Out
Like A Lamb…
The stock market’s performance in March held to the old saying
about March’s weather: “In like a lion and out like a
lamb.” A month ago, we wrote how the stock market was off to
its worst start in nearly 70 years. By quarter-end, however, thanks
to the S&P’s nearly 10% rally off the intra-day lows set
on March 17th, we can now state that the market is off to its worst
start in “only” 7 years. We’ll take improvement
where we can get it. We’re glad the book has been closed on
the eventful and volatile quarter.
Comparing the markets to the weather is apt. Neither can be controlled.
While both may display short-term momentum at times, neither can
be predicted with a high degree of accuracy in the foreseeable future.
That said, though, like everyone knows that the cold weather of
winter will eventually turn into springtime and eventually into the
heat of summer, and vice versa, long-term investors know that periods
of high market valuations will turn into lower market valuations
and that low stock-market returns will eventually turn into higher
market returns.
Due to the market correction in recent months, stock market valuations
are now back at levels not seen in many years. In short, the long-term
forecast for stock market returns looks better now than it has in
years.
What exactly is “Long Term?”
What is meant by “long-term” in investing? Different
voices provide different definitions, but the consensus generally
says that around ten years or more qualifies as long-term. This contrasts
to “short-term” time horizon, which many would say is
two years or less.
The reason these time frames are important is because investors
need to match an investment portfolio with the highest probability
of meeting their investment objective. When investing for short-term
liabilities, for instance, it is important to emphasize capital preservation
to maximize the chances of actually being able to meet those short-term
obligations. Emphasizing fixed-income and cash instruments may sacrifice
some return potential, but their probability of providing a positive
return over a short time period is higher than it is for equity-oriented
investments.
As for long-term investment objectives, the emphasis shifts away
from relatively stable securities to those securities that can typically
provide higher total returns over time. The stock market for instance,
while clearly more volatile in the short-term and thus more likely
to generate short-term losses than bonds, generally provides higher
total returns over time. For the long-term investor, emphasizing
equity-oriented investments, which participate in the long-term growth
of the economy, is the higher probability way to build a portfolio.
Of course the degree of equity exposure for each investor is a determined
balance of return and risk and primarily depends on each individual’s
own risk tolerance and unique considerations and objectives.
Ten-Year Returns – Now and Ten Years
Ago
So, let’s look at the 10-year annualized returns. First, we
will examine the 10-year returns at the end of March 2008, and then
we’ll look at the 10-year numbers from March 1998. There are
lots of items worthy of comment. First though, let’s review
the numbers.
Over the last ten years, the top performing asset classes were commodities,
emerging international markets, and real estate investment trusts
(REITS). The bottom performing benchmarks were the growth stock benchmarks,
with the Russell 200 Growth index, which represents large cap growth
stocks, at the bottom of the list.
| Annualized Returns through 3/31/08 |
| Name |
10 Year Return through 03/31/08 |
| Dow Jones AIG Commodities |
10.39 |
| MSCI Emerging International Markets |
9.74 |
| FTSE NAREIT Real Estate Investment Trusts |
9.64 |
| Lehman Brothers US Treasury US TIPS |
7.97 |
| Russell 2000 Value (small cap value) |
7.46 |
| Lehman Brothers US Treasury Long |
7.40 |
| Lehman Brothers US Aggregate Bond Index |
6.04 |
| Russell 3000 Value (value stocks) |
5.63 |
| Dow Jones Industrial Average |
5.47 |
| Russell 2000 (small caps) |
4.96 |
| Lehman High Yield Bonds |
4.84 |
| Russell Top 200 Value (large cap value) |
4.46 |
| MSCI EAFE Developed International Markets |
4.14 |
| Russell 3000 (total U.S. stock market) |
3.88 |
| Merrill Lynch 3-Month T-Bill (cash) |
3.73 |
| S&P 500 |
3.50 |
| Russell Top 200 (large caps) |
2.63 |
| NASDAQ Composite |
2.19 |
| Russell 2000 Growth (small cap growth) |
1.75 |
| Russell 3000 Growth (growth stocks) |
1.29 |
| Russell Top 200 Growth (large cap growth) |
0.38 |
Now, let’s look at the 10-year annualized numbers from 10
years ago (one note – commodities only go back to 1991). In
this case, the bottom performing asset class was developed international
markets and the top performing asset class was domestic large cap
growth stocks.
| Annualized Returns through 3/31/98 |
| Name |
10 Year Return
through 03/31/98 |
| Russell Top 200 Growth TR USD |
20.22 |
| DJ Industrial Average TR USD |
19.47 |
| Russell Top 200 TR USD |
19.39 |
| S&P 500 TR |
18.94 |
| Russell 3000 Growth TR USD |
18.70 |
| Russell Top 200 Value TR USD |
18.47 |
| Russell 3000 TR USD |
18.42 |
| Russell 3000 Value TR USD |
18.11 |
| NASDAQ Composite PR USD |
17.23 |
| Russell 2000 Value TR USD |
16.44 |
| Russell 2000 TR USD |
14.86 |
| MSCI EM USD |
13.77 |
| Russell
2000 Growth TR USD |
12.95 |
| FTSE NAREIT All REITs TR |
10.88 |
| LB US Treasury Long TR USD |
10.78 |
| LB US Agg Bond TR USD |
8.94 |
| DJ AIG Commodity (7-year Annlzd return: 4/91-3/98) |
6.23 |
| Merrill Lynch 3-Month T-Bill (cash) |
5.83 |
| MSCI EAFE USD |
3.55 |
The first thing that is interesting in these tables is how vastly
different each time frame has been in terms of the magnitude of total
returns (though both show positive returns across all asset classes).
The current 10-year annualized returns, for example, are lower than
historical averages. Then again, given the level of financial market
valuations ten years ago, this shouldn’t be too much of a surprise
(even though the economy actually produced above-average growth over
the last ten years!). In addition, the annualized 10-year returns
from a decade ago were clearly above average. Given the cyclicality
of markets, it would be reasonable to expect low-return environments
to follow high-return environments – and vice versa.
Even in the low-return environment, it should be pointed out that
equity-oriented investments — the more volatile asset classes — tended
to generate the higher total returns over time. Bonds have clearly
been competitive over the last 10 years, but the top performers were
still those asset classes participating in economic growth.
I think the table above also speaks to – both for and against — the
concept of “buy-and-hold” investing. First off, we believe,
and the data above appears to prove, that there is no one investment
that a long-term investor can just buy and hold and not think about
again. Conceptually, however, buy and hold investing has some extremely
important attributes, which are key to a successful investment philosophy,
such as a long-term outlook, minimization of transaction costs, and
an equity orientation. Still, it doesn’t really mean buying
one asset class and forgetting about it.
Besides, note how the best performing asset classes generally became
the worst ten years later. How did the worst asset classes from ten
years ago become the best in the most recent ten years? After looking
at this data, the long-term investor should keep in mind the saying
that “the first shall be last and the last shall be first.” Chasing
performance is the worst example of poor investment behavior and
the leading reason why many investors have difficulty achieving satisfactory
returns.
Which is why most investors would be best served in balanced, diversified
portfolios. Instead of chasing the investments that did best historically,
investors should stay consistently invested in a portfolio of multiple
asset classes to participate in long-term global economic growth.
What Exactly is a Balanced, Diversified Portfolio?
A “balanced, diversified portfolio” is an expression
that’s often used, but exactly what does it mean?
A “balanced” portfolio is typically defined as a portfolio
that maintains exposure to multiple asset classes, creating a balance
between return and risk. Balanced funds can often be called “asset
allocation” or “allocation” funds. At Kobren Insight
Management, the allocation among various classes is primarily driven
by the individual client and her or his investment objectives, time
horizon, risk tolerance and other unique considerations. The secondary
consideration, which modifies the strategic allocation decision for
each client, is Kobren’s return and risk outlook for various
asset classes.
A “diversified” portfolio meanwhile, is a portfolio
that is not concentrated in any one specific market exposure or security.
It is the opposite of a concentrated portfolio. Diversifying a portfolio
can reduce portfolio risk in a couple ways, including reducing security
specific-risk (the risk that one security could materially hurt performance;
also called idiosyncratic risk) and reducing over-all volatility.
Most mutual funds are excellent examples of diversified portfolios.
While some mutual funds are actually classified as “non-diversified,” most
funds typically do not concentrate their portfolio on a single market
exposure or two. In fact, the typical mutual fund owns nearly 250
individual securities. As a result, mutual fund portfolios tend to
display much lower volatility than a portfolio consisting of a few
single securities.
Why Balanced, Diversified Portfolios Should Work
There are various reasons why balanced, diversified portfolios work
for the long-term investor.
First, balanced, diversified portfolios provide steadier returns.
In other words, they display less price volatility. Various studies
of investor behavior have shown that lower volatility portfolios
are more attractive to investors and thus investors are more likely
to stick with them during periods of increased market volatility.
While volatility can mean opportunity to the investor with the time,
interest, and expertise to take advantage of it, for those investors
busy doing other things, volatility can often be distracting and
destabilizing.
Staying invested in a balanced, diversified portfolio through various
market cycles can typically provide investors a better experience
than trying to time the market by buying and selling at the wrong
time, which is often the case. In addition to minimizing poor investment
behavior, staying invested in an appropriately balanced and diversified
portfolio generally means that an investor will maintain a higher
average allocation over time to higher returning asset classes, such
as the stock market. It may even enable an investor to modestly participate
in the highest risk asset classes (for example emerging market equities),
something that is extremely difficult to do when that asset class
is the sole investment.
A diversified portfolio also minimizes the damage from individual
securities that may “blow up.” All the great investors
have had high conviction trades that will go sour on them. Yet, they
were able to stay in the game because they diversified. Why concentrate
on one big bet or two and risk permanent damage to an investment
portfolio? As we have said before, investing and gambling are two
separate activities.
Why Balanced, Diversified Portfolios Might
Not Work –
At Least
in the Short Term
In the short term, investors can become frustrated with balanced,
diversified portfolios. Typically, it is during times when the relative
performance difference between balanced, diversified portfolios and
the domestic stock market is greatest.
For instance, when the S&P 500 dominates all other benchmarks,
especially the non-equity asset classes, many begin to question the
value of having any exposure outside the S&P 500. This has been
seen before and will be seen again. Still, as can be seen by the
historical numbers, just as sure as the S&P will rotate to the
top of the performance charts, it will surely rotate back to the
bottom.
Remarkably, another time that balanced, diversified portfolios typically
come under pressure from clients is when they handily beat the S&P.
This is usually when the S&P is posting absolute losses. At that
point, many investors simply don’t want any exposure at all
to the stock market. Again, though, after the S&P have suffered
losses, this is often the worst time to trim exposure to the stock
market.
Summary
In closing, we believe that the balanced, diversified portfolio is
the all-weather investment approach that should suit the purposes
of most investors. While specific life changes will gradually modify
an individual’s balance of assets over time, the steady approach
should help most investors eventually attain their long-term goals.
The key is to maintain a disciplined, long-term orientation and
stay invested. As the investing legend Sir John Templeton said, “History
shows that time, not timing, is the key to investment success.”
Sincerely,
