Every year, the markets provide investors with lessons on the prudent investment strategy. This year’s bear market provided a sufficient number of lessons that it should be considered a “doctoral seminar.”
Lesson 1: Neither investment banks nor other active managers (including hedge funds) can protect investors from bear markets. All crystal balls are cloudy, which is why Warren Buffett concluded: “The only value of stock forecasters is to make fortune tellers look good.”(1)
If their money managers could protect you, why did firms like Lehman Brothers and Bear Stearns go belly up and Merrill Lynch have to be rescued by Bank of America? It is in the best interest of these firms to manage their risks well. Yet, they have clearly demonstrated that they cannot. As evidence of their lack of ability to forecast events consider that in 2008 Lehman spent $751 million buying back its own stock at an average price of $49.60 and Merrill Lynch spent $5.27 billion buying back its stock in 2007 at an average price of $84.88.(2)
We can only conclude that with all the conflicts of interest that exist between these firms and their clients there is no reason to think that they would manage their clients’ risks any better. Investors don’t need to pay Wall Street big fees to have their money managed. Large fees are only likely to make managers rich, not investors. Wall Street’s best skill is designing product that separates capital from owners.
Lesson 2: Never take more risk than you have the ability, willingness or need to take. Violating this rule is what led to the failure of Lehman, Bear Stearns, AIG and others. They all took on so much leverage, especially considering the risky nature of the assets, that they had to be right all the time, not just in the long run.
Lesson 3: Diversify broadly across many asset classes. However, remember that even low correlating risky assets have a nasty tendency to have correlations rise at the worst time. Thus, make sure your portfolio has sufficient fixed income assets of the highest quality so that overall portfolio risk is reduced to the appropriate level.
Lesson 4: For fixed income assets, stick only with Treasuries, bonds of government agencies and the highest rated municipal bonds (AAA/AA). With municipal bonds make sure the underlying rating (not the rating with credit insurance) meets that test. Anything else (such as high-yield [junk] bonds, convertible bonds, emerging market bonds and preferred stocks) can have the risks show up at the wrong time and, thus, should be avoided. Their risks do not mix well with equity risks.
Thus, although such instruments are touted for their additional return, what little additional expected return they actually offer is more than offset by their greater risks when considered in the context of the overall portfolio. If one is willing to take incremental risk, they should do so by increasing their equity allocation. The incremental expected returns can then be earned more tax efficiently and the risks can be more effectively diversified.
Lesson 5: Don’t confuse the familiar with the safe and concentrate labor capital and financial assets in the same basket. Many employees of once great companies lost not only their jobs, but also much of their financial assets because they made this mistake.
Lesson 6: One of the more persistent myths is that active managers can protect you from bear markets. In 2008, the hardest hit sector was financial stocks. Financials comprise a significant portion of the asset class of value stocks. As benchmarks for the active managers we can use the Vanguard Small Value Index Fund that lost 32.1 percent and the Vanguard (Large) Value Fund that lost 36.0 percent.
The following is a list of the returns of some of the actively managed mutual funds with superstar value managers, four of whom were named by Morningstar in June 2008 as their recommendations to run value superstars, their recommendations (those are noted with *): Legg Mason Value Trust lost 55.1 percent; *Dodge & Cox lost 44.3 percent; Dreman Concentrated Value lost 49.5 percent; *Weitz Value lost 40.7 percent; *Schneider Value lost 55.0 percent; and *Columbia Value and Restructuring lost 47.6 percent.
Of course, some actively managed value funds beat those benchmarks. However, how would you have known ahead of time which ones they would be? As the SEC’s required disclaimer states: Past performance is not a predictor of future performance. Thus, the prudent strategy is to use only passively managed funds.
Lesson 7: We live in a world of uncertainty (the odds of events occurring cannot be measured), not a world of risk (the odds can be measured). And investors much prefer risky bets to uncertainty bets. Since we could not calculate the odds of a bear market like the one we experienced in 2008 occurring, investors require a very large equity risk premium. That is why over the long term stocks have outperformed riskless Treasury bills by such a wide margin.
Lesson 8: Treat neither the unlikely as impossible (U.S. housing prices will fall sharply) nor the likely as certain (stocks will beat bonds over long horizons). And remember that just because something has not happened, doesn’t mean it cannot or will not. Investors should have learned that lesson on September 11, 2001. Making these mistakes led to the demise of Lehman and Bear Stearns.
Lesson 9: There is a great likelihood that each time there is a crisis, some guru will have forecasted it with amazing accuracy. But that ignores two important facts. The first problem is that even blind squirrels occasionally will find acorns. In other words, there are tens of thousands of gurus making forecasts all the time.
Given the number trying, randomly, we should expect some to make accurate forecasts. The crash of October 1987 was forecast with amazing accuracy by a little known analyst named Elaine Garzarelli. Having made such a prescient forecast she was immediately elevated to guru status and everyone was seeking her opinions. Unfortunately, her subsequent forecasts were well off the mark and the returns she produced as a fund manager were so poor that she was fired in May of 1996.
Each crisis produces its own “Garzarelli.” This crisis produced Nouriel Roubini, professor of economics and international business at NYU’s Stern’s School of Business. A problem with Roubini (and almost all forecasters) is that we don’t know how many other forecasts he has made and what is the track record of those forecasts.
Another problem is that the evidence on the accuracy of such forecasts is best summed up by the findings of William Sherden, author of The Fortune Sellers. Sherden studied the performance of seven forecasting professions: investment experts, meteorology, technology assessment, demography, futurology, organizational planning, and economics. He concluded that while none of the experts were very expert, the folks we most often make jokes about—weathermen—actually had the best predictive powers.
Sherden also provided these insights: He said that the First Law of Economics was that for every economist, there is an equal and opposite economist—for every bullish economist, there is a bearish one. His Second Law of Economics was that they are both likely to be wrong. Sherden’s research found that there are no economic forecasters who consistently lead the pack in forecasting accuracy.(3)
Perhaps the most interesting thing about Roubini is that despite his forecast he revealed that his retirement account had a 100 percent allocation to equities. It seems that Roubini knows enough to ignore his own forecasts as they are not likely to lead to abnormal profits.
Lesson 10: Investment returns are not earned smoothly—returns are not even close to being normally distributed (like a bell curve). In fact, the daily returns that are outside of three standard deviations (over 99 percent of the data) are six times what would be predicted by a normal distribution.
The result is that most of the market’s returns come from short, but powerful, bursts of bull and bear markets. Consider the unlucky investor who missed just the best 100 days from 1900 through 2006. He would end with less money than he started with—forget 107 years of inflation.
On the other hand, avoiding the worst 100 days would have increased terminal wealth 43,397 percent. Since a negligible proportion of days determines either a massive creation or destruction of wealth, the odds against successful market timing are simply staggering.(4) That is why Warren Buffett concluded: “Inactivity strikes us as intelligent behavior.”(5)
In the case of the investment banks, their use of large amounts of leverage, combined with the “exceptionally” large negative returns led to their demise—though the historical data shows that such losses were in fact not that exceptional. As Spanish philosopher Santayana said: “Those who don’t know their history are doomed to repeat it.”
This was the same mistake that led to the death of Long Term Capital Management in 1998. Even though their positions would have been profitable in the end, they did not survive to see that result—margin calls forced them to liquidate their positions.
Lesson 11: One of Albert Einstein’s more famous quotations is: “There are only two things that are infinite; the universe and human stupidity; and I’m not sure about the universe.” If Einstein had lived long enough he would have added a third—the ability of Wall Street’s investment bankers to create an endless stream of “innovative” products that exploit investors.
In my thirteen years as director of research of the Buckingham Family of Financial Services I have yet to review a single product that did not fall into the category that can be defined as a product meant to be sold, but never bought. Among the recent entrees are: Accumulators, Booster-Plus Notes, Buffered Notes, Principal Protection Notes, Reverse Convertibles, STRATS and Super-Track Notes. These are all complex derivative products, with the complexity designed in the favor of the issuer.
Lesson 12: Make sure your investment plan incorporates the virtual certainty that crises will occur. We cannot know what form they will take, nor when they will occur. While bear markets are painful, there is no good alternative to buy and hold except avoiding risk and accepting Treasury bill returns. Timing the market is a mug’s game. For example, a study on 100 pension plans that hired the “best managers” around to engage in tactical asset allocation (a fancy term for market timing so large fees can be charged) found that not a single one had benefited from the efforts.(6)
Lesson 13: Since we know that crises will occur, and we cannot know how long they will last, a critical part of the financial planning process is to develop “Plan B”—the actions that will be taken if financial assets fall to such a great degree that if “Plan A” is not altered the result would be its likely failure—the investor will run out of assets. Plan B should list the actions that would be taken if financial assets fell to a predetermined level. Those actions might include remaining in the work force longer (or returning to the work force if that is possible), reduce current spending, reduce the financial goal and moving to a location with a lower cost of living. The use of Monte Carlo simulations can be a valuable tool in determining what, if any, actions are should be considered or are even required.
Lesson 14: There are two good reasons to change a well-thought-out investment plan. The first is that the underlying assumptions upon which it was based have changed. For example, there may have been a loss of a job, a death in the family, a divorce or an inheritance. Each of these events can significantly impact the ability, willingness or need to take risk.
The other good reason to change a plan is if a sharp fall in the value of one’s assets (both financial assets and home prices) leads to the investor realizing that they had, unintentionally, taken more risk than they really should have taken. This mistake may have resulted from the common human trait of overconfidence. In this case, overconfidence in the ability to deal with the emotional stress of severe bear markets. Or it may have resulted from treating the unlikely as impossible.
Even smart people make mistakes. However, once they learn “the error of their ways” they neither repeat nor perpetuate the mistake. Before making any change to a financial plan it is important to make sure that the decision is being made by the head, and not the stomach. In other words, any change should be based on a fundamental analysis of the facts, and not based on the emotions of fear and panic that can rise up during bear markets.
Lesson 15: Trust but verify. The Madoff scandal, perhaps the largest in the history of the investment banking industry, with losses possibly reaching as high as $50 billion, was completely avoidable. Those that lost money have only themselves to blame. Relying on social connections and reputations is to rely on hope; and hope is not an investment strategy.
Investors that followed the basic principles of prudent investing would not have been taken in. Investments should only be made within the framework of a highly regulated industry where there is complete transparency. An obvious requirement is that there must be audited financial statements from a well-known and highly regarded CPA firm. Audits verify the financial statements of the money manager as well as check correspondence with the custodians, brokers, and transfer agent of the funds to confirm reported trades and securities held. The fund’s accounting should be performed independently of the money manager. And the fund’s assets should be held in with an independent, regulated custodian such as a bank or trust company.
Final Lesson: The key to successful investing is to get the plan right in the first place, and then stick to it. That means acting like the lowly postage stamp that does one thing, but does it well—sticking to its letter until it reaches its destination. Your job is to stick to your well-developed plan until you reach your financial goal. And, if you don’t have a plan, write one immediately. And make sure the plan includes the aforementioned Plan B—the actions you are prepared to take if the “unexpected” does happen.
1. James Altucher, Trade Like Warren Buffett, Wiley (2005), p. 196.
2. Fortune, December 8, 2008.
3. William Sherden, The Fortune Sellers, Wiley (1998).
4. Javier Estrada, “Black Swans and Market Timing: How Not To Generate Alpha,” November, 2007.
5. 1996 Annual Report of Berkshire Hathaway.
6. David Dreman, Contrarian Investment Strategies (Simon & Schuster, 1998) p. 57.
Disclaimer: Larry's opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.