Did
you know that 19% of all Americans think they belong within the
richest 1% of U.S. households?
… That 82% of people think that they are in the top 30%
safest drivers?
… That 80% of students think that they will finish in the
top half of their
class?
… That people typically think they will have twice as much
money at 
retirement than the average person, even when comparing
themselves to others from their own profession?
In short, individuals are over-confident. While it can be argued
that a positive mental attitude is helpful in many ways to enable
individuals to have functional, productive, and satisfactory lives,
it is not necessarily a helpful attitude in making investment decisions.
Overconfident investors tend to trade excessively, stray beyond
their circle of competence, and often use excessive leverage. They
also tend to concentrate their portfolio.
Given that investment decisions are made in conditions of uncertainty,
and that even the most competent, passionate investment managers
are still wrong a significant portion of the time, building a properly
diversified portfolio is often the most important thing an individual
investor can do.
Did You Know? — II
Did you know that long Treasury Bonds have posted a better annualized
return than the S&P 500 equity index over the last 5 calendar
years? Over the last 6 years? Over the last 7 years? Over the
last 8 years? Over the last 9 years?
For a “long-term” investor, who might state that they
don’t need the money for at least ten years (and therefore
want to put everything in stocks), this last set of numbers may
be a bit of a surprise.
Of course, as with all statistics reported in financial commentaries
(and research outside the investment world), the results are dependent
on the time frame, both the starting point and the ending point.
It could be argued that the time frame chosen (starting from a
period of high stock valuations and incorporating the 2000-2002
bear market) was best suited toward an argument for a diversified
portfolio.
It’s hard to claim complete innocence on that last point,
but nonetheless several things should ring true. First, as demonstrated
above, bond total returns can be competitive with stock returns,
not just in any given year, but over longer time frames, as well.
Risk-adjusted returns (which take volatility into account) may
even be superior. Of course other leading attributes of bonds include
the ability to diversify equity portfolios, particularly in periods
of economic slowdowns.
Second, long-term forward (expected) returns are driven by valuations.
The stock market became quite overvalued in the late 1990s. Looking
back, it should not be a surprise that annualized return of the
S&P 500 from 1998-2006 is below average at just under 6% per
year. While valuation is a poor predictor of short-term performance,
it is important over longer time periods. As value investors often
say: “Value will out.” Meaning that over time, valuations
do matter and that superior long-term returns are often borne from
periods of attractive (low) valuations.
Over the past three years, annualized stock market returns have
been above average, and as a result, today, many investors want
more equity exposure. While given the current environment we are
basically market agnostic (neutral in our view on stocks), we are
not of the mind to add equity exposure at present.
As money manager and market commentator John Hussman has strongly
stated:
“If the parents or the children of Wall Street analysts
were to ask for wise investment advice, would the first thought
of these analysts really be to encourage stock purchases at a multi-year
market high, in a long-uncorrected and strenuously overbought advance,
at a multiple of over 18 times earnings on unusually wide profit
margins, with wages and unit labor costs rising faster than inflation,
while interest rates are rising, bullish sentiment is unusually
high, and corporate insiders are selling heavily?
…We’ve been here before, and the consequences – though
not always immediate – have invariably been bad. There is
not a single instance in historical data since 1871 when the S&P
500 traded above 18 times record earnings and there was not a low
a year or more later that erased every bit of advantage over Treasury
bills. Not one.”
One of the interesting things about our profession is that we
get to hear and learn from lots of bright people. For every accomplished
and proven market analyst like Hussman, we can find many equally
accomplished and articulate analysts who completely disagree with
him.
Yet another reason why we build diversified portfolios.
Did You Know? — III
Did you know that as of this writing, the Dow Jones Industrials
has gone over 930 business days without a single 2% one-day price
decline?
Looking at the broader S&P 500, never mind a one-day 2% loss,
it hasn’t even corrected 2% over any time period since last
July – the second longest such period in 53 years.
Though the recent experience in the market suggests otherwise,
the stock market regularly corrects. As the table below shows,
the stock market often has 5% and 10% corrections. What we have
seen in recent months has been rather extraordinary. Does that
mean that something has fundamentally changed within the market?
Perhaps, but it’s not the most likely answer.
Did You Know? — IV
Did you know that approximately two-thirds of all mutual fund
flows over the last two years have gone into international
and global
mutual funds?
Did you know that the leading benchmark for developed international
equity markets, the MSCI EAFE (Morgan Stanley Capital International
Europe, Australasia, and Far East) Index, beat the S&P 500
Index in 2006? In 2005? In 2004? In 2003? In 2002?
But, did you know the S&P Index beat the EAFE Index in 2001?
In 2000? In 1998? In 1997? In 1996? In 1995? (Note: EAFE beat the
S&P in 1999 by 6%).
Given the strong returns of international markets over the past
several years, and given the long-term historical risk reduction
properties of adding international equities to a domestic-equity
dominated portfolio, the question of whether or not to add international
exposure no longer even seems worth asking. Instead, the question
now seems to be about how much to invest abroad.
This is all rather interesting. While we are big fans of international
investing (it adds to our opportunity set to enhance risk-adjusted
performance), we do remember just a handful of years ago where
the leading thought was to have NO international exposure at all!
The thought back then was that since international markets had
underperformed the U.S. for so many years (see above), and also
because correlations between international and U.S. markets had
risen (meaning international investments didn’t diversify
as strongly as they once had), that international exposure was
just not necessary for investment portfolios. In fact, it might
even be harmful.
Note: the annualized return for the MSCI EAFE over the last five
years has been approximately 15% (through 12/31/06). The return
for the S&P 500 Index over that same time frame has been closer
to 6%.
So, how should an allocation to international exposures be sized
for U.S. based individual investors? Of course, the answer is, “it
depends.”
One important consideration is whether or not the currency exposures
are hedged or not. Our general preference is for funds that do
not hedge, which means we would get the additional diversification
benefits from currency movements.
The United States stock market makes up approximately half of
the world’s total stock market capitalization. Some studies
suggest that should be the benchmark for U.S. investors. Yet, what
that doesn’t take into account is that most U.S. investors
are not fully integrated global consumers, at least not yet. In
other words, our incomes and consumption expenditures are primarily
denominated in U.S. dollars and not a basket of currencies.
If a typical U.S. investor were to invest significantly in non-dollar
assets, they would be introducing a significant risk – currency
risk — that may swamp other market exposures and factor risks.
While we like the diversification of modest non-dollar exposure,
too much of a good thing could ultimately destabilize the investment
portfolio and investor experience and thus an investor’s
ability to “stay the course” with a well diversified
portfolio.
Did You Know? — V
Did you know that Kobren Insight Management had a conference call
on January 30th. In case you missed it, a replay is available
at:
www.kobreninsightmanagement.com/conference_calls/confcalls_index.html
Sincerely,
Eric M. KobrenRusty Vanneman, CFA
PresidentDirector of Research
Portfolio
ManagerCo-Portfolio Manager
