You
are not alone.
There is an old Wall Street saying that warns not to confuse brains
with a bull market. The opposite also holds true -- don’t confuse
a bear market with stupidity. Bear markets make fools of everyone:
This bear market is no exception.
Sure, there will be stories about investors who called the bear
market right and somehow made money in this extraordinary environment,
much like investors who had life-changing and spectacular returns
in bull markets. These success stories, however, are not as common
as you might think.
The reality is that this bear market has thrashed nearly every
asset class, investment strategy and professional money manager.
Asset
classes that typically provide cover in down markets have not.
Disciplined investment strategies, even those some may consider
conservative,
have lost ground. The list of proven, experienced investment managers
with deep losses (often far exceeding the over-all market) is long.
As of November 20th, all of the nearly 12,000 equity funds monitored
by Morningstar had lost money for the year. “Smart” money
has lost. “Big” money has lost. “Fast” money
has lost.
While weak and still deteriorating worldwide economic conditions
are obviously a leading reason the global stock markets are down
so much this year, the brutal magnitude of the losses and the
extreme volatility have been greatly amplified due to non-economic
factors
such as emotional and forced selling. Motivated by sharp losses
and extreme volatility, individual investors have been crying “Just
get me out of the market,” regardless of fundamental factors
such as valuations. They have now dropped their equity allocations
to their lowest levels in decades. Institutional investors meanwhile,
such as mutual funds and hedge funds, are being forced to sell
securities to raise enough cash to meet shareholder redemptions
-- regardless
of what the portfolio managers may think of the investment merits
of the individual securities.
The silver lining to such emotional
selling is that it thankfully tends to be temporary. The markets
will eventually revert back
to tracking fundamental factors at some point. When they do,
given the
degree of market dysfunction and dislocation in recent months,
there should be plenty of opportunity.
Nonetheless, while bear markets are normal, and just a part of
the market cycles, this current bear market has been particularly
brutal.
It has shaken basic confidence in the markets to the point that
investors are starting to wonder why they should even invest.
Can You Be An
Investor?
Many years ago, I worked with an investment professional who consistently
stressed that the most important question for an investor to ask
is not “Which way do I think the market is going?” but
simply, “Can I be an investor?” In short, long-term investment
success wasn’t about calling the market, but more about being
aware of one’s personal financial and emotional capability
to invest in a volatile stock market.
From a financial capability standpoint, in order to be a long-term
investor one needs to be able to stay the course during challenging
markets and ride out temporary losses. Important factors here include
a sufficient income and net worth. The level of debt, if any is
held, should be manageable. A safety net, such as insurance and a
reasonable
amount of cash on hand (at least enough to cover six months of
living expenses), should be established to handle emergencies. By
definition,
a longer time horizon is required. If the money in question was
needed for a specific purpose within the next few years, the capital
should
not be exposed to the stock market.
As for an investor’s psychological or emotional capability
to take on risk, everybody’s emotional reaction to market volatility
is different. It is not uncommon to see people who take significant
risks in their professional or personal lives have conservative investment
temperaments – or vice versa.
Sometimes, it may take years to adequately sort out one’s emotional
risk tolerance. Whether an investor does it on their own, or through
dialogue in a relationship with an experienced investment professional,
an investor often has to live through the ups and downs of the markets
to begin to fully appreciate and understand how much risk and market
volatility they are willing to tolerate. Determining one’s
risk tolerance is not easy, but awareness of how it may be evolving
is critical to formulating an investment strategy that will serve
an investor well over time.
The Best Time to Invest
The stock market is not a zero-sum game. Historically, it
has provided a positive long-term total return. Moving forward,
it is expected
to provide a positive long-term total return. Given this positive
expectation, long-term investors should take note of some advice
from late, great money manager Sir John Templeton, who once quipped
-- the best time to invest in the stock market is whenever you
have the money.
A common statement of many investors of late is that the losses
over the last year are so steep that it will take many years
(“if
ever” for the truly gloomy) before they will recover what
they have lost. Thus, they are exiting the markets; to this investor,
we would like to make a few remarks.
While the losses on stocks
are indeed severe, a decision to invest
in the stock market today should be based on expectations of
total returns going forward, rather than on what they have
been in the
past. Then those return expectations need to be compared with
those of alternative investments including cash (money markets).
On that score, we have commented recently on how the expected
return on stocks looks better now than it has in decades. In
addition,
the return expectations on stocks versus Treasury bonds or
cash are the
most attractive in decades, as well.
To look at one example of why we find stocks very attractive moving
forward, the chart below shows the rolling 10-year annualized return
on our favorite sector of the U.S. equity market – large cap
stocks. As you can see, the most recent 10-year annualized returns
on large cap stocks through Sep 30th were very weak at around 2%
(through Nov 30th they were roughly flat). Large caps have touched
these levels 4 previous times since 1827 and each time the fortunes
of large cap stocks were to turn quite strongly for the better. Like
the economy, the market tends to move in cycles.
Overcoming Emotions
Many investors these days do in fact “intellectually” accept
the notion that the stock market is reasonably priced, if not cheap,
and may present its best buying opportunity in many years. Despite
that view, however, many are not “emotionally” able to
commit new funds -- even to simply rebalance their portfolios back
to desired long-term targets.
Say for example you were at your long-term target allocation at
the beginning of this year with a mix of 50% stocks and 50% bonds.
Using the returns of the S&P 500 index for stocks and the Lehman
Aggregate Bond index for bonds, you would now have 38% in stocks
and 62% in bonds. So just to return your portfolio to its long-term
target would suggest shifting roughly 20% of your bonds back into
stocks.
Yet because investing has a strong emotional component and volatility
has been so destabilizing, it is very hard to do. One potential
way around the emotional nature of this issue is to try moving
towards your goal in steps.
Take an investor who is currently all in cash, but recognizes that
a more reasonable long-term allocation to the stock market given
their personal situation is more like 60%. They could move 20% of
their cash into stocks now, another 20% in three months, and the
final 20% in another three months time.
Compared to an “all or nothing” decision, moving toward
your desired allocation in a somewhat systematic and non-emotional
way, is both easier to start and easier to stay with. If the market
continues down during that first month, only 20% of your money was
affected, and the next 20% will be buying at cheaper prices. If the
market rises, at least you enjoyed those gains on 20% of your money.
One More Thing – Withdrawal Rates
Ultimately, investors cannot control the markets. Investors
do have some control, however, over key elements in a successful
investment
program, including how much they can invest, how a portfolio is invested,
and how money is withdrawn from an investment portfolio.
On this last point regarding portfolio withdrawal rates, it is important
to maintain the discipline to keep withdrawal rates at reasonable
levels, particularly during bear markets. This may mean that lowering
the absolute amount of dollars withdrawn may be required. Standard
rules of thumb for withdrawal rates are typically 3% to 5% of the
over-all portfolio value. Some institutions, such as foundations
and endowments, may establish spending policies that look at withdrawing
a set percentage of a multi-year (such as over 3 years) portfolio
value average instead of a single period value. Either way, adjusting
withdrawal rates based off over-all portfolio values is prudent and
perhaps even necessary for some investors given the current market
conditions.
A Time to Plant
We believe that most investors are better served
by not being radical in their investment approach. Instead, for most
investors the best
investment plan is to build an appropriate allocation based off an
investor’s unique time horizon and risk tolerance. Moderate
adjustments may be made around the neutral allocations based off
relative valuations. Re-balancing, more than ever after strong market
moves, is also a good investment practice.
In the end, investing is humbling. This is the case in all market
environments, but especially so when the stock market is down. Nonetheless,
it is important to remember that a new bull market will surely follow
the current bear market --- just like it always has. There is simply
a time and place for each. Like there is a time to harvest, there
is also a time to plant. With the stock market at its best valuations
in at least a generation, this appears to be an excellent time to
plant.
Sincerely,
