Rollercoaster Investing

Without realizing it most investors are “Rollercoaster Investors”. The value of their investments is on a wild ride with an unknown destination. Most roller coasters I’ve been on are very exciting, but have ended up where they started. They are great for a short term thrill, but they didn’t do much else than shake me up. If I want to get somewhere I’d prefer much more progress and much less excitement.

There are many things I would do for enjoyment or a thrill. I recently walked the Kalalau Trial down the Na pali Coast on Kauai. A different type of rollercoaster and perhaps the ultimate Trial in terms of spectacular scenery and degree of difficulty. It was a great experience and somewhat humbling. It was far more dangerous than I realized and very physically demanding. I’m clearly no longer 25 years old, but I will never forget the breathtaking sights.

When it comes to investing, however, I do not want a rollercoaster. To me “thrill” equals risk, and risk is something I want to avoid as much as possible, or at least control. My primary concern is that I want to be confident that over time I will be making consistent progress, and that this progress, as far as possible, is secure.

In order to achieve this I believe you have to embrace an investment philosophy in line with this objective; this is simply described as consistently producing positive absolute returns with your portfolio. This means approaching each investment on its own merit and finding situations where your probability of success is clearly high, and you have only a minimal loss if you are wrong. If you apply this approach to a wide variety of diverse assets and have good idea generation I believe it is only a matter of time before your account is moving in a consistently rising trajectory.

Here is an example of one of my accounts over the last three years compared to the S&P 500:

 

According to Harris direct, over this period the S&P500 has fallen 8.55% while my account has grown by 22.48%, for an out performance of 31.02%. Further examples of my track record are given in the "Track record" section of www.chrisbelchamber.com .

Lower risk, lower volatility and a higher long term return is my objective and I believe this produces a far more attractive outcome and profile that should suit most investors. However, most investors in the US end up taking a different route. Most investors have as a central strategy a very high allocation to equities, broadly defined, on a permanent basis. Indeed I know of one large broker in the US that seems to advocate 100% equities all the time.

Investors need to be aware that this is a certain recipe for a wild ride to an unknown destination - a rollercoaster. Stock markets fall on average by 43%, according to John Mauldin, through a recession cycle. So to commit to a permanently high allocation to equities is to accept a huge level of volatility to the value of your portfolio. Will it still be successful in the long term? Maybe if you have a very long time horizon, say 50 years before you need the money. Maybe not. Is it an optimal approach to investment? In my opinion for most people it is not, and most people do not have 50 years.

Since 1800, traditional analysis suggests that there have been seven secular bull and bear markets. Using John Mauldin’s numbers again, the average secular bear market has lasted around 14 years with an average return of 0.3%. The average secular bull market has lasted around 15 years with an average 13.2% return. So if we are currently in a secular bear market investors may be committing themselves to no return for many years.

More than likely we are still in a secular bear market. Typically secular bear markets have ended with historically cheap stock market valuations. In Market Notes 36 we showed that currently price/earnings ratios, price-to-book ratios and dividend yields all suggested that the market was still a factor of 2 above where historically cheap valuations stood.  Furthermore, the continued very high ownership levels of equities in the general public, also indicates that the end of the secular bear market is still very many years away. Typically equity ownership hits a trough at the end of a secular bear market whereas it remains near the highs at the current time.

All equities all the time?

At an institutional level it may seem appropriate to make the case that a long term commitment to equities is appropriate, as their very long term performance has been good – an average 6.7 return per annum over 200 years. Institutions plan to be around for decades so why not stick with equities? You can ride the ups and downs. However, individual investors have very different requirements and there are many problems with a long term commitment to equities.

First of all, they are only a good medium term investment around half the time. This means that if we are in a secular bear market you will get a very poor return for an extended period of time. Individuals do not have such a large time horizon as institutional investors, retirement dates are getting closer all the time, a 14 year period of near zero returns is a heavy price to pay for an individual with limited time.

Secondly, these long term returns ignore the huge level of volatility of equity market returns. What if you need the money when the market is at a trough? This could mean that just through bad timing you might end up with half the money you might otherwise have achieved, given the cyclical swings in the stock market. 

Thirdly, investors don’t seem to realize that they often bear very high investment expenses that substantially erode their investment returns over time. These costs would significantly lower investor’s returns from the numbers given above. It is not so unusual for investors to be paying 3% annually in investment costs, often without realizing it. These costs often come with equity investment either through mutual fund fees or high transaction fees.

Why all the pro-Equity advice?

The pro-equity constituency is huge but driven at least in part by self-interest. As an example, let’s consider another industry, and a pharmaceutical company with a new drug. It is clearly a benefit to the drug company if it is able to sell the drug, and without a doubt it will advocate that the benefits easily outweigh the risks. How can they be sure? Well we all hope that there is sufficient scientific evidence to support their claim. But the economic incentives benefit the drug company if the drug is introduced, while the public bears the risks and the costs. This is an unbalanced distribution of costs and benefits, between the drug company and the public.

Investors need to understand that Wall Street, the Mutual fund business, corporate executives and even the existing government (whatever the party) are all advocates of the stock market and high turnover. If public investors were to reduce their allocation from above 50% to say 25% and reduce the activity of their accounts, this would be a devastating blow to these constituencies. Clearly, pro-equity advice is not unbiased. Wall Street benefits from a high allocation and high turnover and investors need to remember this when they are advised to actively trade a high equity allocation. It is the investors who bear both the cost and the consequences of this advice, while counterparties derive the benefit.

The clearest example of this advice bias is that many investors are still unaware and underinvested in an ideal investment asset class. I am still amazed how few investors are even aware of TIPS (Treasury Inflation Protected Securities). TIPS are a low risk, low costs investment vehicle that produces guaranteed returns. The few investors who try to buy them still find great difficulty even though the market is huge and expanding. Despite their great benefits as an investment vehicle, they are very suboptimal for many counterparties, who prefer not to advocate their use in investor’s portfolios. Asking your broker what he thinks about TIPS is usually very revealing as regards his attitude to your account.

 

Conclusion

For most people when we talk about investing for retirement we are talking about money that people will depend upon when they are 80 or 90 years old. This should be regarded as a serious matter. In order to most effectively achieve their investment goals a great deal of care needs to be taken is choosing the most optimal investment strategy.

Conventional investment advice often advocates a very high and permanent allocation to equities. There is clearly an element of self interest in this advice. Investors need to understand that this approach is often a high risk, high cost strategy with a very uncertain medium term outcome. There are many other approaches that will certainly reduce volatility and cost and can provide much more likelihood of a positive outcome, and for many people a more conservative approach is far more appropriate. A consistent focus on absolute returns is such a strategy. Managed well it may also produce higher medium term returns as well as all the other benefits.

 

 

 

 

 

 

 

Notice

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. Chris Belchamber (the author) may or may not have investments or positions in any assets or derivatives cited above.

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