By Andrew D. Davis
The fluctuations in the securities markets have increased in recent days, driven by a myriad of economic data that has some investors fearing the onset of a recession. The former Federal Reserve Chairman, Alan Greenspan, a little out of character, publicly gave his probability of a recession by year end 2007 at one in three. His well-followed speech sent a ripple throughout markets, bringing back the memories when market participants hung on his every word.
The large sell-off in China and other emerging markets caused investors world wide to reevaluate the risk premiums that are factored into their portfolios. Some market pundits were crediting this to an unwinding of the Japanese Yen “carry trade”, that in lay speak can be described as borrowing Yen where rates are low and investing in securities in other higher yielding assets denominated in foreign currencies. After the fact it was discovered that the Chinese government was rumored to be mulling over the idea of increasing the capital gains tax, leading equity holders to sell off highly appreciated assets in hopes of avoiding this “rumored” burden. Others claim the recent troubles in the sub-prime mortgage lending market will add further uncertainty to the picture.
Most economists believe that the former housing boom added over 1 percentage point to GDP annually over the last three years. It is well documented that the domestic housing market has weakened, and may weaken further, and the impact on the economy still remains to be seen. Trying to rationalize all of this “noise” into investment decisions can be a tedious process indeed.
At times like this, where perceived “bad news” leads to negative market sentiment and at times a sustained correction, having an investment policy statement (IPS) founded on a well thought out financial plan can provide the necessary guidance. The first step in this process is to select an investment objective that outlines the risk tolerance and return expectation for your portfolio. This is done by considering all aspects of your financial profile and determining what you want, or more importantly, what you need the portfolio to achieve within a pre-determined time horizon.
Documenting one’s ability and willingness to take risk will help in handling the short term negative impact that the market may have on a portfolio. For instance, the ability to take risk addresses and quantifies the amount of downside volatility the portfolio can sustain and still have a reasonable probability of obtaining the stated investment objective. On the other hand, the willingness to take risk must be discussed to assure the investor is comfortable with the potential fluctuations the selected asset allocation may experience. These distinctions are based on the psychology of the investor and their background. For example, the entrepreneurial type will typically have a good understanding of risk (many entrepreneurs put “everything on the line” to get their businesses off the ground) and therefore will have a high willingness to take risk. Conversely, a corporate employee who has diligently saved for retirement over a 35 year period will typically have a lower willingness to take risk due to the comfort of job security and the smoothing effect of saving over time. This type of analysis is the best way to ensure an investor will correctly define his objective, and ultimately, find the best suited asset allocation.
Granted, gauging one’s tolerance for risk is not an easy task. Human nature lends itself to over confidence in market trends, media hype and other distractions, and all too often investors find themselves chasing the market as opposed to prudently investing for the purpose of achieving a reasonable, measurable return. We believe that creating an IPS, based on the understanding that investing for the long term will smooth out short term volatility, helps investors avoid mistakes that may inhibit desired results. The understanding that negative returns are not uncommon in the securities markets, however painful, is very important to achieving long term success. A brief review of the history of stock market returns will reveal that we have survived the many “gloom and doom” scenarios in the past. This history is one of many tools used to gauge investor risk tolerance at the onset of an investment program, not after the fact when downside risk reveals itself. A review of the empirical evidence is important to introducing market risk to investors.
The attached market studies by Crandall & Pierce illustrate how dramatic the differences can be between a 1-year holding period (Chart 1) versus a 10-year holding period (Chart 2) for various asset mixes.
These charts represent all 1 and 10 year holding periods, respectively, from January 1950 to December 2006. Please keep in mind that the time periods represented are “rolling” 1 and 10 year periods, resulting in 672 and 564 observations, respectively. Let’s review the 100% equity allocation represented by the Standard & Poor’s 500 index. As you can see, over the last 50 years, the largest loss in any 1 year period is -38.9%, far worse than most short term investors can accept. Conversely, if one’s holding period extends out to 10 years you can take comfort in the fact that over the last 50 years the broad equity market (S&P 500) has never experienced a negative return. The worst return as noted on the 10 year chart is +0.5%, annually. I will qualify this by saying past performance is no guarantee of future results, however we have been through oil crises, multiple wars, political upheaval, fraud, financial crises, currency crises, terrorist attacks, etc. etc. Even factoring in all of these negative events and many more, having a long term perspective has in fact smoothed out the dramatic short term corrections we have experienced over the years.
These charts also introduce another important element of investing: diversification. As you move down these charts we begin to introduce fixed income securities to the asset mix. Bonds tend to have a negative correlation to stocks, meaning that over time stocks and bonds move in opposite directions, to a degree. For example, Chart 1 shows that the largest loss for a 100% bond allocation, as represented by the 5 year U.S. Treasury Bond, measured to be -4.9%; far better than the -39% witnessed in the equity allocation. Not perfect, but a lot more reasonable for a short term investor. Moving to Chart 2 with the 10 year comparison, the smallest gain returned 1.5%, annually. Clearly, the risk characteristics of fixed income securities are a much better fit for the risk adverse investor. Our job as investment advisors is to put together all of the pieces of the puzzle that are involved in forming the IPS and setting the asset allocation (proportion of stocks to bonds) that best suits the investors individual needs.
We strongly believe that investors should have an IPS that outlines a diversified investment strategy with a look towards long term results. Under this scenario increased volatility may be viewed as an opportunity, the opportunity to buy when others are selling, versus an obstacle. That is not to say investing imprudently in a downturn will result in outsized returns. However, when capital flows deflate in one overvalued area it tends to be invested in other assets perceived to have “value”. A thorough understanding of market returns is very important in defining the risk tolerance of each investor. When this risk tolerance is better understood, coupled with the stated return expectation, the investment objective can more easily be discerned. We encourage our clients to factor out the day to day “noise” in the markets and continue to follow a long term diversified investment policy, as defined in each of our clients’ IPS.