June 2007
Monthly Investment Commentary | June 2007
Anyone who manages assets can relate to the challenge of maintaining discipline at times when markets are one-sided. Today, thanks to a strong stock market, investors are apt to be willing to take on more risk. During a down market, they are more likely to want to reduce risk until the rough patch is over. But the truth is that risk is counterintuitive: it is actually lowest when it “feels” highest, and vice versa. This month we talk about this seemingly instinctive propensity for investors to misperceive risk. As we consider many of the investors we know, even some with a lot of experience and knowledge, we can’t help but be struck by how many of them failed to perceive risk accurately in early 2000, as the stock market bubble was nearing the bursting point. By the fall of 2002, as we reached what proved to be the bottom of a painful bear market, investors saw risk levels as enormous. It’s unfortunate but true that investors see the least risk when risk is actually greatest, and perceive the most risk when it is actually much lower. Humans are wired to do simple, survival-oriented pattern recognition. Many of the ebbs and flows of ancient life were recurrent—seasons, migrations, appearance and disappearance of food and predators—and our skill at extrapolating suited us well. In the stock market, though, this trait underlies the age-old tendency for investors to get whipsawed (the academic field of behavioral finance studies how these human biases lead to decision errors). Investors decide to buy after a strong run convinces them that they are missing opportunities, and decide to sell after prolonged periods of weakness destroy their confidence and convince them that the bottom is nowhere in sight. And unfortunately, these periods often occur in the neighborhood of market tops and bottoms. Warren Buffet quipped that stocks are about the only thing people avoid when they go on sale. Most successful investors are able to ignore the emotional pull that occurs as the markets cycle between fear and greed—not simply for the sake of being contrarian or because they have cast-iron stomachs, but as a byproduct of a process in which they seek to buy stocks whose prices are sufficiently low relative to their prospects to suggest that over time they will earn a good return. In short, they have a decision framework that gives them a consistent basis on which to decide when to buy and when to sell an investment (more on this in a minute). Think back to early 2000. After almost two decades of mostly rising stock prices, and fueled by belief that we were in a new economy in which technology had changed the landscape forever, investors’ perception of risk was very low. Even as valuations reached levels that defied logic, investors rushed to buy stocks. A look at fundamentals at that time revealed that many stocks were priced for perfection—in other words, everything had to go exactly right for many, many years to come if that valuation was going to prove to be “correct.” Less than three years later, investors were driven by fear instead of greed, and still were not focused on fundamentals. Of course, markets aren’t that certain. It is difficult to determine what a company is going to earn, and there are many variables that play into investment returns. But the broader point remains valid: investment decisions based on hope, fear, or greed will lead an investor to buy when others are buying and sell when others are selling—a guaranteed way to get terrible investment results—while decisions based on a return expectation that is derived from rational analysis help support a disciplined, consistent approach that is far more likely to succeed over time. Investors who aren’t willing to conceive a process to guide their investment decisions have little insulation from the powerful emotions that drive the market over the short term, and realistically they would probably be better off saving than investing. Our process uses four model portfolios, each with a different risk threshold. These models were developed by studying historical risk and return relationships of various asset classes of U.S. and foreign stocks and bonds, and determining an appropriate allocation. Additionally, we look at historical valuation relationships between asset classes, and carefully evaluate current fundamentals. If we believe an asset class is significantly undervalued and offers a compelling return opportunity over the next several years, we will overweight it—but only in a way that we believe will not compromise our risk threshold. Similarly, if we believe an asset class can benefit our portfolios by reducing risk while still having a favorable return outlook, we will add it to our portfolios. Often we are early in making a tactical move, and a bargain-priced asset class becomes even more undervalued. But we can tolerate a good value becoming a better value, because while it may have temporarily decreased our actual return, unless something fundamental has changed it has increased our potential return. You don’t get to go back and do it over again; you can only make decisions from the current point forward. Having a clear understanding of why we own the position and what our expectations are makes maintaining our discipline much easier through the inevitable short-term gyrations. In the end, each individual has the ultimate say over the investment decisions they make or allow to be made on their behalf. Assuming you are an investor (rather than a saver), then you are in a competition. If you can shake yourself away from the mindset of your mostly mediocre competitors, and instead start to think about investing in the context of a decision framework that correctly views lower prices as more attractive and higher prices as less attractive, then you are going to find it easier to make good, consistent decisions. This is easier said than done, because prices become more attractive when sentiment is negative and less attractive when sentiment is positive, and so making good investment decisions almost always “feels” wrong. But over time you can learn to think differently. You may find yourself thinking proactively about opportunities, instead of reactively about having too much exposure when the market is weak and too little when it is strong. You will start seeing and doing things differently from everyone else, which in the long run is how you succeed in investing. — Stapp Financial Planning, PLLC This information is also available at www.stappfinancial.com, or you can download a PDF version. If you do not want to receive future e-mail newsletters from Stapp Financial, link to our subscription form, or send an e-mail to bstapp@stappfinancial.com. Before acting on any advice it is recommended to seek appropriate counsel applicable to your individual circumstances. |
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Stocks continued to advance in May. The large-cap S&P 500 (as measured by Vanguard 500 Index Fund) gained 3.5% in May, bringing its year-to-date return to a healthy 8.7%. Based on Russell style indexes, large-cap growth and value performed similarly for the month (up 3.6%), with growth remaining ahead of value by about 100 basis points for the year to date. Small-cap value performed in line with large-cap value for the month, while small-cap growth outperformed its large-cap brethren with a 4.5% gain in May. Vanguard Total International Stock Index Fund gained just over 3%, lifting year-to-date gains for the foreign stock proxy into the low double digits. Bonds missed out on the party in May. The domestic Vanguard Total Bond Market Index lost a little under 1%, while foreign bonds of developed markets lost around 2%. Our tactical positions in commodity futures (up 0.1%) and short-term emerging-market bonds (up 0.9%) added value, because they were funded by a reduction in our position in domestic bonds.