The global stock markets are probably not priced with a lot of bargains. High quality, fixed income markets are full of fears. All markets including commodities and real estate are likely to be more volatile for the next couple of years than what we have recently experienced. If you disagree leave the worrying to the rest of us.
Our concern is based on the volatility that won’t be constrained and lead to panic-driven major disruptions. Since we don’t know what our next investment voyages will be like, we should examine our navigational tools. In our lives we know from our own or observed experiences that frequent changes rarely produce optimum results and in many cases deplete resources substantially. Thus the key to using the appropriate tools is the discipline to use them correctly and even when periodically they produce sub-optimum near-term results. Nevertheless there may be times when changing tools makes sense. Usually the best time to make switches is whenever a tool is too successful and not when it is underperforming. This reliance on intelligent discipline is one of the may lessons that I learned in the US Marine Corps.
Our basic four investment philosophical tools are:
1. Reliance on Simplistic Approaches
2. Recognition of Complexity
3. Goal focused Strategies
4. Timely Tactical moves
A study of most very successful individual investors appears to demonstrate that large wealth is generated by investing in ownership of equity, usually very concentrated to the point of a single investment. It takes an unusual person that can tolerate the cyclicality involved in a single or even a highly concentrated portfolio. This cyclicality produces too much trauma for most. So they start to diversify. The problem with diversifying is that almost every day a new potential threat to one’s wealth shows up, particularly in the media. The standard risk control measure for new risks is to add some new protective investment. Over time this approach leads to a large number of investments.
In the modern world, people and institutions seek comfort in becoming part of the masses and either directly or indirectly index their portfolios. The thinking behind this is that all of these investors can’t be wrong, but equally they can’t be as right as the successful wealth-builders. Other simple philosophies are to only invest in highly credit rated stocks and bonds which produce similar upside and downside results. It is like someone who goes to the racetrack to bet on winning horses, so they bet on almost every horse in the race. Quite often they will have a winning ticket, but most of the time the money received will not pay for all the losing tickets. The nice part of simple moves is that they do not require additional thinking or analyzing.
There are no two people exactly alike. Even my twin grandsons, not only are they different, but they strive to be different. While each market has on the surface similar characteristics of prior market cycles, there are enough differences so the past is a bit instructive but not totally predictive. I believe that each portfolio and investor are different than others. One of the risks that some investors face in dealing with live managers and brokers as well as the so-called robo advisors is that at times one’s needs and preferences are not utilized in portfolios. One of the ways I recommend dealing with this is to divide an investment portfolio in terms of expected payouts. I start often with four timespan portfolios.
Each portfolio can be selective in terms of levels of aggressiveness/conservative as well as many other selection functions. Because consultants want to deliver the past to clients, they ask about the dispersion of performance within a manager’s book of business. To the extent that there is little dispersion, there is little attention as to the differences between people and institutions. All 401(k), pension plans, endowments, and families are different and deserved to be treated that way. However, there is an expense to managing complexity. The difference is similar to buying off the rack versus custom produced and fitted clothes. Each has its place, but overtime the old rule of getting what you pay for generally works.
Goal Focused Strategies
Almost every physical and investment trip has bends and turns with occasional reversals. Those who successfully complete their trip do so because they have a navigational tool of an effective compass. We all understand that prices go down as well as up. While there are relatively few complete wipeouts, we have seen 90% declines in leveraged, highly speculative stocks in the 1960s and the 1930s. These are rarities. Most general stock market declines in a single generation are on the 50% variety. Within each rolling ten year period there is a 25% fall, and often within a ten year period there are three years of greater than 10% decline. Strategies should recognize the downside potentials, but also be aware and positioned for the upside.
Since 1926 the general stock market has on an annual basis gained in the range of 9%. We have experienced gains of three or four times the average and have seen a number of concentrated funds with speculative holdings post annual gains of over 100%.
Some may feel that because the number of publicly traded stocks is down by a factor of 50%, the institutionalization of trading, and the growth of index funds that past upsides will be curtailed. I would argue eventually the reverse. Periods of extreme concentration as we have been in, lead to lack of focus on securities that are not part of the highly valued concentrated portfolios particularly in the market capitalization weighted indices.
A very important point in assessing long-term investing is the power of reinvesting cash distributions (interest, dividends, and capital distributions). The great Sidney Homer, the long term head of Salomon Brothers fixed income research pointed out that for the long term bond investor there are three returns of cash over the life of the bond: (a) proceeds from maturities, (b) current interest coupon payments, (c) and interest on interest.
Most people don’t fully appreciate that the third element produces the most cash. For example a bond with a 4% coupon held for a twenty year maturity will receive 100% of its issue price, 80% of its issue price for twenty years in interest payments, and if they can reinvest the interest payments at the same 4% for the period they will receive 119% of the issue price. The message here is that by buying and holding solid bonds and reinvesting the income, the return to the investor is larger than most believe. The key is not spending the interest and reinvesting it at a similar rate as the initial issue. (If you sense a certain rhythm to this approach it is worth noting Mr. Homer’s parents were both professional classical musicians.)
The interest on interest example is actually more powerful in investing dividend stocks and funds. Today they are many solid equity companies who are yielding 2% to 3% that over the next twenty years are likely to raise their current dividends at least at the rate of inflation, if not higher. Many of these stocks’ twenty year dividends will be higher than a 4% coupon on a high quality bond. Both many dividend paying stocks and all mutual funds have reinvestment mechanisms, so the equity investor does not have to look for current income opportunities the way the bond investor does. I am biased, but I believe the reinvestment potential through good mutual funds is better than many individual stocks. The US and UK regulators do not value the reinvestment mechanism in their assessment of the value to investors. Dividend paying stocks and mutual funds could represent a significant part of endowments and individuals long term portfolio segments.
Timely Tactical Moves
The first thing is to determine is whether the investor has trading skills. Can they recognize the difference between intra day and daily volatility vs. a meaningful change in price trends? There are some that believe that they posses this skill and a few may. It is very definitely an art form that requires the right personality approaches with extreme discipline.
Others attempt to be anticipatory and get ahead of new trends. As someone that has been known to be premature, too soon is often equivalent of being wrong. At times one may have to concede that one is premature and reposition for closer to fruition trends.
Contrarians can identify where they think the crowd is wrong and take a contrary view. Most of the time these moves don’t have much price risk as the market doesn’t believe in them.
My dilemma is to find the correct communications with potential clients as to which of these tools should be used with all or a portion of their accounts. Any thoughts would be appreciated.
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A. Michael Lipper, CFA
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