There was a really interesting chart put forth by Business Insider showing the country’s deficit during the presidencies of Reagan and Obama. The general consensus was that Reagan was a fiscal conservative and Obama is an out-of-control spender. I was shocked to see the charts overlaid and to see this was just not the case:
Not only is Obama’s deficit (as a % of GDP) less than Reagan, but he started from a much worse position. Now, in all fairness, you can’t really give too much credit to Obama for this improvement. The improvement comes from two areas: first, the US has seen an improving economy during this period. You could argue that Bush II’s actions at the end of his presidency along with Obama’s continuation of those policies helped stave off an economic catastrophe but other than that, the economy has bounced back because of many other factors other than political. Second, the gridlock in Congress has basically made it very difficult to enact significant spending increases. In addition, because of the sunset laws on the tax code, we have seen increases in tax revenues. Basically, the government has not grown at the rate it had in the past.
Does any of this matter to the investment markets? Probably somewhat, but much less than what political pundits would have you believe. I always cringe when I hear about someone making an investment decision because of the “direction our country is going” or how “the new healthcare law is going to punish investors”. These are more political comments, and history has shown that the markets care about earnings, growth and valuation, not who is in office.
While we are only about a quarter of the way through 2014, it has been interesting to look at performance across asset classes. What we are seeing is that some of the worst performing asset classes of 2013 are off to a great start in 2014. The numbers are below (using mutual funds as proxies for various asset classes):
|Asset Class||Fund Symbol||2013||2014 YTD|
The funds that performed best last year are towards the bottom of the pack so far this year, and the ones showing some of the worst returns last year are now back on top. The investment markets are impossible to predict. We continue to believe that being diversified across asset classes is still the optimal approach for investors. You have to accept a few things when you take this approach:
- Your portfolio will never be on the top of this list- if you invest in various asset classes, you have to realize that your portfolio’s performance will be somewhere in the middle of all of these asset classes, since you will be blending your returns across a number of investments. For years when something like commodities is the best performer, no one really cares because commodities are not a market talked about very often. But in 2013, the best performing asset class was US stocks. Many investors who read financial magazines or watch financial TV questioned why their portfolio was not keeping pace with the S&P 500. This chart above is the reason.
- Your portfolio will never be on the bottom of this list- if you concentrate your assets in one asset class, there will come a time when all the other investment markets outperform you. For most investors, this is a difficult pill to swallow, especially when losses can be severe.
I often tell clients that when you are properly diversified you always have something to complain about. This was true last year and will continue to be true moving forward. The start of 2014 is another example of why staying diversified is so important.
If you read this blog regularly, you know our feelings towards hedge funds. These products tend to charge high fees and (at least for the last several years) have been a major drag on an investor’s portfolios. New research from HFR has come out that shows how many of these hedge funds are closed every year:
To put that in perspective, half of all individual hedge funds have closed in the last five years.
Here is the chart showing funds launched and closed since 1996:
So what is going on here? If there is so much money flowing into these investments and the wealthy love them so much, why are these funds dropping like flies. First, I am sure there is a good amount of them that never met the critical mass needed to be profitable. There is another problem with a hedge fund’s structure that misaligns the manager’s goals with the investor’s goals. Hedge funds have a performance fee of typically 20%, meaning they get 20% of the profits they generate. For most hedge funds they also have a high water mark, meaning that if the fund loses money investors don’t have to pay the 20% of profits until they retrace their losses and get back into the black. For those funds that lose money and realize it may take years to hit their high water mark, an obvious choice may be to close the fund. They won’t be able to earn their 20% of profits so why not close the doors and start a new fund where they can reset the high water mark? Look at how many funds closed their doors in 2008. I wonder if this was a major reason why.
I always like to look at incentives. These structures can create excessive risk taking and bad incentives for hedge fund managers. With a 50% chance the fund you invest in is going to be closed in 5 years, I would much rather stick with a “boring” strategy of buying and holding low cost, passive investment vehicles. I like the odds and the incentives much better.
I often come across investors who believe stocks are risky. In one sense I guess they are. In 2008 we saw 50%+ losses in the market which was scary for even the most die hard investor. People tend to focus on these short bursts of volatility and figure that anything that can go up and down that much must be unstable. But the reality is that there is only two dates that matter for investors, the day you buy and the day you sell. From our research we have done on the stock market, choosing the length of time between those dates can drastically improve your odds of a successful investment and the risk associated with that investment. Let’s look at some of the data on the probability of achieving returns over different intervals. I used data taken from the CRSP 1-10 Index from 1926 until 2014:
|Probability of Achieving Annualized Returns|
One of the key findings is how low the probability of loss is with stocks over long periods of time. In fact, over all rolling 10 year periods we found only 5% of those periods are negative. In addition, only 17% of those periods had returns less than 5%. Those sound like pretty good odds for investors who are willing to buy stocks and not touch them for 10 years. The breakeven point seems to be around 10% returns. About half of all rolling 10 year periods in the market generate returns above 10%, and half below.
For those of you waiting on the sideline, or thinking there will be a better time to enter this market, you may be right, but the odds are not in your favor. The longer you wait, the higher the probability that you will be getting in at higher prices. Investors should play the odds by staying invested.
“Everybody has a plan until they get punched in the mouth.” – Mike Tyson
I love that quote. It is very fitting for investors and something we all need to consider. Many of us have investment strategies for how we will manage our money. The real question is how you will react when the inevitable crisis happens. Unfortunately, the market will collapse again. That is the nature of markets. There is no way to adequately predict when it is going to happen, so what is your plan for when it does happen? I’ll give you three answers I tend to hear from investors:
- If things start getting bad, I’ll reduce my risk. If this is your strategy get used to the whipsawed feeling, because you are going to experience it often. The fact is that the market drops on bad news ALL THE TIME. In fact a recent chart from JP Morgan shows that on average the market drops 15 percent intra-year. This doesn’t mean the market is always negative, just that you will experience periods of losses throughout the year. If you think you can dance in and out of the market around these drops, I would urge you to reconsider.
- I use stop losses to make sure I don’t lose too much. This is similar to the first point, but just more quantitative. It doesn’t work either. Please see our post detailing why.
- I use different metrics to determine when to get in or out of the market. When pressed about these metrics they tend to not have any sort of reliability. Here is a quick tip- you or I don’t have any sort of trading system for beating the market. If there really was some indicator we could point to that would lead to outperformance, the armies of wall street traders would jump all over it, arbitraging it away and rendering it useless.
So what should your plan be for market collapses? As hard as it may be to hear, it is pretty simple. Develop an allocation of risky and safe assets that you feel comfortable with. Understand how it will perform in both good and bad markets. Then, stick with that allocation in good and bad times. Don’t let your emotions dominate the discipline that is required to be a successful investor. This may not be what you want to hear, but it is the best way to be a successful investor over time.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.