Is Volatility the Enemy?

From our upcoming newsletter:


After a few good years of market returns, it’s inevitable that the "c" word begins to be uttered throughout the investment world- and by that I mean "crash". From cable news, to newspapers and magazines, to emails, people predict doom & gloom.

But is market volatility, especially negative volatility, our real enemy? Let’s look at an example based on the re-turns S&P 500. John Q, Investor, started investing in 2000. He invested, like clockwork, $10,000 on the first trading day of every year until January of 2014. But un-like most investors, he was given a choice to invest in the real stock market, or a magical one, where the direction was always up! The market genie told John, "Both stock markets will close at the same price on January 2nd, 2014, but the magical market will never lose. It’ll be a smooth ride up, the same positive return every year!" Given the opportunity to never agonize through a down year, John chose this market, as opposed to the "real" world, which saw major swings between Jan 2000- Jan 2014.

So, did John make the right choice by eliminating all downside volatility? In John’s magical stock market, he ended up with $168,050. He made about $18,000 on his investment and he never lost money in any year. He wanted to compare his results with his copycat brother in law Tom. (Tom matched John’s investments exactly, only he invested in the real world market). Tom had $221,793 by January of 2014. This beat John’s returns by almost 25%! Why? While market corrections may be no fun to live through, they do provide a period of time when our investment dollars go further. With lower stock prices, investors can buy more shares.

So if volatility is not our enemy, who is? I like to borrow a famous literary quote that says "We have met the enemy, and he is us". Poor investor decision making (like John above), is the main cause of diluted portfolio re-turns.

Without risk, there is no reward.  Will the market "crash" again.  Most certainly.  It always has, and it will over and over again.  No one can predict with certainty when.  What matters is our response to it.  Wise investors will whether through them, and look at the bright side of the situation.  But this is not to say investing is without risk.  Each investor needs to answer the question, "how much market volatility am I willing to bear?"

Buffet vs the "Experts"

This post is largely taken from an article from NBC news, but I thought it would be worth commenting on it.  The article can be found at:

http://www.nbcnews.com/business/markets/buffett-has-big-lead-stock-bet-vs-experts-n23646

About six years ago, the famed Warren Buffet made a wager with a group of hedge fund managers.  Hedge fund managers are touted as the most sophisticated, nimble, and adept money managers on the planet.  They are not burden by the regulatory issues facing mutual funds, and they can employ a vast array of financial maneuvers.  Warren's ten year wager was that he could outperform a group of hedge fund managers using a simple low cost index fund; meaning that for all their flash and sizzle, the masters of the financial universe would be unable to beat the market due to the market's efficiency. 

With four years remaining, Warren's simple index fund has a commanding lead, earning 43.8% vs 12.5% for the hedge funds (as of the time of the article).  What is more telling is that Warren chose an index fund to compete against them, not his own company's stock.

2013 Year In Review

It is likely that 2013 will go down in the books as a very good year for the markets.  As of December 13^th, the S&P 500 Index (a US market index) was up over 27%.  The international markets were also up, with the MSCI EAFE Index returning over 16%.  Most investors are pleased with these results.  However, it is at times like these that questions begin to be raised:

 

“What do you think the markets are going to do now?”

“Aren’t the markets really high?”

“When is the correction coming?”

 

It is impossible for anyone to tell what direction the market will go.  I can recall specific instances, even back in January of 2012, of people saying that they were going to stay out of the market because it was “too high”.  Those same people have missed out on the gains that have since occurred.  It is impossible for anyone to tell which direction the next 10, 20, 30 or even 40% move in the markets will go.  It could be up, it could be down. 

 

There has never been a 100% decline in the global stock market- and if it would occur, the state of your investments would (likely) not be your greatest concern.  After all, such an event would have to wipe out the entire value of all companies, all over the world.  By contrast, if we examine the historical record, 100% increases, over varying time intervals, have certainly occurred.

Remember that the day to day, week to week, and month to month market movements are largely  random.  In our world of instant gratification, investors need to learn to ignore the minute by minute market news given by media sources.  By weathering the volatility of the markets, long term investors who are disciplined ensure they are fully invested when the market makes a true and meaningful move upward. On the contrary, many undisciplined investors try in vain to time the market to avoid losses and lock in gains; but in reality the record shows this mostly leads to frustration, regret, and missed opportunities.  But like many things in life, the rules to successful investing are easy.  It's actually adhering to them that is difficult.

Reality Check

Over past few months, and even years, investors who have braved getting back into the market have enjoyed strong returns.  That is a fact.  However, in recent conversations, a few investors seem to be getting increasingly nervous about the pending "correction" coming.  In their view, the market is "too high" and has to come down.  And as such, they are shelving any long term investing decisions.  In fact, it wasn't just this year, but even in 2012.  Those investors have lost out on what was a prosperous 2013 thus far.

In one respect they are right.  The market will, as it always has, go down from time to time.  It is not a straight shot up.  The point to take from the question is, that even if they are right, what is the long term consequences?  I would argue, nothing.  A bear market is usually defined as a market decline of 20% or more.  If I look back at history, we have had a bear market, or worse, in every decade (including the 90s) in recent memory.  However, if you were a long term investor over those years, these bear markets were nothing more than a great buying opportunity, and were not a portfolio destroying event.  As long term investors, it is vitally important to keep a long term view, and not be influenced by the day to day hype.

Default: Nightmare on Wall St?

 

Nothing on the news this week seems to be encouraging.  There is gridlock in Washington, and there are dire warnings of financial meltdown if the US defaults on it's debt.  I am sure the memories of 2008 are still fresh in investor's minds, and on the whole they are terrified of going through that again just as many people have recovered their losses from the last correction.

As the debt ceiling showdown looms, I thought it would be a good idea to look at the possible effects of a US default on the financial markets- namely the US Stock markets.  To do that, we can look at the last global debt default. 

The last time a major world power defaulted on its debt was Russia in 1998.  The combination of the Asian financial crisis and falling natural resource prices put the Russian economy in dire straits.  By August of that year the Russian gov’t was no longer able to make good on its obligations.  From January to August of 1998, the Russian stock market declined about 75%.  The black line on the first chart below tracks the Russian stock market (the red line is the Dow Jones, just for comparison).

 There are two things I’d like to draw from the below chart.  The first is that Russia’s default, and most other sovereign debt defaults, are the end result of some other drastic economic effect.  As you can see below, the Russian markets were falling long before the actual default later in 1998- serious trouble had surfaced before then.  There were real economic and financial reasons why the country was unable to pay its debt service, and eventually they had to accept default.  Our current situation is nothing like that.  Instead of economic reasons, the only reason we would have a default is through a self-inflicted wound due to the total failure of our government.  It’s unclear how the markets would react to a default with this unique set of circumstances.  After all, if a default were to occur, it would be surprising if it was anything but very short.  This fact alone would make our “voluntary” default somewhat novel.

 The other thing you can observe from the chart below, is that the Russian markets did in fact recover.  It was not fun to be an investor there in 1998, however, two years later in 2000 the markets had recovered, and then some.  In fact, from 1998 to 2008, while the Dow Jones made almost no gain, the Russian market would have grown by a factor of at least four even AFTER the 08 crash (second chart).  So in short, a default on sovereign debt, as we have seen elsewhere, is temporarily disruptive, but in the long run not the portfolio destroying event it is hyped up to be. 

 

 

 I have to credit www.tradingeconomics.com for these graphs.  The site is a wealth of statistics and charts.

 

 

Horse Sense

Horse Sense

by Margaret Wittkopp, President

 

Do you have “horse sense”?  Having good horse sense means you know how to handle yourself, have common sense and are a prudent person.  A person without “horse sense” is not considered to have much common sense.  Maybe you have horse sense when you are around your horses…but do you have the same horse sense when it comes to your financial life?   

There are many commonalities between good horse sense and good financial sense, especially when it comes to investing. Here are a few examples:

Patience:   It takes patience to train a horse, gain their confidence and get them to do what you want them to do.  Some have used abusive and brutal techniques to get a horse to behave, but anyone with horse sense knows that is not an effective way to train horses.   

It also takes patience to be a good investor: knowing your risk tolerance and structuring your investment according to your objectives, riding out the ups and downs of the markets, prudently re-balancing and avoiding the pitfalls of the quick fix.

Discipline:  Having the discipline to work your horse regularly and with consistent cues is hard work and necessary for good results with your horse. 

Discipline is also a necessary ingredient to financial success.  Avoiding the pitfalls that so many investors fall into like: track record investing, market timing, and speculative investments among other deadly practices.

Soundness:  A sound horse is a healthy horse, and a sound investment/financial plan is based on sound science, is academically proven, and verifiable.  Before I buy a horse I want it checked out by a veterinarian I trust.  A sound Investment plan should undergo the same scrutiny.

VERITAS Financial Services, LLC 506 East Mill Street Suite 101 Plymouth, WI 53073 920-893-5262   923 South Main Street Suite E Oshkosh, WI 54902 920-251-4862 www.veritasinvesting.com www.facebook.com/veritasinvesting

Courage:  It takes courage to ride a 1000 lb animal.  No matter how they act on the ground, under saddle anything can happen.  We all know that, and still the desire to ride overcomes our fear.

To be financially successful it is important to “bridle” the forces of the market to our advantage.  We do this through investing in the market.  When done in a prudent and cost effective way we can, and generally will, experience the rewards of the market.  To get the rewards of the market we must have the courage to seek the truth about investing and implement it.

Everyone needs a COACH/Trainer:   A good trainer is invaluable, from braking out a horse to knowing how to ride the horse to ...well you name it.  To have a great experience with our horse we need coaching along the way.

A Coach, (not a salesperson disguised as an “advisor” “planner” "wealth manager” etc.)  helps you understand markets, structure your investments prudently,  according to your personal needs and objectives.   And most importantly a Coach tells you want you need to know…. not what you want to hear, to keep you moving toward your goals and helping you have a successful financial life.

Confidence:  This is the reward we receive from our discipline, patience and the courage we develop from working with our horse. 

Confidence is also what we gain when we know how to answer the: “20 Must Answer Questions for Financial Peace of Mind”.  See the attached quiz and find out how you are as an investor.  Answers must be 100% sure to count as a yes…and only you will benefit from knowing.

 

Fund Manager Success: Repeatable or Not?

For those of you who read my blog posts or receive our emails, you'll know that Standard and Poor's compiles some very interesting information on mutual fund manager performance versus their benchmarks.  The SPIVA Scorecard is a piece that I reference often.

Today, I ran across a new paper from S&P, The Persistence Scorecard.  This report looks at performance persistence in mutual funds.  For example, let's say a broker tries to sell you a fund whose manager has been on fire this year, beating the market by 10%.  Should you take this as an assurance that you will enjoy these lofty returns into the future?

Without retyping the entire article, I'll relay one of their findings that essentially summarizes the findings.  Over the three year period ending March of 2013, out of the top 25% of all performing US Equity funds at the start, only 4.69% of those funds remained in the top 25% of performers at the end of the 3 year period.

So, if you are entertaining purchasing a fund just because of its manager's stellar record, you may want to reconsider that decision, and find other, better criteria for fund selection.

Fidelity's at it Again

Well folks, remember when I did the blog post about Fidelity encouraging advisors to sell their stock mutual funds a few months ago--- after much of the market has recovered?  Well, they are at it again with a new slick marketing piece.  This is just the inside.  It's more than a postcard this time.

I'd just like to make a few comments on this.  First, they do point out that the market (S&P 500) is up 160% since the low in 2009.  How many of these marketing pieces did Fidelity make like this at the bottom?  Zero.  Stock funds will sell now because stocks are up.

Second, notice the first sentence "Fidelity experts forecast".  Whenever you see the word forecast from your investment professional, you should run, not walk, away.  Forecasting is part and parcel to market timing and stock picking, two activites that are speculating, not investing.

Their comment of "why are your clients avoiding stocks" should more accurately be put "why are you avoiding stocks".  During the market decline we never sold our clients out to cash, gold, or any annuity product.

But, who can blame them.  Fidelity needs to sell funds.  With their gold fund down 46.65% year to date, why not go with what's doing well.

Are You a High Net Worth Investor?

Almost daily we recieve solicitations from companies wanting us to sell their products, and advising us on how to "target" high net worth individuals.

Are you a high net worth individual? Are you tired of being "targeted" by commissioned based agents/advisors? Many firms specialize in targeting individuals with $250,000 or more to invest.  (Trust us, we can buy lists of these exact prospects).  These individuals are vulnerable to salespitches that are not necessarily designed for their best interest.  Held capitive by commission based compensation, the typical advisor has strong incentive to close the sale and make sure their bills get paid.

 Maybe you don't think of yourself as a "High Net Worth" individual.. but you are if you have $250,000 or more in your 401K or other investable assets. If you want a prudent no-nonsense approach to managing your "nest egg" maybe you should learn about the Veritas approach.

What is the Real Rate of Return?

One of the intriguing paradoxes in investing is the difference between a fund’s reported return, and the personal rates of return for the people that own that fund.  For example, fund x may have earned 10% in the last 3 years on average, but, what did the “average” investor in that fund earn over the same time period?  The difference may be surprising to you.

Let’s look at a stalwart fund of the broker sold community: The Growth Fund of America.  If you look up the fund on any internet based reporting service, you notice that its five year return is 3.73% per year.  Not bad considering that time period held some of the 2008 downturn.  But what does that number mean?  That is not the return of the average investor, it is simply the return of the fund.  For an investor to have earned that, they would have had to buy the fund on day one, held it entirely, and still have been holding it at the end of the five year period.  As advisors and investors, what concerns us is INVESTOR return, not fund return.  The average investor return over that same period was only 1.18%!   That means that if we look at all of the investors that held that fund during that five year period their average return was only 1.18% per year. 

How could that be?  Well, here again we see that investor behavior trumps the many other factors that contribute to successful investing.  Over that five year period, investors in that fund continued to engage in many of the bad behaviors that investors fall prey to, among them likely market timing and track record investing.  But this is not something that we only see at American Funds.  Fidelity Growth company has a five year return of 7.04%, while its five year “investor” return is only 3.86%.  Here again, investor’s fail to get their full rate of return because of a lack of discipline; discipline which can only be acquired through a commitment on the part of the advisor and client to lifelong investor coaching. Without it, investors do and will continue to leave money on the table.

And now, for a truly amazing thing.  Do you know that an investor in a fund can actually earn MORE than the fund itself?  Take for example a fund that many of our clients own internally in their own portfolio, DFA US Small Cap.  Its five year fund return is 9.44%, while the INVESTOR return over that period was 10.22%.  Can you figure out how this can possibly be?  We’ll have the answer in our next newsletter.