As 1999 came to a close, investing in "The Market" seemed poised to replace baseball as our national pastime. From 1990-1999, the S&P 500 (a broad index of large US stocks) provided an average annual return of 18.2%. Gaining access to the next internet initial public offering was akin to buying the winning lottery ticket. The idea of investing anywhere but in US stocks was considered passé. The insatiable appetite for risk drove stocks to levels never seen. In summary, long standing investing principles seemed to longer apply.
Fast forward to 2011. As of this writing, the S&P 500 has lost money since the beginning of 2000. Stock markets have endured wave after wave of gut-wrenching selloffs. Investors are fleeing equities and directing money into bonds at a record pace. The insatiable appetite for safety has driven bonds to levels not seen in decades. In summary, long standing investing principles seem to longer apply.
At first glance, the 2000 environment is the exact opposite as the 2011 environment. But each illustrates the long-standing investment tendency to follow the crowd. Whether the prevailing sentiment is greed (as it was in 2000) or fear (as it is today), making long-term investment decisions based on short-term emotions may be temporarily comforting, but it also proves to be one of the least successful approaches to managing one’s net worth.
Most people are familiar with the basic principles of investment management and financial planning. During difficult environments, they are often disregarded, even dismissed, as outdated. But as investors search for answers in this challenging environment, I believe it is more important than ever to adhere to the basics:
Stocks are more volatile than bonds.
In today’s environment, investors do not need to be reminded of this. However, over long periods of time, we expect stocks to provide more return than bonds. Many challenge this, and point to the last decade as proof. But fundamentally, it is more financially rewarding to be an owner of a profitable company (a stock holder) than a lender to a profitable company (a bond holder).
Diversification matters.
While equity investors who focused solely on large cap companies in 2000 likely lost money over the last 11 years, an investor who had exposure to small and mid capitalization stocks, international stocks, hard assets and bonds, in addition to large cap stocks, made a reasonable rate of return over the same period.
The price you pay for an asset is important.
Over the last 10 years, one particular U.S. corporation has increased profits by 196%. They repurchased 22.6% of outstanding stock. They increased the annual dividend from $0 to $2.69 per share. By nearly every financial measurement, the company is more attractive today than it was 10 years ago. Yet, an investor who held the stock over the last decade has lost money. One simple reason for the loss: the stock was too expensive 10 years ago.
Time horizon is the biggest factor when evaluating an investment.
If there is a fixed need for an asset within 5 years, it should not be allocated to stocks. Ever. This is not an attempt to predict whether stocks will go up or down over the next 5 years. It is acceptance of the fact that stock prices will fluctuate, sometimes significantly, over short periods of time. If we have a predictable expense, we need a predictable pool of assets to meet the need. Anyone who has weathered the last decade understands that stocks are a not predictable over short periods of time.
There are obvious problems facing our economy. Unemployment is high, growth is low and the Federal Government faces the difficult task of needing to stimulate the economy without adding to our growing budget deficit. In a world of growing globalization, we are clearly not alone. The European Union faces the difficult task of assuring their strong economies are not bankrupted by their less fiscally prudent members. Because of these issues, and a laundry list of other challenges, we may be facing a prolonged period of increased volatility. But in the face of all of the uncertainty, I will close with the fifth basic investment principle:
"The four most dangerous words in finance are 'this time is different"
-By Tory Meiborg & Tim Terry