The market is in correction mode. We have just experienced the worst 90 days since 2011. The S&P 500 index was down 6.9% for the quarter ended September 30, 2015. The Wall Street Journal notes “daily swings grew bigger as investors fretted over China…while a commodities selloff and rising junk-bond yields added to the anxiety.”
The market is struggling with the challenges of ultra-low interest rates and the likely increase in the cost of money now being considered by the Federal Reserve. This is a perpetual struggle between traders and their efforts to race a step ahead of what central bank will do next and the economic effects of those actions. It is likely that rates will rise and the world will not end.
There will be many proclamations of doom and dread of higher cost of money by all manner of financial pundits. Our course will be to remain patient and long-term minded in the midst of an annoying (but normal) down year.
Fear Mongering
Nothing in life is to be feared. It is only to be understood. ~Marie Curie
In the hyper speed world of 2015 it seems that Bad News travels incredibly fast. Fear is powerful. Fear has a foundation built into the human brain, stem and roots. Anxiety is a relentless motivator in our conscious and sub-conscious that has allowed for much of humankind’s survival and prosperity. Fear has evolved as a coping and defense mechanism to warn our cave dweller ancestors to run away and survive another day. These nervous cavemen were able to hoard food and firewood to allow for survival in the incredibly challenging wilderness. Evolutionary instinctive psychological dynamics are much less applicable to the decisions that modern day rational investors need to make.
There is a time to take counsel of your fears, and there is a time to never listen to any fear. ~George S. Patton
Since the bear market and Financial Crisis that bottomed in March of 2009, there has been a pervasive anticipation in the investor community for signs of a reoccurrence or the next shoe to drop. This is a daily feeling that investors need to grapple with and develop a strong constitution that can help keep an even perspective as we face the inevitable ups and downs of the economic cycles now and in the future.
Each day it is critical that we strive for robust understanding and courage as investors. As has been discussed many times in these commentaries, investors are effectively business owners. The courage and resilience that success in business demands is also required of investors. Business will not always be booming. The value of any given asset, stock, mutual fund or piece of real estate is determined by what a buyer is willing to pay for it. As demand pushes prices higher, economic dynamics of supply and demand along with a myriad of additional factors drive prices to sometimes decline. After periods of rising prices, there is often a pause or correction as many of those who have the means to purchase are already owners of a given asset.
The market will have a correction (decline) of ten percent or more on a regular basis. As a rule of thumb, this should occur every year or so as momentum for buying pauses. Prior to this August 2015 downturn, the US and other global markets had gone up without correction for an unusually long period. “Buyer Fatigue” is an expression that attempts to describe what can happen when a run-up in prices finally breaks and selling begins. There is simply less people, traders, investors and institutions left in the marketplace to buy shares.
A “buyers strike” is likely a big part of what is happening now. Thinning in the broad public investor desire to buy is a natural part of the market cycle. As prices come down, this does not mean that anything has actually changed in the underlying quality of our investments and the urge to look for stability in the face of decline needs to be resisted. In observing this summer swoon unfold, one may ask, “where does the money go when traders sell?” Ultimately, a lot of the proceeds of short-term traders and investors who become shortsighted and exit their positions will need to be reinvested. Former sellers will ultimately look for re-entry and be the buyers of those very investments that they sold previously.
Many of our fears are tissue-paper-thin, and a single courageous step would carry us clear through them. ~Brendan Francis
We can be certain there will be a continuous stream of events that cause uncertainty, stress, fear and the occasional panic. Our fundamental belief in the rewards of ownership is crucial to avoiding the temptation to seek stability. The desire for stability means that we would need to reduce or relinquish ownership of great companies. Why would a rational investor sell quality investments because the price is down when the confidence in the future potential of the investment remains un-changed? If there are fewer buyers willing to bid for ownership of Google, General Mills, Intel or Costco, does that mean they are not great companies that are likely to be increasingly valuable assets in the future?
The rationale for this philosophy is that incredible growth and appreciation of wealth over long periods historically has been through ownership of equities. There is strong historical evidence that bonds, fixed investments and other “conservative” instruments have less potential to grow over time. It is good to have some diversification into these asset classes, but in order to grow wealth, we must focus on a core that consists of a majority of equities in our portfolios. This will expose us to the volatility and the vagaries of investor (and trader) demand for our shares of ownership in the short run, but in the middle and long run, we should end up with more wealth. More money creates greater safety than less money with lower volatility. The volatile road is the route to the greatest security because we have the potential to end up with more value.
Consider an article published by Morningstar in July 2009, just as the markets were beginning to recover from the financial crisis.
https://corporate.morningstar.com/ib/documents/MediaMentions/AreBondsGoingToOutPerformStocks.pdf
There is much to say about this article, but let us take the returns for “Large Stocks” Versus “Government Bonds” 9.6% vs 5.7% that is cited in the chart. For discussion we can say that the historical evidence shows that over the long run there is an approximately 3% advantage for stocks versus bonds when held over long periods of time. This premium creates more money as we hold our portfolio long term. As the timeframe grows, stock investors have historically ended up with significantly more wealth.
In order to get the reward, we must persevere during the down parts of the cycle. Some studies show the average mutual fund investor holding period to be less than four years. When the tendency is to trade first and ask questions never, the average anxious investor ends up with greatly reduced wealth. The fundamental question that investors seem to fail to answer correctly is “Do you want more or do you want less”. In other words, by being patient, long-term minded investors, we will have more and be safer by having more value created in our portfolio over its lifetime.
There are very few monsters who warrant the fear we have of them. ~Andre Gide
The courage, discipline, and toughness required for success in the long-term investment process is not a common trait. In my 23 years of experience as an investment consultant and advisor, I have been witness continuously to emotionally unstable and shortsighted decision making by many people that I have been able to observe. Investing is should be straightforward and readily understandable but it will never be easy. Many people succumb to the short-term scares and seek stability with little understanding of the costs of such decisions.
The math involved in this crucial decision process is not intuitive. I have conversations all the time where I work very hard to help people understand that the urge for stable account values and isolation from market fluctuation can be costly traps that create a short-term comfort at the expense of the power of greater wealth over time. Very often, I will listen as people speak of their view of the economy. It is difficult for any layperson to have the necessary perspective, let alone expertise to have any sense of the broad global or US economic environment. The overwhelming complexity of our modern world can cause investors to make structural changes to investment strategy based on transient dynamics and periodic lower prices that are actually a quite common part of market cycles.
It is striking to learn about just how ill equipped most of us are in the mathematical tools and skills necessary for quality decision making. To illustrate, I have excerpted these two paragraphs from Daniel Gardner’s great and important book, “The Science of Fear”.
http://www.amazon.com/Science-Fear-Culture-Manipulates-Brain/dp/0452295467/ref=asap_bc?ie=UTF8
“In a series of four studies, a team of psychologists led by Ellen Peters, a colleague of Slovic’s as Decision Research, examined whether numeracy makes any difference to mistakes Gut tends to make. It did in a big way. The studies repeated several well-known experiments—including some mentioned earlier in this book—but this time participants were also tested to see how skilled they were with numbers and math. The results were unequivocal: The more numerate people were, the less likely they were to be tripped up by Gut’s mistakes. It’s not clear whether this effect is the result of a numerate person’s Head being better able to intervene and correct Gut or if numeracy, like golf, is a skill that can be learned by the conscious mind and then transferred, with lots of practice, to the unconscious mind. But in either case, numeracy helps.
Much less encouraging is what Ms. Peters found when she tested the numeracy levels of the people in her experiments. Only 74 percent were able to answer this question correctly: “If person A’s chance of getting a disease in 1 in 100 in ten years, and Person B’s risk is double that of Person A, what is B’s risk?” Sixty-one percent got this question right: “Imagine that we roll a fair, six-sided die 1,000 times. Out of 1,000 rolls, how many times do you think the die will come up even (2, 4 or 6)?” And just 46 percent figured out this one: “In the Acme Publishing Sweepstakes, the chance of winning a car is one in 1,000. What percent of tickets of Acme Publishing Sweepstakes win a car?” Peters test subjects were university students. When a nation’s university educated elite has such a weak grasp of the numbers that define risk, that nation is in danger of getting risk very wrong.”
The above excerpt is from an author that has published powerful work about how people think and react in overly fearful ways to the most important decisions and challenges that we face in the modern world. What is so very important about this is that we must have a humble perspective on what it is that we really know and do not know. The notion of the “Gut” versus the “Head” in our thoughts, fears and decision-making is something that needs to be recognized for the crucial role that our subconscious and instincts play in all of our choices. The science does not reflect well on what we often hear described as “common sense”.
It is imperative to stay vigilant in our assessment of our own level of knowledge and understanding. With a long-term buy and hold approach, we do not have to make as many decisions, so complex ongoing analysis should have a reduced role to play in our ultimate success. Investment values are determined by dynamic factors at the intersection of economics, politics, demographics and a myriad of other factors. No one can figure it out, let alone consistently predict the future. The beauty of long term investing in broadly diversified mutual fund portfolios is that there is nothing to figure out. You just need to patience and toughness to hold on. Tenacity and persistence is the most important thing, kinda like life, eh?
To conquer fear is the beginning of wisdom. ~Bertrand Russell
The Wall Street Journal of 9-26-15 had a piece that referenced the important work of Warton Researcher Phillip Tetlock. I was excited to see that something that I began to follow and wrote about in my commentary dated 10/8/2013 was being cited by the WSJ.
https://adviceman.net/2013/10/08/market-comment-q3-2013/
http://blogs.wsj.com/briefly/2015/09/25/5-ways-to-see-the-financial-future/
Tetlock has just released new material, which I am very excited about and will be reading very soon.
http://www.amazon.com/Superforecasting-The-Art-Science-Prediction/dp/0804136696
I employ these commentaries to help organize my thoughts and philosophy. There are many newsletter services that I could hire and save all of the time involved in producing this material. I could publish a bucket of market update ad homonyms that offer little insight or value. The process of putting this together has become a great way for me to organize my thinking and create an archive of what I say. It is very important to me that I am absorbing the material on a daily basis from The Economist, The New York Times, The Wall Street Journal, Barrons, Forbes, Fortune, Kipplinger’s, Bloomberg and all of the other subscription material that I review every month. I spend an inordinate amount of time with these sources so that I can have the most positive impact on the investment process that we are all in together.
I am proud to find that some of the material that I deem to be worthy of comment resurfaces in important and respected publications. Any financial commentator can talk about Oil, China or the Euro and what has been happening in the economic landscape. I feel that my role is in digging deep to build a sound philosophy and framework that give all of you the highest probability of success. Stay strong and courageous.
Fear is the lengthened shadow of ignorance. ~Arnold Glasow