Capitalism Stock Certificate 2011

The Resilience of Capitalism: Part II

Capitalism Stock Certificate 2011
updated from December 2008



Now that February 2009 numbers are in, I wanted to update my discussion about this very challenging investment environment over the last 16 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 new and updated 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.  Table 2 below indicates that over the last 50 years ending Dec. 2008, 98% of 541 five year monthly rolling periods have been positive for Index Portfolio 90 and 100% of 481 ten year periods have had positive gains. However, you would still be prudent to have an allocation of fixed income that will meet your withdrawal needs for approximately 6 years.  So if you are withdrawing 5% per year, you should have at least 30% of your portfolio in fixed income mutual funds.  

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 5% of your portfolio value per year. 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 February 2009, as compared to periods before this decline started.

February 2009 ends a period that will enter the record books as the largest 12-month monthly rolling period loss in the last 50 years for most IFA Index Portfolios. There were still greater losses in 12 months during the Great Depression. To quantify, let's look at the IFA Index Portfolio 90 (IP90), which is the equity portion of most of the IFA Index Portfolios.

  • For the 50 years ending December 2007, the worst 12-month performance was from Oct. 1973 to Sept. 1974, where IP90 lost 35.3%. During the Great Depression IP90 lost 72.5% from July 1931 to June 1932 and for the most recent 12 months ending February 2009, it lost 50%.
  • For the 50 years ending December 2007, the worst 2-year annualized loss was 22% back in Jan. 1973 to Dec. 1974, while the current 2-year annualized loss ending February 2009 is 32.05%.
  • The current 10-year annualized return ending Feb. 2009 is 2.05%, with a total return of 22.5%, 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 -3.49%, with a total loss of -29.88%, for the period ending Feb. 2009.
  • If you had invested in a simulated Index Portfolio 90 back in March 1, 1989 (20 years ago), you would have earned an annualized return of 6.95%, growing $100,000 to $383,523, despite the unusual decline of 50% in the last 12 months.

    Finally, based on the last 50 years from Mar. 1958 to Feb. 2009, the expected return of Index Portfolio 90 going forward is about 10.7%. To review the probabilities of recovery after a market decline, see here. This 10.7% 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 ending February, 2009, 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?

 

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. IFA believes that 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. The current correction is the second worst in stock market history, with the Great Depression retaining the number one spot. Today it is critically important for investors to understand that the markets are very resilient and can reverse themselves when times seem most dire.

An example of such a time is found when we look at the simulated Index Portfolio 100 returns for the two-year time period from July 1931 through June 1933. This was an incredibly volatile time period in which the worst monthly rolling 12-month time period in the last 81 years was the July 1931 through June 1932 with Index Portfolio 100 losing 72% in just 12 months. In the subsequent 12 months from July 1932 through June 1933, the same simulated portfolio roared back with a 264% gain. The total return for the 2-year period was a positive 3.52%. Any investor who held that Index Portfolio for the first year would have surely agonized over the massive 12-month losses, but would have been soundly rewarded by maintaining steadfast discipline. This is precisely the sort of discipline IFA is advising right now for each of its clients.

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. If you have doubts about the survival of Capitalism, I highly recommend you watch the three chapter video from PBS.org, titled Commanding Heights: The Battle for the World Economy:

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, 10-years and 15-years) that resulted in gains and losses for an Index Portfolio 90 over the last 81 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 continuously update the "What's New" column on the ifa.com home page. A recent and important 6-minute video message from DFA founder and CEO David Booth provides compelling answers regarding Why You Stick Around in a Tough Market. Booth cites that periods of stress overlook optimism for the long-term perspective, advising that "You've already paid for the risk, so it might be good to stick around for the expected return." To view his message, click here.

In addition, we have added advice from Yale investment manager David Swensen as quoted in an NPR article: "Swensen says our instinct is to sell when stocks fall. If something is hurting, you want to make it stop and get away from it. But, he says, "in the investment world, you have to have the exact opposite instinct," the article stated. "When you buy high and sell low, it's a very, very tough way to make money," Swensen says. It may not be this month, or this year, but Swensen says the economy will recover and the stock market will start rising again. So he says you just need to hang in there and not make any big changes to your retirement portfolio. "Take a deep breath and relax," he says. "Don't panic." Swensen's final recommendation? "If you're not already in the market through index funds, he says you should sell your actively managed funds and buy index funds…Swensen has done some research on this point. He and others have found the odds are 100 to 1 that you're better off in an index fund," the article concluded.

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 16 months 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 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.