The Three Dangerous Times
The three particularly dangerous times for investors: when markets go up, when they go down and when they are flat.
For the last two years, U.S. markets have been in a narrow trading range. Some days the market is up a lot, some days it’s down big. But overall, for two years the broad market is close to flat — up 3 percent a year — a third of the long-term average.
During a long flat period, investors get bored and are often up to mischief, searching for alternatives that promise much and mask danger.
In bear markets — the market often plunges quickly –and investors are prone to panic and do things that imperil their finances for many years.
When the market is doing well — bull markets — people get exuberant and overconfident and may take on greater risks and obligations than they intend. This sets them up for failure in the next cycle.
Given this bleak picture, what should investors do to improve their odds of success? Investors need to be patient, avoid emotional decisions and think long-term.
None of this is easy but it’s important for a successful investment experience.
The U.S. stock market is off to its worst start ever — down nearly 12 percent in just three weeks. Standard & Poors searched records back to 1897 and couldn’t find anything worse.
While the market has been drifting lower since summer — including a brief but scary decline in late August — this drop has seemingly come out of nowhere and is unremitting in its furor.
Yesterday, the Dow dropped 550 points by midday before rallying sharply. While there are always things to worry about, this seems to be the bear market about nothing.
The Chinese economy, the second largest in the world, may be getting unhinged. And the oil market has gone from boom to busted in 18 months but hey, nobody’s perfect.
If it weren’t for these minor issues, the outlook might seem bright. Job growth has been strong in the U.S. and corporate balance sheets are in the best shape in years.
Worldwide, corporations and investors are awash in cash and looking desperately for places to stash it (no place more frantic than Colorado where legal marijuana growers can’t access the banking system).
So what’s an investor to do? It’s usually best to hunker down and not panic. And if you feel like panicking, turn off the TV and the Internet and take a walk. You’ll feel better and in the long run, your portfolio will thank you.
Index Funds have attained a near untouchable status among the financial press and investors. And for good reason. The funds — at least the highly diversified ones — are regularly among the top long-term investments. Recently, a Bloomberg article took an opposite tack, bashing index funds for being mindless machines that let nimble investors exploit their announced intentions. The article is harsh but accurate. Index funds are predictable and not perfect investments but they do serve many investors well. There are approaches that take the index funds as a useful starting point, attempt to preserve what’s good and enhance returns by avoiding some of the index fund flaws. Trading is one significant area. Index funds buy and sell holding whenever an index changes essentially letting the marketplace know what you are going to trade before you do it. A more patient approach to trading can lead to significant gains. For the rest of the gory details, here’s the link to “Can you really game index funds?” http://www.bloombergview.com/articles/2015-07-07/can-you-really-game-index-funds-
If there were a bond bubble, this is what it would look like: trillions of dollars of Eurobonds going for negative interest rates, the 10 year German bund yielding pennies and Mexico promising to pay back bonds in 100 years with an interest rate of 4 percent. More than half of the world’s government bonds are yielding less than one percent. We don’t have any experience with this kind of a world. We know it won’t last forever but we don’t know when and how it will end. We do know that we should be careful in buying bonds. None of this means that we shouldn’t buy bonds or that everyone will lose money. A good guess is that many, if not most, of these bond buyers haven’t thought through the end game and if trouble comes, it will be unexpected. There are many reasons why interest rates are so low. One is that the Great Recession was so terrifying that people still haven’t recovered. They aren’t willing to sign up for risky assets and as a consequence they have made a once safe asset one of the riskiest. As the saying goes, buyer beware.
Like Mining Low Grade Ore
Most investors look for a big strike, a huge vein of ore. It’s always possible that they will find it but the odds are heavily against them.
Successful investing is more like mining for low grade ore. It’s a less exciting, methodical process that takes a long time. But with careful attention to strategy and execution, the probability of success is much higher.
Working with low grade ore isn’t as exciting and you’ll never have one of those “Eureka” moments. But neither do you have the frustration of one barren mine after another.
Investors look for the magic stock or the magic fund, a lottery ticket, that will bring them quick riches. In practice what works is a long-term, diversified portfolio with careful attention to minimizing taxes, watching costs and removing emotion from the process.
Those who react to the latest news or are constantly on the lookout for a winner fly in the face of decades of market history. While there is a logic and temptation to that approach, nearly all academic literature belies this notion.
Once in a blue moon, investment lightning strikes. Do you want to put your future on the line with those odds?
Apple Goes Into Dow
This week Apple Computer becomes part of the prestigious Dow Jones Industrial Average. The Dow is made up of 30 stocks and since its creation in 1896 has become the single most widely cited indicator of stock market performance. And yet its quirky structure shows the dangers of relying on any one indicator to mark investment performance. The Dow Jones average is based on just price, not the total value of the companies. Once a stock splits, its weight in the Dow goes down even though the value stays the same. After some moves in the Dow this week Goldman Sachs will have the heaviest weight in the average because it has the highest price. Moves in the price of Goldman stock will have a disproportionate affect on the average. Often the Dow moves in sync with other major averages such as the S&P 500 but many times they have widely divergent moves. While the Dow is a good shorthand way of following the stock market, keep in mind that its only a snapshot of a small number of stocks and there are thousands of other great companies.
Desperately Seeking Yield
Investors are perplexed and concerned about continued low interest rates.
People who think of themselves as conservative investors like to rely on guaranteed fixed interest rates. Over the last six years that hasn’t been much fun.
In early 2009, the Federal Reserve Board lowered their short-term interest rate target to close to zero and it’s remained there ever since. It seems hard to believe but as recently as early 2008, the target was 4.25 percent.
Investors’ choices in this environment are unattractive: they can accept little risk and interest rates of close to zero or take on different kinds of risk.
Many investors refuse to take on risk. In fact, by some estimates as much as $3 trillion is invested at negative interest rates. With a negative interest rate it means that the investor is paying the issuer or custodian to hold their money. They’ll get less money back than they put in.
In a world of seemingly low interest rates forever, investors will take increasingly “clever” or risky moves to get higher yields. They may not recognize the risks until it’s too late but the risks are there. Prudent assessment of risks and an overall plan are the best ways to survive this period.
The U.S. stock market has been on a tear for nearly five years. It’s sometimes hard to keep that in mind when we have a terrifying dip like we did last week. But over this five year period the U.S. stock market has nearly tripled.
Most foreign stock markets haven’t fared nearly as well. A month ago, the U.S. stock market represented 52 percent of the value of all global stock markets, according to Dimensional Fund Advisors. At year end 2007, the U.S. represented 41 percent of the world stock market value. That may not sound like a big deal but it amounts to $4.7 trillion.
In practical terms, many investors are getting discouraged about international investing when the U.S. is doing so well. But over the long term, international markets have outperformed the U.S.
With only five percent of world population and 25 percent of world Gross Domestic Product, it seems unlikely that in coming decades the U.S. will dominate global stock markets to this extent.
Prudent investors should look beyond the recent past and try to envision the world economy over the long term. If they do, they’ll realize that international stocks should be part of most well diversified portfolios.
Recently the New York Times highlighted the troubles of the New York City pension system. The pool of money held to pay future benefits is at least $100 billion short of where it needs to be.
Experts debate the exact amount but it’s clear that there’s not enough money to cover obligations. The pension troubles consuming the budget, rising from 2 percent of total spending to 11 percent in a decade.
What’s also clear is that this huge institutional investor is making the same mistakes as ordinary, small investors: paying too little attention to something that cries out for focus, failing to properly allocate assets and falling prey to the siren song of unrealistically high projected returns in alluring investments.
It’s a shame that boring old stocks and bonds don’t have the pizzazz of alternative investments — hedge funds, private equity, venture capital.
The Times mentions that the pension system’s investment return goal was unrealistically high at 8 percent annually. Actual returns were two percent a year.
Individuals make the same mistakes and this doesn’t have to be; a little realism and some good planning go a long way toward achieving a successful and comfortable retirement. We can help.