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Investing 101
In two of FIM Group’s posts this past year, we relayed findings from the market research company DALBAR, Inc., that we found to be interesting: over a 20-year period the average investor in stock funds earned significantly less than the funds themselves. This paradox is the result of investors’ emotional behavior, including selling out of fear and not getting invested again until after stock prices have recovered much of their declines. The most recent market cycle, which hit its nadir on March 9, 2009, was a textbook case study in what might be called “the overwound spring effect.” This effect also signals why it is important to get the best wealth management advice.
During normal times, the “spring” of the market – the tension between volatility and return (risk and reward) – is
modestly wound to a state of equilibrium. In this state, prices fluctuate and investors are rewarded somewhat proportionally to the amount of prudent risk they accept. When left invested over the long term (multiple decades) the portion of investors’ assets in stocks, as measured by the S&P 500 or Dow Jones Industrial Average, has averaged a total return, including dividends and capital appreciation, of a little under 10% a year [source: Ned Davis Research]. To achieve those favorable returns (relative to inflation or riskless investments), investors had to be patient through normal market price fluctuations.
Under less common periods of mass hysteria, whether it’s manic buying, when “everyone is making money in the markets,” or panic selling, when “no one knows how low it will go,” investor sentiment reaches extremes. Those extremes have an effect on the relationship between investment prices and their intrinsic values similar to that of a spring wound well past the point of equilibrium. Just as it is difficult to hold on to an overwound spring for more than a brief period, the markets are not able to hold security prices to extremely overvalued or undervalued states for very long. What happens next in investment markets is often similar to the spring when the holder can no longer keep it compressed – it snaps back with ferocity.
For examples of extreme overvalued states, think oil in mid-2008, tech stocks in the late 1990s, Japan stock and real estate prices in the late 1980s or precious metals in the early 1980s. In every case, the ensuing unwinding of overvalued prices was not pleasant for those holding assets at such levels. Thus the reason FIM Group feels it is imprudent to “buy and hold at any price.”
For examples of extreme undervalued states, we can look at U.S. stocks in 1982 (when price-to-earnings multiples had fallen to below 10 after 16 years of disappointing returns [source: Crestmont Research]), “junk” bonds in 1991 (after their prices had fallen and yields had risen to more than 20% [source: Ned Davis Research] in the wake of Milken, Boesky, et al), Asian stocks in 1998 (after the Asian economic crisis decimated prices), Hawaii real estate in 1998 (after an economic collapse in Japan and the rest of Asia depressed Hawaii’s economy), resort prices in 2001 (after the attacks of 9/11 made markets react as though no one would ever board an airplane again), oil in early 2009 (after it had swung from $147/barrel to under $40/barrel [source: Bloomberg]), and finally, the point of this article, many “value stocks” in the spring of 2009 after “the panic of 2008.”
Many great value-oriented managers with multi-decade records of superb risk-averse market-beating performance (like Warren Buffett, Marty Whitman, Mason Hawkins, Bill Miller and Chuck Royce) had declines that approached 50%, 60% and even 70%. Being disciplined investors (as opposed to speculators or market timers), all of these proven opportunistic value managers, of which FIM Group is a member, did not sell just because everyone else did. Rather, the discipline we all followed was to resist fear, hold our noses and take advantage of the bargains created by these opportunities. Beginning in the spring of 2009, when these over-tightened springs of opportunity were finally released, returns of all the aforementioned managers exceeded the returns of the major market indices.
It is imperative for investors to understand that the first half of each “bull” (rising or recovering) market has historically been when the bulk of the market’s returns have been achieved. The data that supports this ferocious snapback tendency is very compelling. Since 1929, subsequent to each “bear” (declining) market, the Dow Jones Industrial Average gains in the first half of the ensuing “bull” markets have averaged 43.5%, whereas its gains in the second half of each bull market have averaged only 16.8% (source: Bloomberg). In other words, a major risk to investors trying to time the market is not being invested at the bottom. Next time the thought that “it’s different this time” washes over you, remember these very important guiding truths: 1) It’s different every time in some way; 2) People often repeat their behavior; and 3) While they may inherit the world someday, it is during times like these that wealth often transfers from the meek to the emotionally prepared.
To learn about wealth management advice from the best wealth management firm, Financial & Investment Management Group -more please visit www.FIMG.net or call 800.632.5528.
