The Resilience of Capitalism

In light of the very turbulent investment markets over the last few weeks, I offer the following much-needed perspectives.

Many investors may find themselves questioning their ability to remain in their investments right now. If you are concerned, the first step is to consider the proper time horizon for your investments. If your time horizon or liquidity needs have changed since you last took the Risk Capacity Survey, you should take the survey again to determine if an adjustment in your Index Portfolio (risk exposure) is necessary at this time. If you are routinely withdrawing funds from your portfolio, we recommend that you not withdraw more than 7% of your portfolio’s value per year, with a 5% withdrawal being optimal.  When markets have declined, you should reduce your withdrawals to as low as you can stand. In other words, cover your fixed costs and reduce your variable costs.

As a general rule of thumb, the equity allocation of your portfolio should have an approximate time horizon or holding period of 7 to 10 years.  This would indicate that you should have an allocation of fixed income that will meet your withdrawal needs for approximately 5 years.  So if you are withdrawing 5% per year, you should have at least 25% of your portfolio in fixed income.  Our Risk Capacity Survey is the best method to determine your asset allocation, because it considers all five dimensions of your risk capacity, of which time horizon is the most important, but not the only factor.  (See Step 10: Risk Capacity of The 12-Step Program for Active Investors.)

History is not required to repeat itself, but out of the last 481 ten-year periods for Index Portfolio 90, not one had a annualized return below a positive 4.27% per year and the average annualized return in 10-year periods was 13.36% with a standard deviation of 4.21%.  The highest return in 10-year periods occurred from 9/77 to 8/87, where Index Portfolio 90, a simulated and rebalanced blend of eleven indexes from around the world, earned 22.84% annualized over that 10 years.

To most people’s surprise, the worst 4-year period was a loss of only -1.74% annualized. In contrast, the last four  years ending September 30, 2008 had an annualized return of 6.22% (see www.ifacalc.com and please note that the month of October 2008 is not over yet.).  But if you invested the equity portion of your portfolio at just the wrong time, way back in January 1969, you would have gone through 6 years of gyrating ups and downs that resulted in an annualized loss of -5.29% per year.  However, if you stayed the course for 10 years from this unlucky starting point, as IFA currently suggests you should do, you would have ended up with a positive 6.57%  annualized return for the 10-year period ending in December 31, 1978.  Remember that these well diversified portfolios contain about 17,000 companies from 40 countries around the world, what I like to refer to as Capitalism, Inc.  Over time, these companies will make profits and that is what ultimately drives stock market returns.  If they all stopped making profits for extended periods of time, we would have problems far beyond the stock market.

In an October 17, 2008 Op/Ed article, Warren Buffett stated that he is aggressively buying U.S. stocks, stating “If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.” Buffett continued:

“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.”

“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

“Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: ‘“I skate to where the puck is going to be, not to where it has been.”

In William Bernstein’s book, The Four Pillars of Investing, he discusses market bottoms and the agony and the opportunity that exist at that point in time. In the section titled How to Handle the Panic he says, "What separates the professional from the amateur are two things: first, the knowledge that brutal bear markets are a fact of life and that there is no way to avoid their effects; and second, that when times get tough, the former stays the course; the latter abandons the blueprints, or, more often than not, has no blueprints at all."  The blueprint for IFA clients is the Investment Policy Statement, the investment strategy is discussed and the answers to the risk capacity survey are spelled out and analyzed. Here is a paragraph from the IFA Investment Policy Statement:

“A properly constructed IPS provides support for the investment manager to follow a well-conceived, long-term investment discipline, rather than one that is based on constant revisions brought on by lack of knowledge, overconfidence or panic in reaction to short-term market movements. The absence of a written policy reduces decision making to an individual event basis and often leads to chasing short-term results that detracts from achieving long-term market rates of returns. The existence of a written and agreed upon policy encourages all parties to maintain their focus on the long-term nature of the investment process, especially during the extreme fluctuations in stock market returns.”

We are making continuous updates to the ifa.com "What's New" column on the home page, but a recent important message from DFA’s Weston Wellington is titled “Is It Different This Time?" Click here to view it. This insightful and informative presentation reveals that time after time, headlines have been poor predictors of future market movements. I encourage you to take some time to view Weston’s outstanding research regarding stock market greed, fears and media hype in relation to what actually happened.

An important Marketwatch.com interview with Vanguard founder John Bogle provides further insight as to how to manage investments through this challenging time. He tells us that if you're following the rules of asset allocation, diversification and long-term time horizon, stay the course. This is precisely the advice IFA has been telling its clients since for almost 10 years. Many investors are just now learning these age old lessons of investing.
An investor’s return is explained by their risk exposure, not by the speculation they made on future prices.  Way back in 1900, Louis Bachelier explained in his now famous paper, “The Theory of Speculation”, that investors should not expect to benefit from speculation on future prices. When you add in the cost of trading and trading mistakes, active investors should expect far less than the market rate of return for the risk they took.

As painful as the last few weeks have been, many investors have learned the hard way that poor risk management, leverage and lack of transparency carry steep levies. But as we have heard before, when you lose, don’t lose the lesson.

Nobel Prize winning economists and academics have revealed that broad-based diversification among low-cost indexes has shown to be the most prudent investing strategy over time. Harry Markowitz, the 1990 Nobel Prize in Economics winner and newly added Academic Consultant to Index Funds Advisors, recently stated, “In choosing a portfolio, investors should seek broad diversification. They should understand that equities and corporate bonds involve risk and that markets inevitably fluctuate. Their portfolio should be such that they are willing to ride out the bad as well as the good times. “

When the markets abruptly turn around, investors who bought and held risk-appropriate portfolios of low-cost passively managed index funds will be in position to benefit from the market’s reaction to the unexpected news events that will once again show the resilience of capitalism.  In the meantime, as long as you invest according to your risk capacity and keep your eyes fixed on your time horizon, you should do your best to ignore the media and spend your time on the things in your life that you enjoy.