The Stock Marketís Decade-Long Drought
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. The Stock Market’s “Lost Decade”
2. The Importance Of Risk Management
3. Lesser-Known Investment Risks
4. How To Determine Your Own Risk Tolerance
A recent Investor’s Business Daily article highlighted how, at that time, the S&P 500 Index was essentially in the same place as it was nine years before. On Tuesday, March 25th, the S&P 500 Index closed at 1352.99, below the 1362.80 level it attained in April of 1999. While the market has rebounded a bit since then, it’s still about where it was almost a decade ago.
This sideways motion, coupled with the market’s recent volatility, also reminds us that there are different kinds of risks in the investment markets. While we’re all familiar with the risk of investment losses, many investors are not as familiar with the risks of staying essentially in the same place for extended periods of time. Plus, there are other lesser-known investment risks that should be considered.
With all of the different types of risks involved in investing, investors should only commit their hard-earned capital after they have identified all of the risks, to the extent possible, and are sure they are comfortable with them. Unfortunately, many people invest in programs and strategies that tout the potential for high returns, but they frequently fail to fully evaluate the risks associated with those types of investments.
This week, I will discuss some of the obvious risks in stock market investing, but more importantly, several types of risk that many investors never think about. So read this one carefully. This is an E-Letter that you may want to share with your adult children and others.
“Lost Decades” Are Not A Recent Phenomenon
The nine-year time frame mentioned in the Investor’s Business Daily (IBD) article helps to illustrate that there can be significant periods of time during which the market goes nowhere. Actually, the term “sideways market” is somewhat of a misnomer, in that there is market activity, but it’s in the form of a sharp downward move, and then a slow recovery period back to its original price level. If you happen to be in the market at the top, then the recovery period can be a very frustrating experience, even for seasoned investors.
A quick review of historical stock market statistics shows that there have been other 10-plus-year dry spells in market performance in the 20th Century. For example, an investment in stocks making up the S&P 500 Index during the periods from 1929 through 1942 (13 years) and 1966 through 1982 (16 years) would have amounted to no more than a break-even investment.
The IBD article states that, during this most recent nine-year sideways move, the S&P 500 has fallen in value an average of 0.37% per year. If you figure in dividends on S&P 500 stocks and inflation, you get an average return of only a paltry 1.3% per year over the past ten years (March 1998 to March 2008). This is a rude awakening for those who have been assured that the stock market’s historical average annual returns are in the 10% to 12% range.
Extended periods of sideways market movements can also pose a very real risk for investors. Let’s take the case of an employee who changed jobs and rolled his 401(k) distribution into an IRA in April of 2000, investing it in an S&P 500 Index fund. That investor is still below where he started eight years ago, and has lost all those years of potential compounding to boot.
The same would hold true for a parent or grandparent who funded a child’s education expenses with a lump sum in early 2000. With no growth over such a long period of time, additional funds may have to be committed in order to meet the need for college tuition and expenses.
I would be remiss if I didn’t clarify that these sideways markets are worse for lump-sum investments or accumulated balances in retirement plans, especially for those close to retirement. They are not, however, necessarily bad news for younger investors who utilize dollar-cost-averaging techniques, such as participants in a 401(k) who make regular monthly contributions.
The Importance Of Risk Management
No matter what the cause, the market’s recent action underscores the inherent risk of investing in the stock market. It also shows the danger of the buy-and-hold strategy, especially one that recommends investing in unmanaged “index” mutual funds. Sure, the markets will likely rebound eventually, but that will be of little consolation to investors who need their money now for retirement, or who may have bailed out of the markets at or near the bottom.
In past E-Letters, I have illustrated the relationship between losses and the amount of return you have to earn just to get back to where you started. Whenever I reprint this “break-even” table, I receive quite a response from readers indicating how this information opened their eyes to the risks they were taking. Because evaluating risks and avoiding large losses is so important, I have reproduced that break-even table below:
To demonstrate the point of this table, the S&P 500 Index plunged apprx. 45% from its high of 1527.46 during the bear market of 2000-2002. Buy-and-hold index fund investors who suffered that 45% decline had to earn a total cumulative return of over 81%, just to get back to where they were in March of 2000, and it took them over seven years to do so.
However, even though the S&P 500 Index hit a “new record” in May of 2007 (and eventually climbed as high as 1565.15 on October 9th), the subprime debacle and potential recession have taken buy-and-hold investors back under water again! The S&P 500 Index closed at 1390.33 last Friday, down 175 points from its 2007 record territory.
For Nasdaq investors, the situation is much worse. Those who rode the market all the way down, over 70%, will require a return of over 233% just to get back to even, and the Nasdaq Index is nowhere near that point now, some eight years later.
Stock market volatility during the recovery phase of a sideways market is often significant, and the last couple of years have been no exception. This volatility is like riding a roller coaster for many investors. New interim highs make them feel that a market rally has taken hold, only to then experience yet another downhill run. Some who can’t stand the fluctuations in value get out of the market and sit on the sidelines, often without any plan for how to get back into the market later on.
Less Familiar Risks Facing Investors
Since I assume that everyone reading this is well aware of the risk that the market can, and does, go down from time to time, I will now focus on some of the other risks associated with investing that you may not have thought about. Some are very basic risks, and some are esoteric, but I have seen all of them influence investors’ behavior over the course of my career. Some of the most frequently encountered “uncommon risks” include the following:
1. Political Risk: Whenever I write about politics, I usually get responses from some readers who would prefer that I stick only to investment and economic topics. The truth is that I write about political issues not only because it interests me so much, but also because politics can have such an impact on the economy and the investment markets.
Over my 30+ year career, I have often written about the downside risks of the unchecked spending by Congress. And that’s not all - in addition to running up huge deficits, politicians can and do pass laws and take other actions that directly influence the investment markets. You need look no further than the ongoing presidential campaign to catch a glimpse of proposals aimed at improving our economic well-being.
I had to chuckle at the recent debate performance of presidential candidate Barack Obama when discussing how he would pay for some of his proposed government programs. When he said he’d raise the capital gains tax, debate moderator Charles Gibson noted historical evidence of how increasing the capital gains tax rate actually reduces tax revenues from that source, while lowering the tax rate actually increases tax revenues.
So, a common-sense evaluation of the situation would seem to indicate that keeping capital gains tax rates low would mean more revenue for Mr. Obama’s grandiose plans for expanding health care benefits and other liberal plans he has, right? Not a chance.
Instead, he started talking about rich hedge fund managers who are able to take advantage of this low tax rate. In essence, he’s willing to increase taxes on the 100 million Americans who own stock in order to stem perceived abuses by a few hedge fund managers. Isn’t that how we got the Alternative Minimum Tax back in the 1960s?
This example embodies the risk that political expediency sometimes trumps common sense, even when it is substantiated by hard evidence. Obama is so focused on soaking the rich that he can’t even consider the fact that low capital gains rates actually increase tax revenues.
Another political risk could be in the form of protectionist legislation. It’s no secret that our exploding trade deficit has had some in Congress talking about new protectionist legislation for years. Such legislation would be a major blunder, in my opinion, not to mention it could spark a longer, deeper recession and an accompanying bear market in stocks.
Another political risk drawn from the pages of recent newspaper headlines is the Federal Reserve. The Fed Chairman and the Governors are political appointees. The Fed’s decisions can move the markets in a variety of ways, and even mere comments spoken (or not spoken) by the Fed Chairman can move the markets abruptly. And of course we now know that the Fed can orchestrate major corporate buyouts and negotiate to back up questionable securities with taxpayer money.
Unfortunately, political risks will always be there; we can’t always know them in advance or eliminate them; and there will be times when they affect the investment markets negatively. Having all of your money in a buy-and-hold investment strategy means you will likely lose money when politics sends the markets lower.
Other risks, however, are more personal and controllable. The remainder of my discussion will focus on these risks.
2. Goal-Related Risks: First century philosopher Seneca said, “If one does not know to which port one is sailing, no wind is favorable.” Many investors have portfolios without a long-term plan, in that they are not geared toward meeting a pre-determined set of financial goals. In my past E-Letters on the basics of financial planning, I have discussed how setting specific goals is the very first step toward financial independence. Unfortunately, there are many investors, including some experienced ones, who have not taken this first step. As a result, they risk investing inappropriately.
Another goal-related risk is having pre-set objectives that are totally unrealistic. During the go-go 1990s, many investors believed that the stock markets would produce returns of 20% (or more) per year indefinitely, which was a part of the herd mentality back then. In the late 1970s and early 80s, investors thought bank certificates of deposit and fixed annuities would always have double-digit yields. As we know now, both assumptions were clearly wrong.
If your expectations for portfolio returns are too high, there is a very good chance your financial goals will not be met. And more importantly, this can lead to saving too little money to meet your retirement goals. Unfortunately, this can also lead to investing in securities and strategies that are far too risky in order to try to “juice” the returns.
Plus, Mike Posey has discussed in his Retirement Focus issues how having unrealistic return expectations in retirement can lead to a withdrawal percentage that may be too high for the level of assets to support. The result is the real possibility of running out of money during retirement.
A final goal-related problem is taking a level of investment risk that is inappropriate for your financial situation. This is why it is so important to have a well-defined investment plan. Some investors expose themselves to far greater investment risk than they need to because they follow pre-set asset allocation models that have nothing to do with their individual set of circumstances.
On the flipside, there are investors who invest too conservatively and risk losing purchasing power to inflation. Investing too conservatively can also raise the odds of not meeting investment goals, as well as the risk of outliving your assets.
3. Emotional Risks: This type of risk is probably the one I have encountered most frequently in my 30-plus years in the investment business. Investor emotions are often irrational, so a clear, well-reasoned approach won’t necessarily seem like the best course – especially if large losses have occurred in the recent past. In the discussion that follows, I will address three different emotional risks, and afterward point out the consequences that can come from them.
First is the emotional risk of regaining lost ground. Following the bear market of 2000-2002, many of the new clients that came to me had lost a lot of money. Some of these stressed that their primary investment goal was to “make it all back as fast as possible.” Unfortunately, trying to recover large losses in a short period of time is a recipe for financial disaster. As the break-even table above shows, coming back from a loss of 30-40-50% requires a very large return and all the risks associated with huge returns. Coming back from such a loss can take years, and for older investors, it may never happen.
Next, investors should be aware of the emotional risk of fearing future losses. Following the 2000-2002 bear market, many investors who got burned decided that they would never, ever invest in equities again. While large losses are traumatic, these investors should take time to see how they were invested and determine if a more reasoned approach to the markets might make more sense. Stuffing money into a mattress or investing only in CDs is not likely to build the nest egg they will need for a secure financial future.
A final emotional risk is what I call peer pressure investing, which I describe as wanting investments that will allow investors to have “bragging rights” among their peers. During the go-go 1990s, it became fashionable for many investors to brag about how their latest tech stocks were going through the roof. Of course, you never heard much about their losers, which were many as we went through the bear market. Some investors also get hooked on having the latest “trendy” investments in their portfolios, whatever they may be. This can also be disastrous.
For example, “hedge funds” have been one of the hottest selling investments in the new millennium, even though they are generally restricted to only the wealthiest investors. There are now even mutual funds that seek to offer hedge-like strategies to investors who would not otherwise qualify under the hedge fund rules. The “snob appeal” associated with some of these investment strategies often provides an emotional boost to the ego, but usually at the cost of much higher risk. All hedge funds and alternative investments have their own set of inherent risks and unfortunately, many investors are not qualified to assess those risks.
The consequence for investors who get caught up in emotional risks is that they make themselves vulnerable to another big risk of becoming prey for less than scrupulous investment operators. There’s an old adage in the direct marketing business that says the two best sales approaches are fear and greed, both of which are strong emotional triggers.
It is one of the big frustrations of my job to see so many investors who won’t agree to a well-diversified portfolio of investments, but will eagerly jump into an investment scam that promises the world but delivers disappointment. Remember, if something sounds too good to be true…. just say no.
4. Fee Risk: There are many well-known firms in the financial industry that continually preach that you should only invest in funds and products with the lowest fees. They tout studies that show that, on the average, low-fee investments do just as well or better than those with higher fees. The clear purpose is to move investors toward index-type funds that have low fees, but also have no protection from downward swings in the market.
To say that the average high-fee fund doesn’t do any better than index funds is like saying that on the average, pro baseball players don’t have any better batting averages than Little Leaguers. If you average them all together, that may be true, but professional team managers and owners don’t worry about averages. They go after those players who have shown the ability to beat the averages season after season, even though they cost a lot more money.
The same thing goes for the money management industry. If you package all of them together, the average doesn’t look very impressive. However, there are some money managers and actively managed mutual funds that have shown the ability to add value over and above their fees for many years. Firms like mine spend lots of time and money searching out these managers and funds to offer to clients, and sophisticated investors will gladly pay higher fees where the manager or fund can be shown to add value.
In case you doubt me on this, look at the hedge fund industry. This is an arena where only sophisticated, high-net-worth individuals can participate, and where some of the best money management talent in the world is located. However, it is also where money management fees are far higher than those found in the mutual fund industry.
I am not saying that high fees automatically guarantee superior performance, since they do not. What I am saying is that you should not automatically reject investment products just because they have higher fees than other alternatives you may be considering. Each investment must be analyzed in detail to determine if the manager or fund is adding value over and above the level of fees charged.
5. Diversification Risk: We all know the risk of not being diversified. However, there is an associated risk of thinking you are diversified when you are not. Many investors believe diversification means that you buy a lot of different mutual funds. However, they frequently don’t look below the surface to see how the funds are invested. We sometimes receive statements from prospective clients whose existing portfolios show a number of different funds, all of which have basically the same core stock holdings. That’s duplication, not diversification.
Another diversification-related risk is not having exposure to various investment strategies. Since the “Modern Portfolio Theory” of investing has become so popular over the last 15-20 years, most investors know that they should diversify among the various “asset classes” such as large cap stocks, small cap stocks, bonds, international, etc. However, very little is said about diversifying among various investment strategies.
Buy-and-hold is still the conventional strategy, even though it’s a guaranteed loser in a bear market. If you have read this E-Letter for long, you know that I prefer “active” or “tactical” investment management strategies, and in particular those that have the flexibility to move out of the market and/or “hedge” their positions if market conditions turn ugly.
In short, the buy-and-hold mantra has been pounded into investors’ consciousness by mutual fund families and brokerage firms largely because it is in their best interests to do so. Yet, there are other valid investment strategies that should also be part of your overall portfolio.
6. Relationship (Trust) Risk: This one bothers me the most because it can be so devastating to future working relationships with clients. We sometimes have investors come to us who have had bad experiences with prior Advisors or brokers. When we inquire about their prior experience, they usually say that they trusted this person to do what was right for them, and then got burned.
As discussed above, most mutual fund families and large brokerage firms tout the buy-and-hold strategy, which is a guaranteed loser in a bear market. Aside from that, the financial services industry has its share of unscrupulous brokers and Advisors who will take a client’s money and invest it where it generates the biggest commission, rather than what is most suitable for the client. And others put their clients into the latest “hot” investments (which typically lose a lot when they go cold), even if they are not suitable for the client.
Since many investors are not familiar with the markets or terms like asset allocation, risk tolerance, correlation, etc., they place their trust in someone they think will do what is best for them. Sadly, this trust is sometimes misplaced.
Quality Investment Advisors, on the other hand, strive to determine the appropriate financial goals and risk tolerance for every client, and then insist that the client understands them as well. You should insist on nothing less when seeking professional management of your money.
I wish there was a sure-fire way to tell the good investment professionals from the charlatans, but there’s not. There are, however, resources to help you evaluate a prospective money manager, broker or other financial advisor. The Securities & Exchange Commission (SEC) has a number of educational resources available on its website, as well as alerts about investment scams and other inappropriate practices making the rounds. The SEC website also has a way to check out a prospective broker or Investment Advisor. Just go to www.sec.gov/investor.shtml to view the various investor resources available there.
You can also check out the Financial Planning Association (FPA) website at www.fpanet.org/public, since many quality investment professionals belong to that organization and adhere to its Code of Ethics. The FPA website even has an e-mail hotline you can use to get answers to your questions from a qualified professional.
7. Illustration Risk: Investment projections were a part of the financial planning landscape even before low-cost computers came on the scene. However, the computer’s ability to crunch large amounts of information has made such illustrations much more common in today’s financial services marketplace.
While the availability of tons of historical information and the computer power to analyze it is a great advantage, it is also important to realize the limitations of this information. One of the first things I learned about computers was the phrase “garbage in – garbage out.” For our purposes, this means that any computer-generated projection is only as good as the assumptions used to create it. Bad assumptions about future returns, inflation, etc. can lead to inappropriate results, so it’s always important to ask what assumptions have been used in regard to any computerized proposals you might receive.
Conclusion – Determining Your Risk Tolerance
By now, I hope you have a better appreciation for the variety of risks that can and do influence your investments. I have discussed risks that you can’t do anything about, such as market risk and political risk, as well as a number of risks that are under your control. The first step in managing risks is to determine your own risk tolerance.
There are a number of websites on the Internet that offer free risk tolerance analysis, but I do not recommend them. The biggest risk in using Internet questionnaires is that you never know where your personal information will go from there. Plus, I believe that a combination of one-on-one discussions AND the questionnaire results is the best way to go.
Simply CLICK HERE and you will go directly to our Risk Analysis Profile. You can complete the questionnaire and send it to us (fax 512-263-3459 or mail). When we receive your completed questionnaire, we will give you a no-obligation analysis of your answers. Of course, we would love to talk with you at length about how our risk-managed investments may complement your current portfolio, but if you only want your risk tolerance score, that’s your call. We don’t hassle anyone!
So, I invite you to take the Risk Analysis Profile free of charge and with no obligation. You may be surprised at how you score, and it will be valuable information for you to have. If you have questions about how to complete the questionnaire, or would like to talk to one of our experienced Investment Consultants about how your current portfolio is invested, give us a call at 1-800-348-3601, or e-mail us at firstname.lastname@example.org.
Very best regards,
Gary D. Halbert
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