Capitalism Stock Certificate 2012

The Resilience of Capitalism

Capitalism Stock Certificate 2012

As of the end of 2013, the S&P 500 Index has not only fully recovered from the 51% drop that began in late 2007 and lasted through March of 2009, it has actually gained 37% beyond the high point in 2007, equating to an annualized return of 5.3%. We all remember the despair that pervaded the airwaves with the talk of a new Great Depression. While some would argue that the main street economy has yet to fully recover from the recession, important indicators such as unemployment have definitely shown recent improvement.

There is no doubt that owners of equities will be challenged with steep declines during which they will be tempted to sell out. This is usually a regrettable decision. As J.P. Morgan said, “In bear markets, stocks return to their rightful owners.” So who are the rightful owners of stocks? The rightful owners are simply those who have the ability to bear the risk (volatility) that stocks entail and who have the patience to endure the inevitable declines that they will impose upon their owners. Unfortunately, many investors discover the hard way that stocks are not the right investment for them—at least not stocks by themselves. The purpose of IFA’s Risk Capacity Survey is to determine a blend of globally diversified stocks and bonds that is right for each investor, and by “right”, we mean that they are able to hold it through all types of markets.

One of the top considerations in the Risk Capacity Survey is whether and to what extent you are regularly withdrawing funds from your portfolio. Investors who have the ability to lower their withdrawals in the face of a market drop can hold a higher-risk portfolio compared to investors who are inflexible in their withdrawals. An additional primary consideration is how large of a drop in the value of your portfolio are you willing to stomach, so let’s review some historical returns data.

  • The largest 12-month monthly rolling period loss in the last 50 years was the period that ended on 2/28/2009, during which IFA’s Index Portfolio 100 (the equity portion of the IFA Index Portfolios) lost 49.4%.
  • Prior to this period, the worst 12-month performance for Portfolio 100 over the last 50 years was from 10/1/1973 to 9/30/1974, where it lost 36.0%.
  • The worst 2-year annualized loss for Portfolio 100 was 31.4% from March 2007 to February 2009. During this period, a dollar shrank to 47 cents.
  • The worst 10-year annualized return for Portfolio 100 was 3.5% (that’s positive 3.5%) from March 1999 to February 2009. During this same time period, an S&P 500 Index fund incurred an annualized loss of 3.4%.
  • If you had invested in a simulated Index Portfolio 100 back in March of 1989 and held it for 20 years, you would have earned an annualized return of 7.3%, growing $100,000 to $409,000, despite the 49.4% decline of the last twelve months of that period.

Lastly, the 50-year period ending in February 2009 showed an annualized return of 10.7% for Portfolio 100. Please note that this period includes the three bear markets of 1973-1974, 2000-2002, and 2007-2009. In fact, the first five years and ten months (from 3/1/1969 to 12/31/1974) had an annualized loss of 5.6%, turning a $100,000 investment into $71,400. The annualized return of 10.7% for the whole 50-year period could also be considered the average cost of capital for the approximately 12,000 companies from 43 countries in that portfolio. Recall that the cost of capital is paid to investors. IFA thinks of these portfolios as manifestations of 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 see for sources, updates and disclosures.

The table below summarizes this information.

IFA’s Risk Capacity Survey also considers other dimensions of risk such as wealth, income, and level of investment knowledge. (For more information about risk capacity, see Step 10: Risk Capacity of the 12-Step Program for Active Investors.) Please call IFA (888-643-3133) if you would like to discuss your survey results with a fiduciary wealth advisor.

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. 

IFA has clearly demonstrated that market timingstock pickingmanager 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 detract 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."

Putting it all into perspective, it is critically important to understand that capital markets have tanked in the past, and (with a few exceptions such as Japan) 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 100 grew by 25.9% per year for a total return of 216.5% (see and my video).

An important Morningstar interview with Vanguard founder John Bogle provides further insight as to how to manage investments during bear markets. 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 its clients for over 14 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.

Aside from the usual gloom and doom, bear markets carry some silver linings. As painful as they are, they teach many investors 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 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 market rebounds after a drop, 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.