Happy New Year!
Each New Year when I write my first letter there are two ways to describe how I am feeling. One is I am optimistic and the other is I am not as optimistic. I am never pessimistic, or at least I try not to be.
Most of you know my range of moods regarding the equity markets is somewhat limited to optimism. I have learned that the market rewards those with a long term perspective and frequently punishes those who focus on the short term. I have more to say about what is long term later.
Investing in all asset classes requires commitment to achieve wealth. The primary difference lies in the expected rate of return and time it takes to reach a given level of wealth. Fixed income investors receive lower rates of return. As a result, investors in fixed income must invest significantly more money to achieve levels of wealth. For example $10,000 invested in bonds maturing in 30 years and yielding 3.5% will have grown to $44,390. The example assumes all interest payments are reinvested at the same rate. Later we will illustrate investments in stocks with their returns.
Unfortunately, most of what we hear and read about investing in stocks seems to be measured in days or months. Numerous articles can be found written by people claiming to know what the best performing stocks will be in 2018. The airways and internet are filled with interviews and articles with opinions purporting to know the immediate future for the stock market. The claims of such market prognosticators are no more likely than politicians’ campaign promises.
When we focus on the long term the emotion in short term results gives way to longer term reality. Consider the following.
Let’s assume you were age 30 in any of the following years. Let’s also assume you invested $10,000 in stocks measured by the S&P 500 when you were age 30. How much would you say your annual rate of return would have been?
Notice all are positive in spite of the “lost decade” of the ought’s. I think it safe to say most readers are astonished or simply do not believe it. Some may think I am manipulating data to prove my point. My point is and has always been the same: Investing is a long term proposition.
For most of us fear of losing money in the course of investing greatly influences how we think. To overcome “normal” perceptions we must consistently ignore the short term and focus on the long term. It includes periods when returns are excessively good. Great positive returns are no more likely to persist than negative returns. We know bull markets last longer than bear markets. It is why the chart for age 30 examples all show positive returns.
But when we focus on a selected, relatively short time period, the returns can show startling different results. During the period from 1/1/2000 to 1/1/2010, the S&P returned a negative -0.58%.
Data from Dalbar show investors tend to sell after and during market declines and buy after the market has risen. Fear of losses in declining markets triggers selling and over-confidence in rising markets triggers buying. The net result is investors tend to buy high and sell low. It is not a “winning formula”. It is the pattern that naturally evolves when too much attention is on the short term. For those who believe 10 years is long term, they obviously should have significantly less invested in equities.
Many reasons are cited for investors who fail to actually earn long term returns in line with the S&P 500. Included are high costs, frequent trading and inept advice. There are numerous factors but the real culprit is too many investors never commit to long term investing. Instead they succumb to emotion that leads to excessive trading and too frequent changes in asset allocation. Even asset allocation has its faults if the allocations are subject to frequent changes. An allocation that is 70% equities when the market is rising and is reduced to 50% after it falls is the equivalent of buying high and selling low. It is more sophisticated but it too destroys future wealth.
When the market falls 20% and the investor does absolutely nothing, a portfolio invested 70% stocks and 30% fixed income automatically adjusts to about 56% equities.
What must happen for the strategy to work requires selling fixed income and buying more equities to rebalance to 70/30. Frequently fear causes some investors to sell equities reducing exposure to stocks even more. In our example the market reduced equities to 56%. Actual sales could easily reduce the allocation to less than 50%. Holding and rebalancing is critically important for an asset allocation strategy to work efficiently.
The picture becomes even clearer when we consider the actual dollar amounts we could have earned had we stayed committed to stocks.
Is there a lesson to be learned from this exercise? It needs to be more than “coulda, woulda, shoulda”.
Our goal is to help our clients achieve financial security in the most efficient fashion that suits their temperament and their ability to live with risk. We are all different and each of us requires an understanding for what is needed to maximize their potential for accumulating wealth.
Many people do not care about wealth but all care about knowing they will not run out of money during their lifetimes. If Social Security, pensions, dividends and interest pay for all living expenses then wealth may not be that important. But if more is required to pay bills, it is only wealth that can pay the difference.
Wealth is simply that sum of money and assets that remain after all expenses are paid. Sadly accumulated wealth is not enough for many retirees. Allowing for dividends and interest and a reasonable withdrawal, too many retirees are forced to “drain” their savings and investments when they spend more than they earn. When forced to withdrawal annual sums greater than 5% of their invested net worth, retirees must spend very carefully and exercise discipline. Of course a reasonable rate for withdrawals depends upon the age of the retiree. When younger the withdrawal rate should be closer to 4%.
When people ask me how much net worth is required to be wealthy, I say it depends. Wealthy may be used to describe a person or couple who live on $40,000 per year and receives Social Security and other income amounting to $60,000. It seems to me you are wealthy when you are financially secure and live within your means.
You might ask is a person wealthy if they require $200,000 per year in living expenses but their income is $160,000? Using my definition the answer is maybe. I would say if the liquid assets, to include stocks and bonds, support their withdrawal rate [no more than 5%] they meet my definition for being wealthy. If they must draw down their net worth at rates greater than 5% to pay bills, a financial plan is required to determine if they risk outliving their income. Again age is a factor. A 5% rate would be much too high if needed by a 62 year old retiree to fill a gap between income and expenditures.
Our job as financial counselors is to work with our clients to achieve “wealth” that allows them to be financially secure. Our definition for being wealthy is clearly different. However, we believe it is the only one that really matters. When we spend more than we have, bad things happen.
Think about this. A person who retires at age 65 and lives to age 90 must pay their bills for 25 years without benefiting from job promotions and salary increases.
If inflation is 3% during those 25 years the purchasing power of a dollar will decline to about 48 cents by age 90.
It is a big challenge to accumulate wealth sufficient to pay bills in retirement. Without equities in the mix, it is difficult to visualize success. Perhaps this analogy helps to understand.
You live in New York City and you must go to Washington, D.C. The distance is 225 miles. You have 5 hours. If you choose to drive at speeds less than 35 miles, you will definitely be late. Investing is a little like that. Starting early is better than later and getting to the goal earlier is not only advisable but may be necessary.
Our outlook remains unchanged. We are investing fixed income accounts in shorter term and mostly higher quality securities to protect our clients from declines in market value when interest rates rise. We are optimistic about prospects for the bull market to continue. While a correction or even a bear market is overdue, we would invest cash reserves now. We believe the longer term outlook for stocks is very positive. When the inevitable correction or bear market happens, we believe they will be short-lived followed by higher highs. The risk for investing must always assume short term declines are likely. Now is no different. Buy stocks for the long run.
Thomas J. Curran Kevin T. Curran, CFA
Chief Executive Officer CIO & Portfolio Manager
This material was prepared by or obtained from sources that CIM believes to be reliable, but CIM does not guarantee its accuracy. The securities identified do not represent all of the securities purchased, sold or recommended and the reader should not assume that any listed security was or will be profitable. Market indices referenced are unmanaged and representative of large and small domestic and international stocks and bonds, each with unique risks. Information about them is provided to illustrate market trends and does not represent the performance of any specific investment. You cannot invest directly in an index. Past performance cannot guarantee future results.