid investment philosophy: (1) Is the stock market being manipulated to benefit one political party? (2) If Governor Romney is elected president, will the stock market go up? (3) When will Facebook’s stock go back up to its issue price?

Our answers are, in order, probably not, maybe (maybe not), and who knows? These brilliantly non-committal answers reflect that they are the wrong questions to begin with.

If long-term market growth trends upward — and all evidence to date indicates that it does — why not focus on that instead? Wall Street often profits on flimflam, pretending that you need guru prognosticators to predict impending individual winners and losers, but the evidence indicates that you’re best off ignoring these theatrics and adopting a sound investment philosophy to carry you through.

We elaborate on this theme in our Key Insights quarterly newsletters

For example our April Key Insights newsletter recommended focusing on what you can actually control:

• Forget about trying to forecast near-term moves in the market.
• Form a sensible investment plan that aligns your personal goals with the market’s long-term risks and expected rewards.
• Implement a well-structured portfolio to reflect your plan.
• Stick with it.

If you’ve ever read the book or seen the movie Moneyball, you know that one of the practices of Oakland Athletics’ general manager Billy Beane is to avoid watching his team’s baseball games live.  Why would a manager do that?  Because he knows he might succumb to irrational decisions based on the heat of the moment.  Instead, he stays focused on his evidence-based philosophy on how the game is best played.

Similarly, you can fret about your investments play by play, or you can follow a sensible long-term approach based on the evidence of what will bring you the most “wins” for the least cost.  The choice is yours. 

 

 

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.  

 

Living with Stock Market Volatility

The current renewed volatility in financial markets is reviving unwelcome feelings among many investors—feelings of anxiety, fear, and a sense of powerlessness. These are completely natural responses. Acting on those emotions, though, can end up doing us more harm than good.

At base, the increase in market volatility is an expression of uncertainty. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to apply a higher discount to risky assets.

So, developed world equities, oil and industrial commodities, emerging markets, and commodity-related currencies like the Australian dollar are weakening as risk aversion drives investors to the perceived safe havens of government bonds, gold, and Swiss francs.

It is all reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets.

As to what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.

* Remember that markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor’s of the US government’s credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in Treasury bonds.

* Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks,” remember someone is buying them. Those people are often the long-term investors.

* Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was last this bad—the S&P 500 turned and put in seven consecutive of months of gains totalling almost 80 percent. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

* Never forget the power of diversification. While equity markets have had a rocky time in 2011, fixed income markets have flourished—making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road.

* Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. As the IMF noted recently, while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving.1 A globally diversified portfolio takes account of these shifts.

* Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.

Jim Parker, a Vice President of Dimensional Fund Advisors, wrote this essay.  It is posted here with permisson.

America’s Tarnished Credit Rating

“In the short-term the stock market is a voting machine, while in the long-term it is a weighing machine.” – Benjamin Graham.

On Friday evening, the Standard & Poor’s debt rating agency  downgraded all U.S. government debt with more than a year of maturity, from the top AAA rating down to AA+.  To put that in perspective, now only 17 countries enjoy the AAA rating on their government bonds.  Typically, that means that they are considered the safest havens for cash, and therefore are able to pay the lowest interests rates on their borrowing. 

Here’s the list, and I’ve included the current yields on each country’s 10-year government bonds in parentheses.  This lets you see what the top-rated countries pay on their debt, compared with the 2.5% interest the U.S.  government has to pay on its 10-year U.S. Treasuries: 

France (3.41%), Germany (2.83%), Canada (2.93%), Australia (5.75%), Finland (3.19%), Norway (3.29%), Sweden (2.82%), Denmark (3.06%), Austria (3.30%), Switzerland (1.53%), Luxembourg (NA), Guernsey (NA), Hong Kong (2.29%), the Isle of Man (NA), Liechtenstein (NA), the Netherlands (3.17%), and Great Britain (3.11%). 

The first thing to notice is that the U.S. government is still borrowing at very attractive rates compared with the triple-A nations, and Treasury rates actually got better during the angry debate in Washington, as investors continued to beat down our doors to lend money to our government.  Why?  The downgrade and recent weakness in the stock market have made bond investors nervous, which usually causes them to buy the safest paper they can find.  The United States still offers the deepest and most liquid bond market in the world.

The second thing to understand is that, despite the high levels of government debt, there is really no crisis in the government finances or in the economy.  S&P officials made it clear that they were more influenced by the recent messy debate in Congress than the fundamentals of government finance.  They may have been particularly rattled by public statements by key members of Congress that it might not be a bad thing if the U.S. government defaulted on its sovereign obligations to its global lenders–sort of like one of us telling the bank that we’re thinking seriously about not making any more mortgage payments.  

David Beers, global head of ratings at S&P, said in a supporting statement that the agency was concerned about “the degree of uncertainty around the political policy process.”  A separate statement by the rating agency said that policymaking and political institutional control had weakened “to a degree more than we envisioned.”

Long-term, our government faces some difficult choices.  The question now is whether we’ll get action from Congress or more political posturing.  We’ll get an early look between now and Tuesday, as a new Congressional committee, made up of Democrats and Republicans, will be set up.  The committee will be looking for $1.5 trillion in deficit cuts that have not yet been specified through the debt ceiling compromise.   (A total of $917 billion in cost reductions has already been earmarked).

What should investors do?

What does all this mean for investors?  The investment markets were clearly rattled by the tone and uncertainty of the debt ceiling debate, with the S&P 500 losing 10.8% of its value over the ten trading days of the Congressional standoff.  Early indications are that global markets have been negatively affected by the S&P downgrade.

But a Money magazine report points out that when a country loses its AAA rating, that is not always terrible news for the nation’s stock market.  Canada, for example, was downgraded from AAA status in April of 1993, but the country’s stocks gained more than 15% the following year.  The Japanese government’s bonds were downgraded in 1998, and the Tokyo stock market climbed more than 25% in the next 12 months.

The awful nature of the debt ceiling debate, plus the downgrade, has clearly added fear and uncertainty to an already sluggish economic recovery.  The Treasury debt downgrade is a blow to U.S. pride, and a warning to Congress–particularly those representatives who think the U.S. can simply walk away from its obligations without consequences. 

However, as the decline in Treasury rates made clear, the downgrade is largely symbolic.  Congressional gridlock and partisan posturing could leave us with a long 15 months until the next time we have a chance to vote on their job security.  But it might be helpful to think back to last summer, when concerns about a double-dip recession and mild panic sent the S&P 500 down a long unhappy slide to a low of 1022.58 on July 2, 2010, with a few additional bounces along the bottom until a September rally.  Investors who sold out of the markets at that time missed significant–and largely unexpected–gains through the fall, winter and spring, as people gradually realized that the world was not coming to an end.  (Despite periodic “end of the world” stories promulgated in the press, the world never does end.)

Our Cloudy Crystal Ball

No one can predict stock market prices, because in the short term, emotions can rule the market, and they are visibly tilting toward panic right now.  Longer-term, market prices always tend to return to fundamentals, and it’s helpful to remember that corporate profits remain strong, new jobs are being added and the economy is still growing. 

The Price of Panicking

The U.S. markets weathered much worse than this in 2008, in 2000, during the first and second world wars and a lot of panic-stricken times in between.  Without the ability to see the future, our best prediction is that the Sun will continue to rise each morning, and the U.S. will emerge from this crisis like it has all the others.  In the past, investors who managed not to succumb to the panic like so many did last summer did extremely well.

The alternative is to get out of the market now (after prices have already declined) and wait to get back in, when the economic environment is settled, and things no longer look downright dangerous.  The price you pay for this respite from anxiety is usually very high.  By the time you feel comfortable  being an investor in stocks again, prices will typically be much higher than when you sold.

Selling low and buying high has never been a winning strategy.

The Proper Role of Bonds in Your Portfolio

Over the years, as I have spoken to quite a few people about bonds, the various conversations have often taken a different direction, depending on the “environment” at the time.  Take, for example, 1999, when common stocks were on a tear; then I had to explain the reasons why anyone would want to invest anything at all in the bond market.  And in recent times, in this “environment” I’ve actually had to talk investors out of investing too much of their money in bonds. 

These are both examples of what Behavioral Economists call “recency.”   Meaning that we tend to place more emphasis (and trust, appropriately or not) on more recent data even as we ignore older data. 

A more general problem, I’ve found, is that investors don’t understand the role that bonds should play in an investment portfolio.  When you buy a bond you are essentially lending money to some entity, whether it’s a corporation, a municipality, a state, or a country.  In exchange for what is essentially your loan, you are promised a regular payment, usually on a semi-annual basis, plus the full amount of the money you lent returned to you at a given date.  Depending on the circumstances, you may or may not realize the promised returns. 

Bonds are considered “fixed income;” investing in them generally means that you will not gain as a result of growth in the economy.  Bonds are considered safe and therefore have a lower expected return than stocks.  But bonds have two inherent risks, namely interest rate risk and, more importantly, credit risk/default risk.  Interest rate risk means that when interest rates rise, bond prices will fall, given the inverse relationship between them. 

Default risk describes what happens when the entity has gotten into financial trouble and does not return your original investment.  Take for example, Greece; certainly you have heard how the threat of Greece defaulting on their bonds is playing havoc with markets there and across the globe. 

Portfolio strategists view bonds as a way to provide stability to a portfolio.  Accordingly, this approach argues for only buying high quality bonds, i.e. those with the highest credit ratings.  The reason is that you won’t want an economy which is going through a “soft patch” to adversely affect both your stock portfolio and your bond portfolio at the same time.  The whole idea is that bonds should provide a safer haven than stocks, albeit with a lower expected return.

Conclusion

It is my belief that, as part of a sensible portfolio, fixed income investments must be limited to high quality issues.  I also believe that it’s a mistake for investors to overemphasize bonds in a portfolio, simply because they are afraid of a bad economy or bearish stock market.

Over the long term, stocks have always outperforned bonds.  And over time, it is the erosion of purchasing power that is the biggest risk for most people.  Most bonds do not protect you from the ravages of inflation.

In the long-term, you need both equity investments for growth and bond investments for stability.  How you make that allocation decision is the most important determinant of how your portfolio will behave in the future.

To be continued.

Risks Worth Taking

Jim Parker of Dimensional Fund Advisors recently wrote a column on the proper approach to risk, as it applies to investing. To me it’s all common sense, but that sometimes is in short supply, just when you need it the most!  Read on to see if you agree.

A wise man once said that to profit without risk and to experience life without danger is as impossible as it is to live without being born. That all may be true, but which risks are worth taking and which are not?

The fact is even the most self-declared risk-averse people take risks every day. There are routine risks to our safety in crossing the road, in riding public transport, in exercising at the gym, in choosing lunch and in using electrical equipment.

Then there are the “big decisions” like selecting a degree course, choosing a career, finding a life partner, buying a house and having children. These are all risky decisions, all uncertain, all involving an element of fate.

In making these decisions, we seek to ameliorate risk by carefully weighing up alternatives, researching the market, judging possible consequences and balancing what feels right emotionally and intellectually, both in the short term and in the long.

Sometimes, we ask an independent outsider to guide us in making our decision. They do this by providing an objective assessment of the potential risks and rewards of various alternatives, by taking a holistic view of our circumstances and by keeping us free of distraction and focused on our original goals.

In investment, this is the value that a good financial advisor can bring—not only in understanding risk and return and how to build a portfolio but in knowing the specific needs, circumstances and aspirations of his or her individual client.

Quite simply, many people who invest without the help of an advisor take risks they do not need to take. They gamble on individual stocks, they rely on forecasts, they chase past returns, they fail to rebalance their portfolios to take account of changing risks and they run up unnecessary costs and tax liabilities.

To use an analogy, this is like trying to cross an eight-lane highway in the face of heavy traffic when there is a pedestrian bridge a little way down the road. You may well get to your destination safely through the traffic, but it will be despite your actions rather than because of them. Understanding risk in investment begins with accepting that the market itself has already done a lot of the worrying for you. Markets are highly competitive, which means that new information is quickly built into prices. Instead of trying to second guess the market, you work with it and take the rewards that are on offer.

Your biggest investment is in spending time with an advisor building a diversified portfolio designed to meet your long-term requirements, then meeting them periodically as your needs change and to ensure you are still on course.

In considering all of this, it is important to understand that risk can never be totally eliminated. If there were no risk, there would be no return. But your chances of a good outcome are far greater if you use the accumulated knowledge of financial science and the guiding hand of an advisor who knows you.

To sum up, risk and return are related. But not all risks are worth taking. The process of working this out starts with not trying to do it all alone.

All that Glitters …

Gold – among the most precious of all metals – has been on a tear, having gone up 18% in just the last three months.  Over the last decade, gold prices soared more than 300%.  Should you jump on this gilded bandwagon and attempt to capture possibly even greater returns in the future?

You have heard it said time and time again: There are no sure things in investing.  This year you cannot even count on death and (estate) taxes going together.  But, in general, you cannot win a race looking backwards.  Past returns are, well, in the past. 

Background

There are several reasons why gold is bought.  There is an industrial demand for it, and manufacturers use it to make jewelry.  The recent high interest and demand in gold is because it is perceived as a better store of value and the ultimate insurance for really bad economic times, as in a depression or hyperinflation.  Furthermore, some investors now consider gold as an asset that can help diversify a portfolio comprised of stocks, bonds, and real estate.  (In my opinion, the addition of an asset class usually happens after a sharp rise in its price.)

Looking at not just the recent past but putting gold prices into the historical context of the last 30 years tells a much less favorable story.

The last time we witnessed such high interest in gold was back in November 1979, when the price of gold rose from $400 an ounce to $850 by mid-January 1980.  Investors who poured in – expecting more of the same – were sorely disappointed.  By the end of March 1980, gold was back to selling at less than $500 an ounce, leaving investors who bought at the peak holding a stunning 40% loss for the quarter. Ouch.

Holding onto it didn’t help either.  By the end of the stock market run-up in early 2000, a single ounce of gold was selling for under $300 on the spot markets.

Today, of course, gold is hot; the shiny metal has tested all-time highs almost monthly, leaping from a little over $1,150 an ounce in late July to its latest all-time high, just over $1,365 in the middle of October.  Is it time to jump on this bandwagon and ride the gains up (according to some bullish newsletters) to $2,000 an ounce or higher?  Or is gold an overpriced investment ready to go bust?

Of course no one really knows. Obviously people disagree, as every time someone buys gold, someone else is selling it.

Things to consider

It isn’t real intrinsic demand driving the price of gold higher. Rather, it is investors (or speculators) who are buying at far higher prices than it costs to produce an ounce of gold.

There is no “shortage” of gold, as production over the past five years has been relatively stable at about 2,485 tons per year. In general, new mines are replacing the depleting production of current ones, so there has been little significant expansion in global output.

As prices rise, the market will probably see more recycled or scrap gold – a category which includes people selling gold jewelry. Between 2004 and 2008, recycled gold contributed 28% to annual supply flows.

There is no economic supply/demand imbalance, unless you count thousands of eager investors looking for more price run-ups or a hedge against inflation.

Is gold a reliable hedge against inflation? Since gold’s peak in the early 1980s, the annual inflation rate dropped, but cumulative inflation increased – just as gold was falling in value through the next two decades. According to InflationData.com, gold’s 1980 peak price on the spot market reached $2,250 if it were measured in today’s inflation-adjusted dollars, and the price fell to an inflation-adjusted $370 just two decades later. If gold had been an effective inflation hedge during that 20-year period, the price would have remained the same in inflation-adjusted terms.

So the numbers indicate that for long periods of time (but not always), gold can be a poor inflation hedge.   However, it does appear to be a pretty good “crisis hedge.” When people are concerned about a global liquidity crisis and/or an economic hangover (as they have been for the past couple of years), gold takes off. When the panic subsides, it is reasonable to expect that the price of the precious metal will decline.

Kenneth Rogoff is certainly not a “gold bug”, and he covers both sides of the argument in his article $10,000 Gold?

Pro

“In my view, the most powerful argument to justify today’s high price of gold is the dramatic emergence of Asia, Latin America, and the Middle East into the global economy. As legions of new consumers gain purchasing power, demand inevitably rises, driving up the price of scarce commodities.”

Con

“Gold prices are extremely sensitive to global interest-rate movements. After all, gold pays no interest and even costs something to store. Today, with interest rates near or at record lows in many countries, it is relatively cheap to speculate in gold instead of investing in bonds. But if real interest rates rise significantly, as well they might someday, gold prices could plummet.”

Conclusion

As Martin Feldstein wrote, “ Unlike common stock, bonds, and real estate, the value of gold does not reflect underlying earnings. Gold is a purely speculative investment. Over the next few years, it may fall to $500 an ounce or rise to $2,000 an ounce. There is no way to know which it will be. Caveat emptor.”

I certainly cannot predict whether the current fears will continue to drive gold higher. But history suggests that as soon as people start feeling more secure about the world situation, gold will suddenly lose its luster and leave its investors with significant losses.

If you buy gold now, are you investing or speculating? If you are speculating, is the best time to do it at near-record high prices?

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