Larry Swedroe is a principal and director of research for St. Louis-based Buckingham Asset Management. He has authored or co-authored seven books. Before joining Buckingham in 1996, he was a senior vice president at Citicorp and vice chairman of Residential Service Corp.

On Monday, IndexUniverse.com Managing Editor Murray Coleman caught up with Swedroe to discuss the plight of bonds and buy-and-hold investing, among other issues. (It should be noted that he and another Buckingham colleague, Joe Hempen, co-authored a book on bond investing in 2006.)

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⁾

The main argument made by advocates of gold is that they believe that it is a good hedge against inflation. For the period from 1935 (when the price of gold was fixed at $35 an ounce by the Federal Reserve) through October 2008, gold did provide a positive real return of 0.6 percent. Unfortunately, not all individuals have horizons of 73 years. We need to consider more realistic investment horizons. This is especially true for retirees (for whom 73 years would be far greater than their horizon), or those nearing retirement, as they face the greatest risk of inflation negatively impacting their lifestyle. We address that issue by considering the period since 1981—the last time there was a “frenzy” for buying gold.

This loss is a tragedy of epic proportions. However, the real tragedy is that had investors followed some basic rules of prudent investing, the investments would never have been made.

When a sophisticated provider of financial services stands toe to toe with a naïve consumer, the all-too-predictable conclusion resembles the results of a heavyweight champion and a ninety-eight-pound weakling. The individual investor loses in a first-round knockout. (David Swensen, Unconventional Success, Free Press (August 2005), p. 341)

Whenever interest rates fall to historically low levels Wall Street’s product machines crank out complex securities that entice investors with extravagant yields, but come accompanied by great risks. Among the more alluring of products is something called a reverse convertible. Small U.S. investors snapped up $8.5 billion worth of these instruments in 2007, up 81 percent from 2006 (1). We will explore how these securities work, beginning with a definition.

We certainly live in interesting times. While I have witnessed events like this before, never have I seen so many at one time and with such a big impact---again, the lesson to remember is to never treat the unlikely as impossible and don't take more risk than you need to (at least without being fully prepared for the possible consequences). With that said, here is a short summary of what I believe is happening.

First, they “bet the house” by using too much leverage, meaning the company would go bust if these bets lost. Highly leveraged institutions must be right all the time because even if they are correct in the long term, they may not weather a short-term storm. This is a lesson these institutions should have learned from the 1998 experience of hedge fund Long-Term Capital Management (LTCM). While banks, with stable deposits bases, leverage between 10:1 and 12:1, Lehman and Bear Stearns had leveraged more than 30:1—and that included only balance sheet assets. Their real leverage, including off balance sheet risks, was much higher. In other words, these investment banks had evolved into highly leveraged hedge funds, and experienced a similar fate to LTCM. 

Home prices have fallen 15% and in some markets about 30%. And expectations for further declines as supply at about 11 months and about 5 indicates stable markets.

The mutual fund industry’s solution (or sales pitch) to what Buffett called “di-worse-si-fying” portfolios is to create “focus” funds: funds that concentrate the fund’s holdings in the manager’s best ideas. While most mutual funds hold well over 100 stocks, the typical focus fund will hold 40 or less. There are even funds that hire several submanagers for just their single best pick.

From an investment standpoint, this trend to “globalization” supposedly lessens the need for global diversification. The financial media has carried so many stories on this theme that it seems that this recommendation threatens to become “conventional wisdom”— an idea that has become so ingrained that few individuals question it. However, before we allow this idea to guide our investment decisions, we can check the historical evidence.

While the expense ratio is an important consideration, it should not be the only one. The reason is that a fund manager can add value in several ways that have nothing to do with “active” investing (active investing being defined as the use of either technical or fundamental analysis to identify specific securities to either over or underweight). Let’s explore some of the ways a fund can add value in terms of portfolio construction, tax management and/or trading strategies.

1. Liquidity is king. There is an old adage on Wall Street that “liquidity can be an illusion—it is there when you don’t need it and can disappear when you do.” While Lehman Brothers apparently learned that lesson in 1998 (and did not make the same mistakes this time around), Bear Stearns did not. They did not line up sufficient liquidity to withstand a crisis—a run on their liquidity. Two issues exacerbated the problem. The first was that the securities that Bear Stearns had its capital tied up in were risky assets. In a liquidity crisis the markets for such assets can literally disappear (there is virtually no bid). Had most of their assets been of greater credit quality, the problem would not have been as severe. The second problem was that the firm was highly leveraged, much more so than the other major investment banks. And when you are highly leveraged you have to be right all the time (because while you might be right in the long run, in the short run you can die, as Long Term Capital Management found out). This is one of the many reasons that we do not recommend hedge funds (many of them employ large amounts of leverage). And given the amount of leverage employed by Bear Stearns they might have been considered not much more than a big hedge fund that happened to provide other financial services. One lesson for investors is that they should always have a sufficient amount of “emergency” reserves (a typical recommendation is to hold at least six months spending requirements) in the form of short-term instruments of the highest credit quality so that they do not have to sell risky assets during a period of financial stress. And finally, if you know you will definitely need cash to meet a known obligation that amount of funds should be invested only in instruments that have guaranteed liquidity (e.g., Treasury instruments).
2. High yielding assets are risky and it is likely that eventually the risks will show up. We just don’t know when it will happen, what might be the trigger, how deep the crisis will be or how long it will last. Those are all unknowable. Thus, the main role of fixed income assets in portfolios should be to reduce the overall level of risk of the portfolio to an acceptable level, allowing the investor to hold the amount of equities that is appropriate given their own unique ability, willingness and need to take risk. Therefore, fixed income instruments should be limited to only those of the highest investment grade. Those investors that followed that principle have basically avoided the problems of not only the subprime mortgage market, but also the junk bond market and the municipal bond market as well. Another important lesson is that equity investors could have diversified away much of the risks of investing in the equity of Bear Stearns, but investors in risky fixed income assets suffered no matter how many different securities they owned because of the liquidity crisis.
3. Credit enhancement is nice, but not sufficient. Because the main role of fixed income assets in a portfolio is to reduce overall portfolio risk to an acceptable level, it is important to maintain the highest credit standards. That is why one of the principles of prudent investing for municipal bond buyers is to look through the credit rating of an insured bond and make sure that on a standalone basis the credit risk is acceptable. It is important to understand that municipal bonds are far less likely to default than a similarly-rated corporate bond. In fact, a single A-rated municipal bond is about 90 percent less likely to default than a single-A rated corporate bond. Similarly a AAA-rated municipal is less likely to default than a AAA-rated corporate. Thus, a municipal bond that is AAA-rated because its credit has been enhanced by a corporate guarantee is not as safe as a AAA-rated municipal bond that does not require the guarantee of an insurer. The market knows that. Yields on insured bonds are higher than on similarly-rated uninsured bonds. Investors should set high standards for the underlying ratings and not try to chase a few extra basis points in yield by purchasing bonds that rely on the credit enhancement to get a rating that passes the credit standard set by the investor in their investment policy statement.
4. Unlikely is not impossible. Bear Stearns made this common error in more than one way. First, it certainly was not impossible that a severe liquidity crisis would develop. Second, their big bet on subprime mortgages depended on housing prices not falling to any significant degree. This had occurred in the 1980s when energy prices collapsed and home prices fell in the oil belt. Just as is occurring today, homeowners were mailing in their keys to their mortgagor. In addition, today’s subprime mortgages had much more lenient terms (less equity required) than was the case in prior periods—making them more risky. And while we had not experienced a nationwide fall in home prices of any degree since the Great Depression, that did not mean that we could not experience one. In fact, one of the more common errors investors make is to fail to understand that just because something has never happened, does not mean it cannot happen (consider the events of September 2001). Thus, one of the most important principles of prudent investing is to never treat the unlikely as impossible and to also not treat the likely as if it is certain.
5. In a crisis the correlation of equity asset classes tends to rise. Broad global diversification across many equity asset classes, including those with low correlation to other portfolio assets, is one of the principles of prudent investing. However, investors also must understand that in times of financial crisis correlations among equity asset classes (and all risky assets such as junk bonds) tend to rise. Evidence of this is how quickly the subprime crisis spread around the globe, impacting all equity asset classes (and all risky bond classes as well). Even with a significant tail wind of rising currency values, international equities fell. In this crisis, the only safe harbor (besides commodities) was the highest quality fixed income instruments. That is why it is important that the portfolio have sufficient high-quality fixed income assets to ensure that overall portfolio risk is at the appropriate level.
6. Active management won’t protect you. Whenever there is a situation like an Enron or a Bear Stearns you will hear about the need for active management to protect you from such “obvious” situations. Nothing could be further from the truth. First, index funds simply own the market cap weighting of all stocks within the index. That means that in aggregate active investors also own the same proportional share of any given stock. A good example of the failure of active management to protect you is that Bear Stearns was one of the largest holdings of the Legg Mason Value Trust that is managed by legendary investor Bill Miller. Miller had beaten the market fifteen years in a row. However, that streak was broken in 2006 when Miller underperformed the S&P by about 10 percent. His 2007 performance was even worse. And in just the first three months of 2008 his fund is underperforming the S&P 500 by a wide margin once again—with Bear Stearns contributing to the underperformance.
7. Hedge funds won’t protect you either. Some of the largest losses were experienced by hedge funds, including two run by Bear Stearns. One of the problems with hedge funds is that their risks often highly correlate with the risks of equities at the worst of times, during crisis. So just when you need the low correlation that they advertise as a benefit, the correlations rise. That is just one of the many reasons you should avoid investing in hedge funds. What hedge funds are effective at is transferring assets from the country club set to investment bankers.
8. Don’t confuse the familiar with the safe and end up having too many eggs in one basket. For the twenty-year period ending in 2006 Bear Stearns stock outperformed Berkshire Hathaway’s stock by an amazing 4.5 percent per annum. With returns like this, who needs Warren Buffett. And consider the following story that appeared in Barron’s in 2004. The author noted that “with the company’s low risk profile and strong controls, investors in Bear Stearns can sleep well, knowing that even a full-blown financial crisis is unlikely to cripple the firm.” (Andrew Bary, “How Sweet It Is.” Barron's, August 2, 2004.) In January 2007, the stock hit an all-time high of $171. We can only wonder how many employees of Bear Stearns had significant portions of their net worth tied up in company stock because they “knew” what a great company it was. And surely they would know if there were problems arising and have sufficient time to exit. It is safe to assume that those same employees would not have invested in Bear Stearns stocks if they were employed elsewhere. Bear Stearns was not any safer because the individuals happened to work there. Yet, employees seem to make that common error because they confuse the familiar with the safe. And for senior management, they may even have an illusion of the ability to control events. The prudent strategy is to diversify all of your assets. And that includes your labor capital, not just your financial assets. And while the surest way to get rich is to concentrate your assets, it is also the surest way to go broke. While investors who had concentrated positions in Bear Stearns suffered greatly, investors that owned market-like global portfolios had a small fraction of 1 percent of their assets in Bear Stearns stock, even when it traded at its peak. This is a clear demonstration of the importance of diversifying equity risks. Unfortunately, as sure as death and taxes, despite the lesson Bear Stearns provided, this same mistake will be repeated many times over by future investors.

Summary

While each crisis the markets face is in different in some way, those that follow the principles of prudent investing can minimize the risks of catastrophic losses. Those rules include:

The smallness of the army renders the natural strength of the community an overmatch for it; and the citizens, not habituated to look up to the military power for protection, or to submit to its oppressions, neither love nor fear the soldiery; they view them with a spirit of jealous acquiescence in a necessary evil, and stand ready to resist a power which they suppose may be exerted to the prejudice of their rights. (Federalist Papers, Alexander Hamilton)

A necessary evil can be defined as an unpleasant necessity; something that is unpleasant or undesirable but is needed to achieve a result. An example of a necessary evil might be taxes. Investors should also view bear markets as a necessary evil. Let’s explore why.

The moral of the story is that children should be wary of old ladies who come knocking at their door tempting them with treats. It is more than likely that the old lady has a hidden agenda. The broker-dealer community knows that individual investors lack sufficient knowledge about the bond market, which makes exploiting them as easy as “taking candy from a baby.” Unfortunately for those investors, Prince Charming will not be riding in on a white horse to save them or their portfolio.

Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient. (Warren Buffett)

A good friend, Sherman Doll, who, like me, is a financial advisor, related the following story. He has been a two-line sport kite flier for several years. While not a pro, he has learned a few tricks by observing the flying behavior of these kites. He told me that one of the most difficult skills for beginners to master is what to do when their kite starts to plunge earthward. The natural, panicky impulse is to yank backward on the lines. However, this action only accelerates the kite’s death spiral. The simple kite-saving technique is to calmly step forward and thrust your arms out. This causes the kite’s downward acceleration to stop, allowing you to regain control of the kite and end its plunge. What does this have to do with investing?

With this knowledge, many investors deviated from pure market-cap weighted portfolios. Instead, they seek to capture the value premium by “tilting” their portfolios to value stocks. Investors who did so were rewarded with large premiums from 2000 through 2006. The premiums were 37.8, 14.5, 12.2, 3.0, 8.3, 8.3 and 12.7 percent, respectively. This produced an annualized premium of 13.4 percent. However, in 2007, the value premium turned sharply negative.

Nash won such accolades because his contributions go beyond his individual statistics, especially points and rebounds. Nash’s main contribution is that he makes everyone around him better players. This attribute is why Nash is generally considered the greatest point guard of his era. It is also demonstrates why it is important to not view a player’s value to the team by viewing his statistics in isolation. One needs to consider how the player impacts the team’s overall performance.

Today, most investment advice focuses on the development of portfolios that are on the “efficient frontier.” A portfolio that is on the efficient frontier is one where no added diversification can lower the portfolio’s risk for a given return expectation (alternately, no additional expected return can be gained without increasing the risk of the portfolio). Working with the “efficient frontier,” investment advisors then tailor portfolios to the individual investor’s unique situation. Unfortunately, far too many investors and/or their advisors only focus on the risks of the investments themselves.

Lesson 1: Globalization and Diversification

One of the more common investment themes we all have been reading about revolves around globalization. With increased globalization the thought is that the correlation of returns of stocks around the globe is rising, reducing the benefits of international diversification. Thus, one need no longer take the risks of investing internationally. Instead, just invest in U.S. multinational companies, like those that dominate the S&P 500 Index. While the world may be getting smaller, the benefits of global diversification should still be obvious to anyone paying attention to stock returns. As one good example, we can only wonder what Japanese investors have felt since 1990 when the Nikkei peaked at about 40,000 (it closed 2007 at 15,308) about the advice that they did not need to diversify internationally.