Thursday, June 08, 2006

May & June Fluctuation in Perspective

May was a tough month for stocks with the S & P 500 down nearly 3%, small stocks down nearly 6%, and Emerging Markets down a whopping 11.57%! June is not shaping up to be any better as we have seen consistent 100 point drops in the Dow.

I understand that all this downward fluctuation (notice how I didn’t say loss) can cause a lot of fear for those who hold stocks, however I’d like to put the recent fluctuation into a little context and perhaps give you a different perspective.

If we look back at stocks since January 2000 (the beginning of the so-called Bear Market) we see returns that are outstanding. In fact every single major asset class has a positive return except large cap growth stocks. While the S & P 500 has struggled since 2000, still down 2.26% (through April of 2006) the rest of the market has had a tremendous run-up. Through April 2006 Micro Cap stock were up 135%, Small stocks up 101%, Small Value stocks up 203%, Large Value stocks up 86%, Real Estate up 240%, International Value stocks up 103%, International small stocks up between 154 – 217%, and Emerging Market stocks up nearly 90% - all since January 2000 – some bear market.

Even through the bad month of May and the bad start in June stocks are up for the year, a portfolio that is 100% invested in stocks that is global in nature is up 4.83%. While that return could be erased easily, it should put the recent fluctuation in perspective.

Stocks can’t always go up; they must go down every so often. If stocks never went down there would be no risk to owning them and the returns would be dismal. The price for the higher returns of stocks is higher fluctuation, in other words, dealing with the drops of the market.

On average stocks drop by 25% every five years. Since World War II stocks have dropped by 20% or more at least 11 times. The one thing that is for certain when investing in stocks is that every so often you will suffer drops in value. Over the long run we expect the market to go higher, but in the short run it can appear to be a circus.

There are many reasons why stock prices are dropping now, but the reasons matter little (as there will always be a reason). What really matters is that you build a diversified portfolio and hold on to it through the good times (the past six years) and the bad times. I guarantee there will be bad times, but the bad times allow for us to have good times.

Stocks appear to be taking a breather from an incredible run up in value, that is ok, natural, and healthy. My advice, as always is not to panic, diversify, rebalance, and continue to hold through the ups and downs that will inevitably come. Nick Murray once said that “The enemy of investment success is not ignorance, its fear.” It’s ok to feel afraid, but don’t let that fear affect your success as an investor.

On a side note, the only asset class that did not drop during May was Real Estate. This surprised me and has yet again made me wrong on real estate (for how many months now?). While I believe real estate is good to hold long term, I do believe that most Real Estate Investment Trusts are overvalued and do not have favorable risk/return characteristics and I have not changed my mind on them. I don’t want to hold REITs right now (with the TIAA Direct Real Estate account as an exception).

Market fluctuation is a fact of life, its not easy, it’s not fun, but without it we wouldn’t have the opportunity to outperform low returning investments like bonds and CD’s. You may be wondering when this streak of bad performance is going to end -I don’t know, nobody knows, and finally it doesn’t really matter to the long term diversified investor.

Scott Dauenhauer, CFP®, MSFP