Now that November 2008 numbers are in, I wanted to update my discussion about this very challenging investment environment over the last several months and offer some much-needed perspectives. I am sympathetic to your concerns and want to help you through this difficult time in the stock market.

Many investors may find themselves questioning their ability to remain in their investments right now. If you are concerned, the first step is to review and take into consideration the proper time horizon for your investments. If your time horizon or liquidity needs have changed from the last time you 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.

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.  

If you are at a point in time when you are routinely withdrawing funds from your portfolio, we recommend that you not withdraw more than 7% of your portfolio value per year. However, a 5% withdrawal rate is a more prudent choice.  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.

Secondly, you should consider the new data for the last 12 months ending November 2008.

November 2008 ends a period that will enter the record books as the largest 12-month monthly rolling loss in the last 50 years for most IFA Index Portfolios. To quantify, let's look at the IFA Index Portfolio 90, which is the equity portion of most of the IFA Index Portfolios.

• Prior to Nov. 2008, the worst 12-month performance over the last 50 years, was from Oct. 1973 to Sept. 1974, where it lost 35.3%.
  
  
• For the most recent 12 months from Dec. 2007 to Nov. 2008, it lost 45.04.%.
  
  
• The worst 2-year annualized loss was 22% back in Jan. 1973 to Dec. 1974, while the current 2-year annualized loss ending Nov. 2008 is 23.96%.
  
  
• The current 10-year annualized return ending Nov. 2008 is +4.01%, with a total return of 48.1%, while the previous worst 10-year annualized return was +4.27%, which occurred from Oct. 1964 to Sept. 1974. The 10-yr return for an S&P 500 index fund is -1.01%, with a total loss of -9.63%, for the period ending Nov. 2008.
  
  
• If you had invested in a simulated Index Portfolio 90 back in Dec. 1988 (20 years ago), you would have earned an annualized return of 8.4%, growing $100,000 to $502,143, despite the unusual decline of 45% in the last 12 months.
  
  Finally, based on the last 50 years from Dec. 1958 to Nov. 2008, the expected return of Index Portfolio 90 going forward is about 11.36%. This could also be considered the average cost of capital for the 17,000 companies in that portfolio. Remember that the cost of capital is paid to the investors. Please see www.ifabt.com for sources, updates and disclosures.

The table below summarizes the updated information.

Table 1:

The Risk Capacity Survey has been updated to reflect these changes, like this question:

Based on $100,000 invested over the last 50 years, the following choices show the highest 12-month dollar loss, the highest-12 month dollar gain, and the annualized returns of 5 different index portfolios. Which portfolio would you choose?

A. Loss of $8,380 (11/07-10/08); Gain of $26,120 (7/82-6/83); Annualized Return = 6.9%; which is Index Portfolio 10. B. Loss of $18,100 (11/07-10/08); Gain of $33,910 (7/82-6/83) ); Annualized Return = 8.3%; which is Index Portfolio 30. C. Loss of $27,090 (11/07-11/08); Gain of $42,080 (7/82-6/83); Annualized Return = 9.6%; which is Index Portfolio 50. D. Loss of $35,500 (11/07-11/08); Gain of $50,670 (7/82-6/83); Annualized Return = 10.7%; which is Index Portfolio 70. E. Loss of $45,000 (11/07-11/08); Gain of $60,230 (8/82-7/83) Annualized Return = 11.7%; which is Index Portfolio 90.

This question has probably been changed since the last time you took the Risk Capacity Survey, so you may want to revisit the survey to check your time horizon and attitude toward risk. Our Risk Capacity Survey is the best method to determine your asset allocation, because it considers all five dimensions of your risk capacity.  (For more information about risk capacity, see Step 10: Risk Capacity of the 12-Step Program for Active Investors.) Please call your advisor (888-643-3133) if you would like to discuss your survey results.

For a further look at Index Portfolio 90, lets look at a couple of other time periods. 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.

Please review the Monthly Rolling Period Analysis which can be found here on the web, or on page 258 of the 2007 edition of my book, Index Funds: The 12-Step Program for Active Investors.  Also review the sources, disclaimers and disclosures at www.ifabt.com and page 374 of the Index Funds book.

The chart below puts into perspective the percentage of various time periods ( days, months, quarters, years, 5-years and 10-years) that resulted in gains and losses for an Index Portfolio 90 over the last 50 years. If you need an explanation about the meaning of this chart, I explain it on this youtube video.

Table 2:

IFA has clearly demonstrated that market timing, stock picking, manager picking, or style drifting have not worked for professional or individual investors.  If you do not understand that, please read Steps 3-6 again.

In William Bernstein’s book , The Four Pillars of Investing, he discusses market bottoms and the agony and the opportunity that exists at that point in time. In his 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 your Investment Policy Statement, where your 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.”

With respect to what we are hearing now about the markets, it is critically important to understand that capital markets have shuddered in the past, and have rebounded due to the impressive resilience of capitalism. In fact, sometimes, markets have changed course just when the headlines or consensus seems the most apocalyptic. Such as the Gallup Poll of October 1974, in which 51% of those surveyed predicted a great depression on the horizon. For the next 5 years from November 1974 to October 1979, Index Portfolio 90 grew by 22.2% per year for a total return of 172.5%. (see www.ifacalc.com and my youtube.com video)

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 it’s clients 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 their 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.

Certainly, there are some silver linings around this current market environment. 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.