Friday, October 17, 2008

Third Quarter Commentary

Winston Churchill once said "Democracy is the worst form of Government ever attempted in the world. The only exceptions to this are all the other ones tried." Nick Murray once said something similar (paraphrased) "Buy and Hold is the worst form of investing ever attempted in the world. The only exception to this are all the other ones tried"

Some have questioned the wisdom of holding stocks when they are going down and that is understandable, why would we want to continue to subject ourselves to this form of punishment? The answer is that there isn't a better way to capture the long term superior return of stocks, except by holding them during the good and bad times. Keep in mind that the allocation to stocks should be within an acceptable range of risk for your goals. I've always told my clients about the 2000 - 2002 period when stocks dropped by 49% from their high (and the NASDAQ 80%) and that you should expect a 20% drop in stocks about once every five years and a 10% drop every two years. So when the market drops by over 40% twice in an eight year period, that seems to me to be excessive and a difficult way to earn money. While I agree its a difficult way to earn money, there hasn't appeared on the horizon a better way and don't expect one to come along.

Sure there will always be the people out there who tout their market timing strategies that supposedly get you out before the market drops and in before it goes up, but that's not really investing and it doesn't work over long periods of time. You may not lose as much during downturns, but you certainly won't make as much during the inevitable upturns.

Warren Buffet talked about market timing as one of those things that hurt your performance in his 2004 annual shareholder report:

"Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job.

Instead many investors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

He wrote just today (October 17th in the New York Times) the following:

"Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over."

If the greatest investor (who in January was Bullish on the American economy) in the history of the world can't predict short term movements, what makes you think your neighbor or some investment guy down the street can?

The hardest thing to do right now is the wisest thing to do, buy stocks. Warren also said in his New York Times piece "A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now."

If Warren Buffet is buying, perhaps our fear, while real, is a bit misplaced.

The key to a good portfolio is to set your asset allocation to a level where you are comfortable with the inevitable short term downward fluctuations (comfortable being a word that is relative). Most people aren't comfortable losing money at all, however the total return available to them after taxes and inflation will be about 2% if they're lucky if they take no risk (and right now if you buy treasuries you are guaranteed a negative return after taxes and inflation). Stocks should be expected to return two to three times that and provide a good hedge against inflation long term. Your biggest enemy in retirement is not stock fluctuation, but inflation. The slow killing off of your purchasing power in retirement will turn that golden nest egg to copper in the span of just a few decades.

These are tough times, there is no doubt about it, but America has faced such times before and come out of them better and stronger than before. A few months ago most people were fretting about the possibility of $200 oil is at less than $70 per barrel, a 50% decline. Things change and prices cycle, that is the nature of free markets (ok, somewhat free markets). We still have fundamental problems in our economy that no one is addressing (Social Security, Medicare, Medicaid, Energy) and things aren't perfect, but things will never be perfect.

Buy and Hold may be the worst form of investing ever attempted, but is much better than all others ever tried.

Hang in there, this too shall pass.

As always, I'm available to talk.

Scott Dauenhauer CFP, MSFP, AIF