Experienced investors have heard this before. It is a headline used many times over the last 60 years. Fear sells. So the media sells high unemployment, potential deflation, and pending economic gloom. Some in the investment community join in the chorus, but fiduciary advisors have a responsibility to muffle the noise and help investors take fear and emotion out of their decision process.
My observation is that while the future is uncertain, it is not nearly as frightening as the headlines try to make us feel. As investors we need to focus on what can be controlled: asset allocation, global diversification and expenses.
At the end of July 2010 the S&P 500 index was at 1101, a level it first hit in the spring of 1998. Ignoring the significant turnover in the index, we could say that the 500 largest US companies have the same value today that they had twelve years ago, and the dividends they paid over that period of time were not impressive either. That is the bad news, but it is hardly news as we have been reminded repeatedly over the past twelve years that technology stocks, and many others, were overvalued in the late 1990s.
The real estate bubble and subsequent credit crisis are more directly the cause of our current economic malaise, but we are approaching the three-year anniversary of the most recent market peak and that hardly seems like news in this era of Twitter.
We believe equity markets are reasonably efficient, so the legitimate concerns of economic doom, and the associated levels of uncertainty, are factored into today’s market values. Therefore, it is reasonable to expect future returns of 6%-8% above inflation, somewhere near the historic return to equity investors. Of course we must also expect volatility similar to the past, so predicting stock market returns over the next 3-5 years is something akin to playing darts wearing a blindfold.
The news I have not heard reported is that an investor, with a moderate portfolio of half stocks and half bonds, had a portfolio value at the end of July that was very nearly equal to its value at the peak of the market in 2007. More conservative investors were ahead of the previous peak, while more aggressive investors were still behind their peak values. The chart at left attempts to illustrate this by showing the amount that had to be invested in earlier periods to be worth $100,000 at the end of July.
This chart also shows how difficult it has been to generate returns over the past ten years that significantly outpaced inflation.
The next chart shows a thirty-year period and illustrates how easy it was to beat inflation by 4% annually if you invested before 1994. In fact you only needed to expose 30% of your portfolio to equity risk.
It won’t sell newspapers, but I think the headline should say, “Ten years is not a long time horizon for equity investors,” and, “Fixed income is really important to managing risk.” I also believe that fundamental diversification will remain the best way to manage uncertainty, including current concerns about inflation, deflation, and double-dip recessions.
The questions you should be asking are:
1. Does my asset allocation contain more risk than I am comfortable with?
2. Am I diversified globally in both my equity and fixed income investments?
3. Am I ignoring my investment expenses or controlling them?
4. Have I set performance benchmarks for my investment portfolio and am I monitoring my performance?
These are the keys to the long-term growth of your wealth in any economic environment.
Note: These results were developed by simulating past returns in the various markets included in each benchmark, assuming the reinvestment of dividends and other earnings . The money market is represented by 90-Day Treasury Bills; the bond market by the Barclays Capital Government/Credit Bond Index; the domestic large cap market by the S&P 500; the domestic small cap market by the Russell 2000 Index; and the international equity market by the EAFE Index. This data is presented to show the long-term relationship between returns at various levels of investment risk. It is not intended to present performance results experienced by clients of Rockbridge Investment Management, but is intended to provide a benchmark against which actual performance might be judged. Also, readers should recognize that future investments would be made under different economic conditions. It should not be assumed that future investors would experience returns, if any, comparable to those shown above. The information given is historic and should not be taken as any indication of future investment results.