Investment Truths for All Seasons

There’s not too much that’s business as usual in today’s market. First, our economic recovery is following a very atypical course. Generally, the more significant a market downturn is, the stronger the rebound. Yet, although the economy contracted about 4 percent during this “Great Recession,” the worst since the Great Depression, the recovery has been considerably less than spectacular. In fact, growth is running at less than half the expected speed due to tight credit conditions, a depressed housing market, and widespread lack of consumer confidence.

It’s important to recognize that the atypical recovery is a global issue, influenced by a number of unprecedented events: the massive earthquake and ensuing nuclear crisis in Japan; sovereign debt concerns in Portugal, Ireland, Italy, Greece, and Spain; the debt, spending, and taxing debate that played out in Congress over the summer and the subsequent downgrading of U.S. debt; unrelenting high unemployment; and historically low interest rates.

Interestingly, today’s unusual and unsettled environment has resulted in even the most time-tested, academically proven investment tenets coming under fire. Therefore, I thought it might be helpful to review what I refer to as the “Seven Basic Truths about Investing.” Here they are:

#1. Stocks will provide a greater return than bonds over the long term. According to Standard & Poor’s, the S&P 500 Index has had an average annual return of 9.9% annually from 1926 to 2010. Over the past 50 years, it’s returned 9.8%, and over the past 25 years, the return has been 9.9%. According to Ibbotson Associates, long-term government bonds have averaged 5.5%, 7.1%, and 8.9% during these same three time periods.

#2. Stocks are riskier than bonds. Since January 1, 1926, there have been 24 calendar years when the S&P 500 Index has had a negative return. In other words, the market has lost money approximately 30% of the time. Over the same period of time, there have been 22 calendar years when long-term government bonds have had a negative total return—or 27.5% of the time.

#3. Stocks are a better hedge against inflation. On an inflation-adjusted basis, the S&P 500 Index has provided average annual returns of 6.7% from 1926 to 2010, 5.4% over the past 50 years, and 6.9% over the past 25 years. There were a total of 10 rolling-year periods when the S&P 500 Index did not keep up with inflation. While long-term government bonds provided inflation-adjusted returns of 2.4%, 2.9%, and 5.9% over those same three periods, there were 33 rolling-year periods when long-term government bonds did not keep up with inflation. One factor influencing the gap between stocks and bonds is that, even in difficult markets, companies can increase their prices to remain competitive.

#4. Diversification is your friend and ally. In Are Stocks a Loser’s Bet?, William J. Bernstein quotes research from Dimensional Fund Advisors that found that from 1980 to 2008, the top-performing 25% of stocks were responsible for all the gains in the broad market, as represented by the University of Chicago’s CRSP (Center for Research in Security Prices) total equity market database. So, you may ask, why not invest in those stocks? Bernstein’s answer, “A portfolio of ‘carefully chosen’ equities could easily wind up with none of the best-performing stocks in the market—and thus produce flat or negative returns over many years. Missing out on even a handful of superstocks can leave you short of your target.”

It is not worth risking your family’s financial security by risking your portfolio on a few stocks, no matter how well you think you understand the company and its prospects. Think of the old adage: “Don’t put all your eggs in one basket.” Spreading your money among stocks, bonds, and cash—asset classes that historically have responded differently to market conditions—is your best defense against being hurt by poor performance in any one stock or any one asset class.

#5. Asset allocation plans work. The often-referenced study by Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal, July/August 1986, found 94% of investment returns to be determined by asset allocation and just 6% attributable to market timing and security selection. Your asset allocation plan should be based upon your risk tolerance and the timeframe for your investment goals. While most investors chase returns and end up concentrated in a handful of stocks or a few asset classes, you can see from the Callan Periodic Table of Investment Returns that one asset class never stays at the top or bottom forever. History teaches us that, like a seesaw, as some investments decline, others rise to offset those losses.

#6. Rebalancing is essential to your long-term success. Routine rebalancing forces you to “sell high” when an asset class has gone through a period of superior performance and “buy low” when an asset class has had below-average performance. The news media and Wall Street are fond of quoting market returns, but individual investors generally earn less than the market. For example, the DALBAR Associates QAIB study dated December 31, 2007 found that although the S&P 500 averaged a healthy 11.9% from 1988 to 2007, the average investor’s return for the same time period was only 4.48%. Why the discrepancy? Individual investors tend to let their emotions dictate their tolerance for exposure to the stock market and make emotional investment decisions rather than being guided by an investment policy statement. The relatively efficient nature of the markets, combined with trading costs and taxes, stack the deck heavily against these emotional day traders.

#7. It’s essential to work with a fiduciary. If there’s one last piece of universal wisdom I’d offer it’s that you should always work with an advisor who is a fiduciary who must act in your best interests. According to the National Association of Personal Financial Advisors (NAPFA), “A financial advisor held to a Fiduciary Standard occupies a position of special trust and confidence when working with a client. As a fiduciary, the financial advisor is required to act with undivided loyalty to the client. This includes disclosure of how the financial advisor is to be compensated and any corresponding conflicts of interest.”

To be the true professionals our clients need and deserve, our entire industry should embrace the fiduciary standard, as well as Wharton Professor Steven Blum’s definition of a professional. “A true professional uses his or her ability and power solely to advance the best interests of the client,” Blum says. “When the professional’s interests diverge from those of the client, the professional always follows only the client’s interests.” I have embraced these definitions in my career, and I hope that soon all advisors will abide by the fiduciary standard. Individual investors deserve nothing less. To determine if an advisor is a fiduciary, consult NAPFA’s “Fiduciary Questionnaire.”

During this period of extreme market turbulence, as a trusted advisor, I seek to provide the discipline and perspective our clients need to hold fast to these investment truths and to help them reach their goals.

Keep the faith!

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