2ND QUARTER MARKET COMMENTARY

The benefits of being proactive when it comes to your investments and retirement savings can be astounding. On the other hand, being reactive to the markets can be damaging at best and devastating at its worst. It’s not that the “buy and hold” strategy is flawed, it’s the implementation of the strategy by both investors and advisors alike that leads to trouble.

Consider the fact that the average investor has earned a mere 3.8% annually over the last 20 years, versus the index returns of 9.1% for the same period¹. In other words, if an investor would have bought the S&P 500 index 20 years ago and left it alone, they would have performed better. Additionally, consider that mutual fund inflows into stocks have been widely regarded as a contrarian indicator. Investors consistently pile into stocks at the peak of the market and dump them at the bottom, effectively buying high and selling low. This is evidenced by mutual fund inflows peaking in early 2007 and bottoming out early in 2009². The lazy spectator would make the case that we should all just own the indexes and forget about trying to outsmart the market. The thinking investor however, would understand why this happens, understand what factors are playing into this market and use this knowledge to their advantage.

Investment Behavior

Researchers who study the psychology of investments (aka Behavioral Finance) point to several human tendencies as justification for investors and fund manager’s apparent insanity. Understanding a few of these tendencies can be incredibly beneficial when evaluating your investments in a proactive manner. Herd theory is the tendency that we all have to mimic the actions of others, no matter how rational or irrational that behavior may be³. We only have to look at the recent bubbles in dot-com and real estate to see these theories in action.

Extrapolation/Recency tendency, according to Sir John Maynard Keynes, is the tendency to take recent results and make predictions about the future (particularly dangerous given market returns over the last 12 months)⁴. This amounts to driving your car while looking through the rear view mirror, only to see the cliff you just drove off.

Self-preservation tendency explains why most fund managers and analysts will always be short-term thinkers making only small incremental changes apart from the herd. Their job depends on it. Advisors and managers can be handsomely rewarded for beating the “benchmark” despite losing significant money for their investors (ie. 2007-2008). On the other hand, underperforming the “benchmark” over the short term, despite giving investors better risk adjusted returns, can be perilous.

There was no question among a select few investors, managers and analysts that the dot-com and real estate bubbles were going to burst. These people were proactive and ready to take action when the time was right. That is not to say that they timed it perfectly and bought at the bottom. They did, however, manage to mind the most important rule of investing, never lose money, keeping a healthy allocation in cash and short-term securities.

Our Market Today

The market as a whole may not be in bubble territory, yet we currently see bubble-like characteristics emerging in a couple areas, namely commodities and cloud computing/social networking. Human tendency has taken over and created a lot of momentum. When that momentum will stall and eventually crash is anyone’s guess. In the meantime, we will avoid these areas like the plague.

Recent valuations suggest that the market as a whole is in fact richly priced on the upper-end of fair value. Many companies are priced to perfection and therefore have very little room to underperform the analyst’s estimates. This added to a softening economy, which some believe may lead to mild recession and it is no wonder why many successful investors are becoming much more conservative (holding significant cash reserves). Referring back to the tendencies of investors and fund managers reminds us that there is good reason to be at the very least conservative and at the very worst fearful of a significant correction coming at some point in the near future. When this will happen or if it will happen at all, is anyone’s guess.

Economist Robert Schiller, professor at Yale University, has developed measures for combating some of the behavioral tendencies mentioned earlier. His research shows that normalizing price to earnings ratios (a measure of valuation) over a longer time period can give a reasonable prediction of future stock market returns (over a 15+ year period). According to his data, we can expect a -0.5% annual real return (before inflation) over the next fifteen years⁵. This compares to the long-term average of 6.5% annual real returns. We believe there is a high probability of earning better returns going forward by being proactive and maintaining a healthy skepticism. Our view is, if there is not a high likelihood of being handsomely compensated for taking risk, why take it. We discussed this at the end of January (see previous posting) and consequently have assisted our clients in avoiding much of the volatility the last several months.

Being proactive means having a plan if the market drops another 10, 15 or 20% and having a plan if the market rises another 10, 15 or 20%. We find that investors' attitudes toward market volatility and risk are very different when a plan is in place. In the near-term, if you feel like jumping in because you are missing out on returns, remember the words of Sir Isaac Newton, “I can calculate the movement of the stars, but not the madness of men.”

1. Colvin, Geoff. “Take Control and Win” Fortune Magazine. June 13, 2011
2. Trim Tabs Research
3. Phung, Albert. “Behavioural Finance – Key Concepts” Investopedia
4. Butler, Philbrick & Assoc. “Theory of Market Momentum.” http://www.Gestaltu.com
5. Butler, Adam and Philbrick, Mike. “Estimating Future Returns.” http://www.advisorperspectives.com/commentaries/dshort_61411.php