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September 30, 2011

The market has been a zoo lately.  The average day in August saw the Dow Jones go either up or down 1.94%. Over the past 30 years, that number has averaged 0.76%.  Viewed another way, August was the sixth most volatile month in the last 30 years.  The volatility hasn’t just been up and down; since the beginning of August, the S&P 500 has dropped about 12%.  This scares investors.  If you've learned that benchmark stocks return 7% to 9% a year, watching the market in August and September makes you wonder whether you've been tricked.  This is especially true since markets have effectively gone nowhere for the past decade.  Probably, many investors are thinking: if stocks are supposed to provide good returns, the past decade has been without gain, and the past few months were all over the place, then why invest in stocks?

Stocks have logged dismal returns over the past decade because that period's starting point is the dot-com bubble.  If you use 1995 as a start date instead of 2000, stocks have returned more than 9% a year for the past 16 years.  If one has an investment advisor that is capable of beating the benchmark return (as I have done over the past five years with client accounts), one could do significantly better.   

Investors have been told, nearly assured, that broad stock market averages return 7% to 9% a year.  You read this in textbooks.  You hear it from brokers and financial advisors.  It's been engrained in investors' minds as an expectation benchmark.  And you’ll hear it here too: over the long term, stocks will earn respectable returns of 7% to 9% a year, if an investor follows a benchmark, like the S&P 500.  But among individual years those returns will be all over the map.

Going back to 1928, annual stock returns have spent very little time around the 7%-9% range.  While the average annual return indeed works out to 7%, most years are either well above, or well below, that level:

Annual Return / the Number of Years the Dow Has Returned that Range Since 1928

Sources: Yahoo! Finance

Out of 82 years, just 14 have fallen into the range that many investors expect to earn.  The other 83% of the time, stocks were in some sort of bull or bear cycle.

Building wealth, the kind of wealth you can really count on over time, can take high levels of patience.  Over a lifetime, one might be tempted by incredible up years, and frustrated by agonizing down years.  The trick is learning that the former doesn't mean an investor is a genius, and the latter doesn't mean he or she is being duped.  Both are part of the true nature of markets.  And both have to be accepted if that investor wants to earn those 7% to 9% benchmark annual returns.  Of course, Niehaus Liberty strives to beat the benchmark market return, and its clients have outpaced the S&P 500 significantly over the past 5 years (as always, past results do not guarantee future success).   

 

Warren Buffett once said that unless you can watch your stocks fall 50% without becoming panic-stricken, you shouldn't be investing.  If we accept that putting up with volatility is what allows stocks to be the greatest wealth generator out of any asset class over long periods of time, then recent experiences shouldn't change anything.

As we move forward, I will continue to search for well-run companies with durable competitive advantages, solid balance sheets, and excellent valuation.  And we have an advantage going forward: about 1/3 of your portfolio is in bond funds.  In a classic case of market unpredictability (and why we don’t try to time the market), the recent volatility started about a week after we exited our hedge based on congress reaching a debt ceiling deal.  We were not, however, hedging against market volatility, but against a possible financial panic caused by a U.S. default. Thankfully, that financial panic did not come to pass.  I did expect some volatility, and I decided to further spread out over time each third in our thirds approach to reinvesting the hedge money into stocks.  My thirds approach usually separates each third investment by weeks, but in volatile times, I like to separate each third by months. This means we will be able to take advantage of some steep discounts as we use that cash to reenter stocks, and that will help put us ahead in the years to come.   

There is some chance that I might add another hedge in the months to come.  If I believe that a Greek default is imminent, and such a default would lead to a financial panic in Europe, I will again add to your portfolio a reverse financial sector ETF to hedge against that probability.  I don’t see that as likely right now, but I will continue to monitor the situation closely.  

As always, I’m available to answer any questions you might have.  

Regards,

Aram Durphy