By Bruno A. Giordano, MBA, CFP
I am so tired of listening to and reading all this bull-hockey about “Modern Portfolio Theory” and the “Efficient Frontier” and “Optimum Asset Allocation” and “Co-Variance Strategy” that I’m about to explode.
Intrinsic to all of these theories is that: markets of the future will behave substantially the same as markets of the past, and that the average investor has what it takes to “stay the course” and not panic and sell during a prolonged secular bear market. (The key words here are “prolonged” and “secular.”)
Let’s examine these two absolutely fallacious assumptions that serve as major premises in the syllogistic reasoning process used by all these well-meaning but logic-flawed pundits. But, before we start, let me make it clear that I am referring to lump sums of money and not to monthly or periodic investing, commonly known as “dollar cost averaging.”
Will markets of the future behave substantially the same as markets of the past? Before I answer that question I would ask if you are comparing the next 10 or 15 years to the last 10 or 15? The last 30? Or, are you comparing the next 70 to the last 70? That’s right. Many so-called pundits use a 70-year or so track record to predict the future. The really uninformed pundits will use five- or ten-year track records of past performance to predict the future. Can you imagine? If they used these short-term track records as contrarian indicators they might be better off. But I stray.
The problem with using a 70-year track record is that most people with money to invest just don’t have that kind of time horizon. My clients are interested in the next 15 years, not the next 70! And, without going into a lot of mind-boggling statistics, suffice it to say that there have been 15-year periods where the performance of a “well diversified portfolio” has not kept up with inflation at best, and has actually lost money at worst.
If you would like to test that last thought, imagine a 62-year-old retiring with about $300,000 of liquid assets in 1972. Also, imagine that he needs $20,000 a year to supplement social security and other income to barely live comfortably. Also, remember that inflation averaged about 7.2 percent during the 15 year period 1973-1988 (government-supplied statistics).
If our retiree has to increase his withdrawal by an average of 7.2 percent per year (one year inflation was as much as 13.3 percent, and one year it was as low as 1.1 percent), he won’t make it. The serious, prolonged bear market of 1973-1974 caused his tidy lump sum to be “whacked” by about 40-50 percent (according to what asset allocation distribution you choose). At that point, the growth of his portfolio would not support the increasing withdrawal requirement. In other words, he’s withdrawing an increasing amount from a decreasing lump sum.‚
In this scenario, he runs out of assets in about 15 years. Great planning, huh? Naturally, I picked one of the worst 15 year periods to make my point. Why not? The “Modern Portfolio Theory” pundits always seem to use the best of times. Besides, shouldn’t you plan for the worst?
There’s no way of knowing what the next 15 years will bring, so why bet the farm on some misguided assumption that we can predict the future? Possible financial suicide! Why take the chance?
The average investor will “stay the course” and not panic and sell in a prolonged, secular bear market. What a laugh! History is replete with examples of what real people do. They panic and sell! Besides, we have ample proof that investors do not get investment returns.
Ibbotson Associates Stocks, Bonds, Bills & Inflation Yearbook of 1993 tells us that, from 1970 to 1993, small stocks enjoyed an average annualized rate of return of 13.71 percent, while the S&P 500 returned 11.39 percent on average.
Meanwhile, according to Dalther surveys, the average holding period for investors in no-load mutual funds is 17 months, and in load funds 48 months. They don’t “stay the course.”
Further, a recent analysis by Morning-star of the asset growth and total returns of 219 growth funds for the five-year period ending May 30, 1994, compared the average funds’ annual return (investment return) with the return on the average dollar invested in these funds (investor return): Investment return of 12.5 percent; Investor return of -2.5 percent.
The funds did very well, but the investors did badly. Why? Real people don’t “stay the course”—they buy high and sell low.
Additionally, my own experience has demonstrated to me over and over again that real people can’t stand to lose money. I get a kick out of the theory that some people are risk-averse. Nothing could be further from the truth. Real people aren’t risk averseare loss averse.
You can explain standard deviation and risk adjusted returns to the average investor until you are blue in the face, and they just won’t get it. They will be happy with good returns from a risk-laden investment; but, the minute they lose money it’s over.
Nick Murray, advisor to investment advisors, brokers, etc., and noted author and speaker on this subject, apparently understands and embraces what I have just discussed. His recommendation to advisors to help people “stay the course”’ is to “manage the client’s expectations” or be a “behavior modifier.” His advice to investment advisors, and I quote from the October, 1996 article in the Dow Jones Investment Advisor, is: “The key to your success is not in changing the funds, but in changing the folks.”
That may be an honest appraisal of what’s required, but I sure wouldn’t want to bet my future on my ability to alter the behavior of “folks.” Real people panic and sell when the going gets rough; and, in my opinion, you would have to have Rasputin-like powers to get them to act differently!
Don’t believe me? Let’s take a look at Japan. In 1989, the NIKKEI index was $39,000+. Japanese investment pundits (they have them over there, too) were saying that the apparently overvalued index was not a problem. Why? Because of the “Holy Trinity” (their words) of: high land values, an extremely positive balance of trade and the abundance of money coming into the market. (Sound familiar?) Also, the Japanese investor is different from his American counterpart, they said. He won’t panic and sell. He has a “cultural group identity.”
As of June 30, 1996, the NIKKEI was down 64 percent from the top, and Japanese equity funds have 91 percent fewer assets. What happened to the “Holy Trinity” and the abundance of money and cultural group identity?
Fear transcends all cultures and time horizons. Panic is an irrational extension of fear. Anyone remember the tulip craze? …the Louisiana land bust? …Florida real estate in the 20’s? …our own stock market in the late 20’s and early 30’s? …the bear market of 1973-74, when corporate profits were up 40 percent and stock prices were down 50 percent to 90 percent?
Real people buy high and sell low. Real people don’t “stay the course.” It’s tough to keep your cool when all those around you are losing theirs.
What to do then? Well, here’s what we do to cope with the problem: Avoid Major Loss.
That’s it! Keep people from losing big time and they will “stay the course.” But, you ask, how do we manage that?
We allocate assets into a portfolio of several asset classes that have a low correlation with each other, and then manage the risk in each asset class.
Our approach is to move portions of each asset class out of harm’s way into the safety of a money market when that particular asset class is not doing well, and vice versa. The more the perceived risk, the larger the portion.
A recent study done by an academician somewhere in the midwest claimed that, if one attempted to do what I just described with the stock market and missed the 50 best months of the last 45-50 years, the return would have been a paltry 3.3 percent instead of 11.4 percent for the buy-and-hold technique. What an arrogant, biased conclusion!
What if I were just as arrogant and biased and did the same type of study, only I assumed that I would miss the 50 worst months. Then, your return would have been 19.9 percent.
Now, of course, I don’t believe any professional would be bad enough to miss all the best months and be “in” for all the bad months.
I also don’t believe any professional would be good enough to be “in” for all the best months and “out” for all the bad months.
But, what if, in my zeal to be “out” of all the worst months, I really messed up and was “out” for all of the best months as well? In short, horrendously poor risk management. In that case, my return would have been 12.1 percent, slightly better than the mythical buy-and-hold investor who “stays the course” regardless of huge losses!
In summary, investors will out-perform a buy-and-hold strategy without participating in the best markets if they are also out of the market during the worst periods.
Let’s be reasonable. How about a risk manager that misses 1/2 of the loss in each of the 50 worst months and is “in” for 1/2 of the gain in each of the 50 best months.
What would his return be? 16 percent!
Imagine a risk manager so inept as to only be “in” for 1/2 of the gain during the best months and who was “out” for only 1/2 of the loss during the worst months. He still would have significantly out-performed the mythical buy-and-hold investor, and with sharply reduced risk.
The message is clear. In the long run, it’s better to be “out” of the worst markets than it is to be “in” the best markets. Why? Because recouping losses is tougher than making profits.
To put it another way, isn’t that what one of the greatest of them all, Sir John Templeton, does? His strategy has always been to retreat from overvalued markets near the top and seek out markets that have already had their major correction.
Or, as Benjamin Graham, who many consider the greatest, said a long time ago, “There are only two rules to investing: Don’t lose money; Never forget rule 1.”
Bruno A. Giordano MBA, CFP, is president of Dorset Financial Services Corporation, located in Devon, PA.