Dimensional Fund Advisors

IFA's Quote of the Week - 39 (Marlena I. Lee)

Dimensional Fund Advisors

"Return generation is the responsibility of the market, which sets prices to compensate investors for the risks they bear. "

-Marlena I. Lee , Author of Rebalancing and Returns, October 2008

 

 

 

Free Markets are Doing Their Job. Uncertainty is Higher. Prices are Lower. Expected Returns are About the Same.


 

October was a spooky month for investors. Certainly, many investors will breathe a welcome sigh of relief to close the books on the month that has handed out more tricks than treats to their portfolios.

October 2008 ends a period that will enter the record books as the largest 12-month monthly rolling loss in the last 50 years. 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 Oct. 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 Nov. 2007 to Oct. 2008, it lost 43.1%.
  • However, the worst 2-year annualized loss was 22% back in Jan. 1973 to Dec. 1974, while the current 2-year annualized loss ending Oct. 2008 is 18.64%.
  • The current 10-year annualized return is 5.67%, while the worst 10-year annualized return was 4.27%, which occurred from Oct. 1964 to Sept. 1974.
  • If you had invested in a simulated Index Portfolio 90 back in Nov. 1988 (20 years ago), you would have earned an annualized return of 8.95%, growing $100,000 to $555,322, despite the unusual decline of 43% in the last 12 months.
  • Finally, based on the last 50 years ended Oct. 2008, the expected return of Index Portfolio 90 going forward is about 11.7%. 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.

Many IFA clients established their risk capacity considering the worst 12-month loss in the last 50 years for their risk level. You may want to take the Risk Capacity Survey again to determine if your risk exposure should be changed based on this updated information, or other factors.

The job of the free market is to set prices so that investors will be compensated for the risk they bear. Thus, the prices of a globally diversified portfolio of stocks have come down 43%, which should be in proportion to the bad news about our global economy. To simplify, the 43% decrease in Index Portfolio 90's value reflects a 43% increase in the perceived uncertainty of achieving the expected returns associated with that portfolio. The price changed, but the expected return remains about the same. The good news is that investors owning equities at these lower prices should be compensated for the risks they bear. It's important to note that this will occur over an appropriate period of time. The more risk exposure, the longer investors should be prepared to wait to earn their compensation (expected annualized return).

teetertotter To better understand this concept, imagine an approximately constant Expected Return set at the fulcrum of this teeter-totter. The Uncertainty of the Expected Return would be on the left side and Price on the right. The current price is moving in an equal and opposite direction to the perceived Uncertainty of the Expected Return of the investment. (also see this sketch)

If market forces between willing buyers and willing sellers caused prices to go down 5%, then it could be assumed that uncertainty of expected returns went up 5% based on negative unpredictable news about capitalism. In this case, the global sellers of about 10 Billion shares/day "pushed" prices down about 5% more than the global buyers of those same 10 Billion shares/day are "pushed" prices up. When uncertainty goes down 5% because of good news, prices go up 5%, allowing the expected return of the investment to remain essentially constant (it changes with the annualized return over some long specified period, like 50 years). If you do not know how to estimate the expected return of your equity and fixed income investments, the Fama-French Five Factor Model is considered the state-of-the-art by most academics. If you need help understanding it, an advisor at IFA can explain it to you.

If you think that prices are not set correctly to reflect news and expected returns, consider that researchers have determined that only about 0.6% professional investors have been able to exploit mispriced stocks and actually obtain returns in excess of risk adjusted market returns. Therefore, prices must be assumed to be set correctly, even if they were not in hind sight.

In the near term, nobody knows whether the news stories will be good and cause prices to go up, or bad and cause prices to go down. IFA acknowledges a lack of fortune-telling prowess to accurately forecast the near term perceptions of capitalism and the prices that follow. What we do know is that high levels of uncertainty create stomach-churning price changes, such as the S&P 500 Index suffering its worst month decline since 1987, then last week delivering the index's best one-week increase in the last 34 years, according to CNBC. We're fairly certain that only the very lucky predicted that outcome.

In the wake of all of this volatility, what should investors do now? The first action to take is to assess your risk capacity. Many investors have learned the hard way that their appetite for juicy returns comes with a sour after-taste from large losses in bad economic times. Your risk capacity is the measure of how much stock market risk you can manage in consideration of your time horizon, your investing knowledge, your attitude toward risk, as well as your savings and income.

If you are invested in a low-cost and globally diversified portfolio of indexes that matches your risk capacity, take a deep breath, accept that the combined knowledge of millions of traders in free markets around the world will do a better job at setting prices than any one individual, and put your investments out of your mind. Invest and Relax.

At IFA, the effort to calm investors goes far beyond lip service. It is supported by reams of stock market data that is readily available at ifa.com. This IFA exclusive data set shows the benefit of remaining calm in the face of high uncertainty, and the importance of relying on long-term data for proper decision making. Investors who may worry that their portfolios have entered an uncharted and apocalyptic era, will be empowered to know that prices have done the same, so that their expected returns remain relatively constant. For this reason, those investors whose time horizons are appropriate for their asset allocations have little to be concerned about. You should only be worried when markets are no longer free to trade, because then the prices are sure to be wrong.