Last week I was contacted by Sarah Morgan, a writer for SmartMoney.com, who had some questions about the recent volatility and decline in the stock market.  Normally, I don’t respond to the press, but her initial question struck me to my core.  Ms. Morgan wanted to know if clients were panicking.  My clients?  Panicking?  She obviously did not know me or my investment philosophy.  My email response to her was this, “I would take it as a tremendous failure of education and preparation if my clients were panicking now.”  

I went on to say that in trying to time the market (which, as I’ve said before, is patently impossible) investors are more likely to hurt themselves by not being invested when the rebound comes.  And, as historical data prove, there is always a rebound, because the long-term trend is up.

I admit that I took pride in being able to tell Ms. Morgan that clients of Key Financial Solutions do not panic.  Rather, they sit and hold tight and ride out the roller coaster.  They’re prepared for short-term fluctuations and declines, simply because they have a long term plan.

Their Investment Policy Statement specifies a well-balanced portfolio that includes a combination of stock mutual funds and bonds (in ratios that we have decided upon, based upon time horizon, risk tolerance, etc.).  So, even a 10% decline in the stock market has little effect on my clients.  And should a market decline be steep enough to affect a portfolio, rebalancing – selling some (appreciated) bonds and buying some (now, underweight) equities – is appropriate to reestablish the portfolio’s target mix.     

That information was enough to spur a half-hour long phone conversation and a follow-up email. 

It was gratifying to read the article, After Market Slide, What’s Your Next Move?, and not just because I was quoted.  No, I was happy to see that Ms. Morgan got it right. She quoted a number of people who said that long-term investing is the key to success.

Having a well thought out Investment Policy Statement is the best chance I know of to stick with a long-term plan.  When markets experience extreme volatility, it sure helps to have a strategy that is based on more than a prediction of what today’s news means to your investment portfolio.

And what are the rewards of long-term investing versus the risk of getting out of the market?  Christopher Davis of Davis Advisors gave a presentation at the NAPFA (National Association of Personal Financial Advisors) National Conference.  Here is what he reported.

Average Annual Returns for 1995 – 2009 for investing in the S&P 500

For a fifteen year period, if you missed the 30 best days, you could have managed to lose 2.6% per year, versus earning 8.0% per year.  Thirty days in 15 years!

So let me turn the original question on its head, “Why would anyone risk being out of the stock market?”

But there are other compelling reasons for listening to him; simply put, he speaks in a way that anyone can understand.  It’s a Midwestern common sense, seasoned with well-earned and certainly, much deserved, confidence. He’s cheerful, loves what he does, and apparently cares very little about consumption.  He is extremely grateful for the opportunity he has had in the United States and the life that he has lived.  He has already given away billions and plans to give away still more to charitable foundations.

Buffett was a guest on the November 13th episode of the Charlie Rose TV show.  Unfortunately, only excerpts of that show are available for online viewing. Go to the Charlie Rose website and search for Warren Buffett. What you’ll find are his ideas on financial regulation, his reasons why he bought the Burlington Northern Santa Fe Railroad, and his assessment of the global economy. There is also a “Web Exclusive” interview.

A full written transcript is available here.

I’d like to focus on his basic optimism about the future of the United States, because in my opinion, you need three things to be a successful long-term investor.

• Faith in the future.
• Patience.
• Discipline.

Here are some relevant quotes from the November 13th program.

(Regarding consumer demand)  Well, it will come back eventually. … Our system will still work. … We talked last year about the patient, you know, being on the floor with a cardiac arrest … and we’re not out of the hospital yet.   But we will come out of the hospital.  This — the things that made America what it is have not disappeared, and they will — they will assert themselves with time.

The American economy will come back.  It won’t be tomorrow, and, you know, it won’t be exactly the same.  But in the end, we have not — we’ve not changed the American people in their capacity to innovate or their excitement about — about becoming more prosperous, and coming up with new ideas.  Businesses will be formed.  Businesses will expand.  But not much tomorrow.

If you look back a couple of hundred years, we’ve gotten where we are not because we’ve gotten smarter or not because we work harder.  We’ve got it because we found ways to unleash more of the human potential.   And what does that?  Well, a rule of law helps.  A market system helps.   Equality of opportunity helps.  All of these things that are still a fundamental part of the American system. As a matter of fact, the American system is now better than it was a couple of hundred years ago, because until the 19th Amendment, you know, we’ve had half the talent in the United States that wasn’t entitled to do much. So we’ve got a great system.  (Emphasis added.)

Well, I have everything I want in life, so there’s nothing to spend it on.  I mean, I could have 10 houses instead of one, would I be happier?  No way.  I could have 10 cars instead of, you know, two in the house.   I wouldn’t be happier.  You know, it would drive me crazy.  I could have a 400-foot boat, you know, and then I’ve got to have a crew of 50 or 60, and some of them (inaudible), sleeping together — I mean, who knows what would be going on. So I don’t — if I wanted to be a ship’s captain, you know, I’d have gone into a different profession.  I have everything in life I want.

I love working — I love working with the people I work with.   I love just viewing the human scene, but I mean, I have an ideal life.  I get to do what I want to do every day.  So, you know, and money can’t — can’t buy any more than that.

As I said earlier, you need three things to be a successful investor:

Faith in the future. Optimism is the only realistic attitude; you cannot be fearful and succeed as an investor.

Patience. Moving in and out of the market or among various investments does not accomplish anything.

Discipline. Do not be driven by headlines or events.  Ask not, “What’s working now?”  Ask, “What always works?”

I believe Warren Buffett to be instructive and inspirational on all three counts.

In a previous post, When Our Brains Short-Circuit, I wrote how our brain can affect our long-term investing performance, because we can be afraid of the wrong things.  There is actually much more to be said on the the discipline known as Behavioral Finance.  And given the extremely difficult year we (investors and advisors, both) have all suffered through, now would be a good time to reassess our actual risk tolerance and try to understand how our emotions affect our investment results.

For an excellent summary of the practical implications of Behavioral Finance, I recommend a video presentation by Scott Bosworth of Dimensional Fund Advisors.  His 20 minute talk, with slides, is called Behavioral Biases and Investment Implications. It combines theory, research and experience, but rest assured it’s not so technical that you’ll need a PhD to sit through it.

Bosworth discusses common biases, how they affect decision-making, and how investor behavior impacts investment results.

Here is my take on his presentation.

Overconfidence and Extrapolation

Overconfidence and over-optimism can cause investors to make irrational investment decisions; for example they may buy stocks that have gone up in price, simply because they have gone up in price.  And many people believe they are smart enough to forecast the future, even though the future is unpredictable.

Hindsight Bias

Selective recall leads us to believe that past events should have been easy to predict.  Consequently, we believe that future events should also be easy to predict.  They are not.

Fear and Panic

When stock prices go down, investors feel the pain and fear more is on the way.  The media feed on this fear.  They are interested only in getting more advertisers, not your investment success.  TV pundits, with their incessant and contradictory predictions, only serve to confuse you further.

After a steep decline, many investors just want to unload their stocks – they’ll sell at any price.  The problem is that this common behavior merely locks in losses.

Moreover, getting out of the market can create more stress (not less) in your life, because at some point you have to decide when to go back into the market.  Just when is that?  After you are no longer afraid?  After the market has gone up by 20%, 30% or more?  After you’ve missed the rebound entirely?

Conclusion

The natural inclination of investors is to buy high and sell low.  That is more than unfortunate. It is also why the research shows that investors typically under-perform the stock market, all of the time.  Buy-and-hold investors, on the other hand, typically earn higher returns than those investors who try to time the market.

Unless you have a trusted advisor with a strong long-term philosophy, you may not survive the stock market’s turmoil.  And make no mistake, the emotional responses of investors is a challenge that financial advisors have had to confront this last year.

Educating clients, instilling discipline and maintaining the right strategy are what good advisors provide.

As you may recall, on Friday, March 6th I wrote that it was a mistake to be scared out of the stock market.  The stock market actually hit its bottom on the next business day, Monday, March 9th.  Since then, prices have soared, not in a perfectly straight line, true, but the increases have indeed been spectacular.

What does that mean?  That I can predict stock market prices?  No, absolutely not.  That remains an “unacquired” skill.

What it does mean, though, is that I follow a buy and hold philosophy, because getting out of and into the stock market again and again is a losing strategy, simply because you are not going to do it well.  One benefit of working with a fee-only financial advisor is avoiding the emotional swings that accompany volatile stock prices.

Please read my March 6th post, Nobody is Buying Stocks?  in which I mocked the total negativity that was seemingly everywhere in the media.  I pointed out just how overblown the language used at the time was:

“With so much uncertainty, investors are parachuting out of companies…”

“No one is taking a back-seat approach. Everyone is just selling.”

“It’s like an unending nightmare.”

Please take a moment to read the entire post (if you haven’t already), but here is the conclusion if time is pressing:

“No one knows what tomorrow will bring, but unless capitalism ceases to function, stockholders will be rewarded in the long term for owning stocks and for taking risks. Yes, there is risk in owning stocks, as we have recently experienced. Since we’ve already seen the risk, how about staying around for the reward?

An old Wall Street proverb is that “Nobody rings a bell at the top or the bottom of a market.”

Are you waiting for that bell to ring?  Don’t.”

As I pointed out, since March 9th stock prices have soared.

Understand, though, stock prices can go down again.  In fact, I can  guarantee that.  Once again, I am not clairvoyant, and I rarely make predictions.  But, I have counseled a buy and hold strategy for many years. There is no evidence that anyone can get in and out of the market at the right time and improve on a buy and hold approach.

Heaven help the person who got out of the market earlier this year.  The March 6th post quoted financial advisor Bijon Mishras who said, “I want to wait for a firm turnaround, and be as safe as possible.” I wrote, “Whoa, Nelly. Remember this quote and see how it turns out.”  So, Bijon, is now the time to get back in?

On March 16th I wrote a series which started with Is Buy and Hold Not Working? Part 1.  I said that timing the market was impossible, “The evidence shows that most investors get it wrong over and over again.”

“Historically, stock markets have had sharp increases following a bear market.  The difficulty is identifying when that move is for real.  Bear market rallies, bear traps, etc. tend to keep investors gun-shy, so a sustainable bull market rally will only be identifiable in hindsight.

Nevertheless, individuals who keep their investments in cash or Money Market funds will miss out on most of the move.”

Conclusion

I’ll stick with what I said on March 27th, “Given what does not work, what is the recommended approach?  In my opinion, it is a diversified, low cost, buy-and-hold portfolio matched to your time horizon and risk tolerance.”

A good advisor should help you do that and also avoid the “big mistakes” of buying high and selling low.  Is that worth the annual amount you pay a fee-only advisor?  I certainly think so.  Do the math.

Have we (i.e. mankind and womankind) developed in such a way that we are prone to making bad long-term decisions?  Is it a matter of evolution?  Is there any hope?

Last week, Nicholas Kristof wrote a column with the eye-catching title, When Our Brains Short-Circuit, that I read with interest.  I believe that the article provides lessons for all of us, as citizens and as investors.

A quick summary of Kristof’s thesis is that, because of the way we perceive risks, our brains are not suited to solving long-term problems.  His column addresses the issue of carbon emissions, global warming and how we are reacting to this threat.  It is not my place to assess the degree of the threat or the comparative advantages and disadvantages of suggested solutions such as a cap-and-trade system versus a tax on carbon, so I won’t even try.

What I would like to do, however, is to point out that our brains can sabotage our individual financial decisions, so the concepts are quite relevant for us as investors.

First, I’d like to recommend Nicholas Kristof’s columns, which are, for me at least, required reading, because he frequently writes about topics that are generally ignored by other columnists.  Sometimes the subjects are quite disturbing – the tragedy in Darfur, human trafficking, and the immense suffering caused by poverty in the developing world.  While it is upsetting to read about such things, he is not just about just gloom and doom.  He also writes inspiring stories about courageous and innovative people who are making significant improvements in the lives of others.  Overall, I find Kristof’s writing riveting.

Here are some quotes from his column.

Evidence is accumulating that the human brain systematically misjudges certain kinds of risks.  In effect, evolution has programmed us to be alert for snakes and enemies with clubs, but we aren’t well prepared to respond to dangers that require forethought.

“What’s important is the threats that were dominant in our evolutionary history,” notes Daniel Gilbert, a professor of psychology at Harvard University.  In contrast, he says, the kinds of dangers that are most serious today — such as climate change — sneak in under the brain’s radar.

Professor Gilbert argues that the threats that get our attention tend to have four features.  First, they are personalized and intentional.  The human brain is highly evolved for social behavior (“that’s why we see faces in clouds, not clouds in faces,” says Mr. Gilbert), and, like gazelles, we are instinctively and obsessively on the lookout for predators and enemies.

Second, we respond to threats that we deem disgusting or immoral — characteristics more associated with sex, betrayal or spoiled food than with atmospheric chemistry.

Third, threats get our attention when they are imminent, while our brain circuitry is often cavalier about the future.  That’s why we are so bad at saving for retirement.

Fourth, we’re far more sensitive to changes that are instantaneous than those that are gradual. We yawn at a slow melting of the glaciers, while if they shrank overnight we might take to the streets.

In short, we’re brilliantly programmed to act on the risks that confronted us in the Pleistocene Age.  We’re less adept with 21st-century challenges.

This short-circuitry in our brains explains many of our policy priorities.  We Americans spend nearly $700 billion a year on the military and less than $3 billion on the F.D.A., even though food-poisoning kills more Americans than foreign armies and terrorists.

Risk Perceptions

All four of Gilbert’s “features” affect people’s perceptions of many aspects of finance, but let’s focus on this one – “we’re far more sensitive to changes that are instantaneous than those that are gradual.”  How does this affect a comparison of risk perception regarding stocks versus bonds?  Remember that all investments have risk. 

Consider the word “bond.”  It sounds substantial, even reassuring; “My word is my bond.”  We believe bonds to be something sturdy and steadfast. Stocks prices, on the other hand, we know to be variable, fluctuating for no apparent reason.

Encouraged by the media, we are all riveted by substantial stock market declines, especially if they occur over a short period of time.  From all media accounts, it seems as though the sky must be falling; certainly the adjectives bandied about by TV broadcasters don’t help: meltdown, disaster, crash. 

Even something as simple as the phrase, “stocks are declining today” is misleading.  It would be more accurate to say “stocks have declined.”  To say they “are declining” implies that they will continue to go down, which may or may not be true.

Market volatility can be sharp, sudden and terrifying.  And yet we know that the long-term trend of stock market prices is up.  In fact, on a yearly basis, stock market returns are positive in seven out of ten years.  Of course, we cannot know which years will be positive and which will be negative, but we do know that investors expect to be rewarded for taking risks, and they are rewarded, over the long term.

The Real Risk

Consider, on the other hand, what I think is the real risk for investors – the long-term erosion of the purchasing power of the U.S. Dollar. You never see a large increase in prices on any given day, but over time, inflation has been slow, constant and nearly invisible.

In truth, we vastly overestimate the probability that a stock market decline will cause us to suffer catastrophic losses, but we also vastly underestimate the probability that, over the decades of retirement, erosion of purchasing power will grind down our lifestyle.

Wise investors will constantly remember that markets can and do go down suddenly and significantly, but they have never stayed down.  For the long-term investor, the effect of declines has been negligible.

By the same token, prices very rarely go up much in any one year, but they virtually never stop going up. You can observe the cumulative effect by comparing a 15-cent first-class U.S. postage stamp issued to celebrate the 1980 summer Olympics with a brand new 44-cent stamp today.

And yes, I know that currently inflation is not a concern.  But my prediction is that it will be; I just do not know when.

Conclusion

I believe that investors should have both stocks and bonds in their long-term portfolio, and for reasons discussed in earlier posts, I favor mutual funds, not individual securities.  My advice is don’t be so concerned with short-term fluctuations in stock prices.  Remember, the real long-term risk is the erosion of your purchasing power.

For a longer discussion of the real risk of the loss of purchasing power over time, read Nick Murray’s book Simple Wealth, Inevitable Wealth, which also provided the postage stamp example.

Everyone wants to know which way the stock market will be headed. Yet, most people say that they are investing for the long term. Why then do so many people have this fascination with predicting the future? What difference will it make? Maybe they are control freaks, or have some other psychological issue?  Personally, I think it’s because this is what investors have been taught will determine a successful investment program.

In any case, the question seems to come up frequently at social gatherings, “Is this a good time to invest in stocks?” Often, friends will repeat to me a forecast that they have heard. For example, three months ago an officer of a non-profit organization told me her stockbroker said that the Dow Jones would be going down to 7,200; at the time, the Dow was about 7,800. (Wow, I thought, a clairvoyant stockbroker.) As it turns out, his prediction came true. But really, how useful was that prediction, given that the Dow Jones Average is now above 8,400?

Market Timing

More recently, two friends were engaged in a conversation about the direction of the stock market.

One friend had determined that it was a “good time to buy” and had acted accordingly. The second friend had reached the opposite conclusion, saying that the market was “overbought” and he expected a pullback. He had actually “taken some profits” by selling some positions, and he had, in addition, sold short two stocks that he thought would be going down. (Selling short is a way to profit from a decline in a security.)

Clearly they disagreed, and very probably only one would turn out to be right. When asked why I remained mum on the subject, I simply replied that I don’t do forecasts.

Now, back to the original question of “Why Attempt to Forecast the Stock Market?” Well, perhaps as a result of the wild ride we all recently “enjoyed” in the stock market, it’s difficult not to try. From a high on October 9, 2007 to the current market bottom of March 9, 2009, the S&P 500 went down almost 57%. This is the sharpest decline since the Great Depression. Since March 9th, though, the S&P 500 has climbed by about 35%.

Wouldn’t it be great if we could have timed those market swings? As I’ve written in the past, although it would be very nice, it is also virtually impossible. Of course, we keep trying. And some people have placed mistaken confidence in “experts” who seem to know what they were talking about.

The problem is, of course, that market gurus frequently disagree. And choosing one simply because he was recently correct in his predictions could be a big mistake, since there is little consistency in making good forecasts.

Long-Term Investing

I would argue that since no one knows what the short-term direction of the stock market will be, it is a mistake to base your investment philosophy on such predictions. Moreover, it is not necessary to predict the future to have a successful investment experience.

If we really are long-term investors, the only way to benefit from growth in the economy is to invest in equities, which are, in fact, ownership interests in corporations. This doesn’t by any means imply that we should only invest in stocks or stock market mutual funds.

But to ignore the basic difference between a fixed income investment, such as a money market mutual fund, CD, or a bond and equity investments is a major mistake. Fixed income investments have a limited, although more predictable, return. Stocks have higher expected returns, but there is more uncertainty as to just what they will be.

Risk and Return

Why do stock investments have a higher expected return than fixed-income investments? Because they have higher risk. Risk and return are two sides of the same coin.

Nobel Prize winning economist William Sharpe summarized it quite well when he talked about the essence of his award winning research and how risk and return are related. “The bottom line: Yes, Virginia, some investments do have higher expected returns than others. Which ones? Well, by and large they’re the ones that will do the worst in bad times.” (Emphasis added.)

This may sound like a flippant remark, but it is the truth. I think, unfortunately, many people have forgotten the word “expected.” When talking about stock market returns, we got so used to hearing that stocks were superior investments in the long-term, that we forgot about risk. No one ever said that “expected” returns would be “realized” returns, though it seems a lot of people jumped to that conclusion.

A couple of months ago, I thought that some people were unfortunately panicking out of stocks. Their approach was to “go to cash and wait for things to sort themselves out.” Based on past experience, I was concerned  that these frightened investors would miss out on the inevitable recovery. Although no one knows if the stock market did hit its bottom in March, as of now, it was a mistake to have gotten out of the market.

My advice for long-term investors remains the same: To choose carefully an appropriate allocation of stocks and bonds, which depends on your time horizon and your need and your willingness to accept the risk.

After that, you need to diversify properly, keep fees and other costs down, and be aware of taxes. Then follow a buy and hold philosophy, with appropriate rebalancing to your target allocation.

Warren Buffett has famously said that investing is “simple, but it’s not easy.”