Quarterly Newsletter – October 2008
What is going on now in the financial markets is both unprecedented and yet also just the same old stuff. And the same rules apply. There are two types of investors, or two types of investment behavior – pro-cyclical and contra-cyclical. Pro-cyclical investors drive markets faster in whatever direction they are already going. They buy when prices are rising and sell when they are falling. This behavior creates bubbles and crashes, as we are now witnessing. When this is done using borrowed money, as with investment banks or hedge funds, the selling can become forced selling. When this occurs assets are sold at any price, any price at all, regardless of long-term value. At this moment money is being pulled from leveraged hedge funds. The funds are being forced to sell anything they have to cover redemptions. Pure blind panic rules the markets.
The pro-cyclical nature of human emotions and the bull-horn of the media contribute to the panic. People can also be forced to sell not by leverage but by fear. The more the markets fall the more it seems- or feels – that they will continue to fall – and down they go. The TV shouts and the fear rises.
But there is a choice. Contra-cyclical investing allows investors to avoid the boom and bust cycles. Consider the following quote from an article by Jason Zweig from the October 4th Wall Street Journal entitled Summon Your Courage and Buy Stocks.
This past Thursday, Columbia Business School held a conference on value investing to commemorate the publication of the revised edition of Benjamin Graham’s classic volume, “Security Analysis.” Seth Klarman of Baupost Group in Boston is an editor of the book and one of the leading value investors in the country.
“Normally, as a buyer you have to compete with a lot of very, very smart competitors,” said Mr. Klarman. “But many of the smartest people are on the sidelines now because of redemptions, margin calls or panicked-out-of-their-mind selling. So you don’t have to be as smart as you did before. You just have to be in the game.”
The day Mr. Klarman spoke, the Dow fell an additional 348 points, and 658 stocks, or more than 15% of the total, hit new 52-week lows on the New York Stock Exchange. Yet the word Mr. Klarman and several other speakers kept using was “excited.”
That is because investments everywhere are priced as if the whole solar system were going out of business. U.S. stocks have lost 24% since January 1; foreign stocks are off 32%; emerging markets, nearly 40%; junk bonds are down 13%; even municipal bonds have fallen almost 10%. Money is pouring into U.S. Treasury debt — so much so that stocks now offer more income than bonds do. The dividend yield on the Dow Jones Industrial Average is currently at 3.14%, higher than the 2.68% yield on the five-year Treasury note.
With so many professional money managers afraid to act, with most of the public in the grip of fear and anger, you should put your cash and your courage to work. If you have no cash, use your courage: Rebalance by selling a little of anything that’s gone up and buying more of whatever’s gone down.
We think this is exactly right.
We first developed and wrote down our principles of investing 18 years ago. They are our culture. We are long-term, contra-cyclical investors. We use a disciplined investment policy approach to steer away from emotions, to sell as markets are rising and to buy as they fall. You absolutely cannot win the investment game without being in the game. The market has fallen. One day it will rise again. There is lots of evidence that markets cannot be successfully timed. Hold on and buy more as prices fall. Your portfolio will rise again only if you stay invested. This is our method.
Here are our principles of investing:
Asset allocation is the single most important factor in determining portfolio risks and return. We believe that your asset allocation should be based on your life and not on some view of the future course of markets. We accomplish this through your financial plan – a detailed model of your financial future under a set of assumptions that are conservative. Financial markets are profoundly unpredictable in the short-term because in the short term they are far more dependent on the supply of liquidity than on judgments about the long-term future earnings of securities. Short term investing is called market timing. The problem with market timing is when to re-buy. If an investor sells and then stays in cash or CDs, that person has an expected return of 0.5% after inflation. Stocks have an expected return of 7% after inflation. This is a gigantic difference. Thus a person who sells stocks will presumably want to re-buy. But when?
Presumably after the market has already gone up. Ok. Fine. That means the investor will, by definition, miss some very good months. Fear will keep this person out of the market till it has gone up “enough” to remove the fear. How much is that? And how much is missed?
Take the period January 1980 through August 2008 (thirty years). In that period of time one dollar would have become $27.13 if invested in the S&P 500. But, if the six single best months
(not in order – the six single best) are removed (because this investor was hiding out waiting to buy) – then the dollar became only $13.88. In other words, missing 2% of the months (6 out of 360) would have reduced the total return by more than 50%. Academic studies have shown that market timing and security selection account for only 6% of the total return of a portfolio. Asset allocation makes up the other 94%. Clearly the thing to keep your eye on is not timing but allocation, which is why it is our first principle.
The holding period on the portfolio is the primary determent of proper asset allocation. Your financial plan helps us construct an appropriate risk structure for your assets. Money for short term goals is invested differently from money for long term goals. Remember that there are two primary investing risks – volatility and inflation. Your investment time horizon for your long-term money is not your retirement date but rather your date of death or in some cases your heirs’ dates of death. Inflation is a huge risk to this long term money. The compromise between mitigating those risks is dependent on the holding period. Thus your long-term money must have some equity exposure. Your short-term money should not. Because it is all laid out in your financial plan you can have confidence that the money invested is taking risk in an appropriate way and that the money not invested is safe from market fluctuations.
Diversification is the key to higher risk-adjusted returns. Through the mutual funds in your portfolio you own shares in approximately 25,000 different companies all around the world. You own U.S. and foreign shares, large and small company shares, growth and value shares and emerging markets and real estate. The bond funds we use are divided between short and long-term debt, inflation adjusted bonds and high-yield bonds. They are also highly diversified, with thousands of bond issuers in them. Both your stock and bond holdings will go up and down as the markets fluctuate but you can be comfortable in the fact that you are not concentrated in one stock (Enron or Lehman Bros.) or in one industry (technology or financials) or one currency. We absolutely do not think it would be wise to go all to one single asset class, namely to cash, and wait till the market does better. This is simply market timing. Owning all the asset classes and rebalancing allows you to be protected no matter the economic circumstances. In a moderate inflation equities outperform cash. In a deflation long bonds out perform cash. In a severe inflation real estate out performs cash. Which do we face? No one knows.
Make portfolio decisions in advance. If we ever doubted that emotions rule investors’ decision making the current crisis has taken care of that. Your Investment Policy Statement reflects decisions made in advance, before the emotion arrives. The IPS tells us when to rebalance and how to deal with new cash flows. No heat of the moment emotional responses, but rather long-term investment principles. The investment decision is setting policy goals and sticking to them. When we agreed on your current allocation we reviewed the data over the last fifty years and focused on the worst time periods. No one likes these market moves but you agreed to the allocation and the rebalancing method knowing markets could fall this much (or even more) again. Trust those decisions. They were not made in the midst of a panic. Imagine how difficult it would be to buy stocks now if you hadn’t made that decision when markets were calm.
Stock investing should be done using passive investment vehicles. The mutual funds we use remain, in our opinion, absolutely the best in the business. You are invested mostly in mutual funds managed by Dimensional Fund Advisors or Vanguard. They are passively managed asset class based vehicles designed to be used in a rebalancing discipline such as ours. Cash flow numbers are illustrative of the professionalism of Dimensional. During the first six months of 2008 fund flows out of all U.S. based equity funds were nearly $60 billion (panicked investors selling and getting out). For Dimensional cash flows were positive. DFA investors added $5 billion to their equity exposure. That is professional investing.
The principles discussed above have been in place for 18 years at Pinney & Scofield, Inc. We believe they hold the key to successful long-term investing. They provide you with something tangible to fall back on when all around you there is chaos. They are who we are. We believe our clients are among the best prepared investors out there and the most likely to succeed in reaching their goals. Why? Because you are part of a culture that espouses a set of principles designed to provide you with strength during times exactly like these. By creating this culture and by reinforcing its message with each letter and contact we have with you, we have made it possible for you to weather stress and keep focused on what is important.
We have now discussed your preparation through the use of a financial plan, an Investment Policy Statement and a set of investing principles. A few words about Schwab are also in order. We believed Schwab was a solid choice when we opened our first client’s account there over 20 years ago. We continue to believe they are the right choice for you to custody your money. Schwab is not an investment bank. They are in the business of holding and trading client accounts. Investment banking, making market bets with their own capital leveraged many times, destroyed Lehman. Schwab does not do that. In addition, the money market funds at Schwab are now insured by the U.S. government.
Please do not hesitate to call or email us. That is why we are here. We heard from some clients that they were hesitant, fearing we would be too busy. While we appreciate the thought we would rather hear from you. We put a lot of thought and effort into these letters but they cannot replace the value of direct discussion. Also if you have not updated your financial plan in a while please call us to get that process started. It really is a peace of mind tool that assists us in answering your financial questions, which is much easier if it kept up to date.
We have found three sources of information to be useful on the crisis. The first is Richard Bookstaber’s A Demon of Our Own Design, an excellent book on derivatives, hedge funds and investment banks. Second, an article by Larry Kotlikoff, the economist who designed the financial planning software we use, entitled No Depression. He presents good reasons to think that this crisis is containable. We have copies or you can use Google. And lastly, a short video from BrasscheckTV – How the Markets Really Work. It is very funny. The book and video were both were done before the crisis began and both are very prescient.
Jim & Dean
