60 Years and Counting

We were encouraged to see recently that John Bogle, the founder of Vanguard Funds, has come out with a new book entitled “The Clash of the Cultures”. Bogle has been in the investment industry for 60 years. He has seen it all, the good and the bad. He was an early advocate of low-cost index fund investing, which was the premise on which he founded Vanguard Funds. It is a good thing for our industry that people like John Bogle and Warren Buffett have lived so long and experienced so much and are willing to share their experience and insights with us.

Bogle’s book is highly critical of the financial services industry, primarily because of what he believes has been a) too great an emphasis on short-term thinking (meaning “trading” or speculating over sound fundamentally-based investing), and b) the industry placing too great an emphasis on its own profit at the expense of the investor. This has come into particularly stark focus in the wake of the events of the past 5-10 years. Some of the investment insights he points out in his book are important:

               

·         Despite the problems our economy is now experiencing, Bogle believes long term investors need to hold stocks to capture growth.

·         The outlook for bonds is abysmal, but alternatives are hard to find.

·         Investors need to have a long-term view and stay the course. Trying to time or second-guess the markets is a losing proposition.

·         Everyone in the industry needs to adopt a fiduciary standard that puts the interests of the client first.

From a financial planning perspective, we could not agree more with Bogle. The abuses of our industry over the past ten years have hurt not only individual investors but the economy as a whole, and while as a nation, we have started to make some progress on addressing these issues, the healing process will take many more years. With respect to investing, we agree with Bogle that diversification and a long-term view are critical elements of successful investing. As financial planners, we believe adequate diversification of client portfolios is a cornerstone of good investing to not only reduce volatility but also capture returns of multiple market sectors. Fundamental research is important not only in identifying attractive investments, but also in maintaining and supporting the fiduciary standard which Bogle advocates: basing decisions on reasoned logic and avoiding speculation. We also believe that time mitigates risk, which supports the importance of long-term investing. Why? Because data on long-term economic trends allows us to place greater confidence in developing a financial plan and investment roadmap and incorporating that confidence into the discipline that a sound financial plan provides.

A “New Paradigm” ?

The Wall Street Journal recently ran an interesting op ed written by Burton Malkiel entitled “Even Amid the Current Turmoil, Stocks Still Beat Bonds”. Malkiel is the Princeton prof who wrote the book “A Random Walk Down Wall Street” and is considered one of the pillars of the Efficient Market Hypothesis (EMH). EMH states that the stock market is completely efficient, discounts all that is known about a stock in the current price, and that it is impossible to outperform the market through trading or investment schemes.

To be sure, EMH has come under question in recent years but Malkiel has been around a long time and is well respected in our industry and I believe his opinions carry some weight. The important points about Malkiel’s article were these:

1.       He believes equities today are more attractive relative to bonds than at any other time in history.

2.       He believes fixed income investments will never earn the returns necessary to meet retirement or pension fund planning objectives.

3.       He believes “the only hope” for generating returns necessary to meet retirement planning goals is to increase investment allocation to equities.

While we agree with Malkiel, the notion of holding more equities at or near retirement flies in the face of a long-held “law” of retirement planning, namely that one should hold a large fixed income allocation at or near retirement. While holding more equities may increase long-term returns, higher equity weightings will result in greater portfolio volatility which increases investment risk.

So for us as financial planners, we are sort of in a “new paradigm”: while increasing equity weightings for retirees may now present a more expedient strategy, the question becomes how do we mitigate the risk of higher volatility which would accompany higher equity exposure? We do this in a number of ways:

§  Make sure client portfolios are adequately diversified both by asset class and market sectors

§  Emphasize income in our investment model as higher portfolio income helps to reduce volatility

§  Take care to understand the risk tolerance of our clients and how this translates to their investments

§  Base investment decisions on fundamental research and reasoned logic

§  Identify and invest in undervalued sector opportunities

§  Make sure all clients have a sound financial plan that keeps them on the proper roadmap particularly with regard to their investments. This reduces the risk of emotionally-driven decisions that can destroy the effectiveness of a sound financial plan.

“It’s All Doom and Gloom……”

I ran into a friend at the gym yesterday morning. He is retired and is one of those types that looks at and worries about his portfolio every day. So he stops me and exclaims “Bob….did you see [xyz morning financial show] this morning?! It’s all doom and gloom ! We’re hosed!....”  Of course, this gentlemen, whose intelligence I respect, is pretty much entirely in cash now and has been for some time.

So why is my friend all in cash? Fear. True, the xyz morning financial show was highlighting all the negatives that morning: Europe, Greece, Spain, fiscal cliff, high unemployment, etc. We agree these are serious issues, but the media always highlights the negative, and why not? Negativity sells, it provokes anxiety that keeps people watching….and that sells commercials (remember, the financial news media is in business to make money selling commercials, not providing quality investment advice).

Now, I am not saying my friend is wrong to be primarily in cash. If he sleeps better at night that is important and he may be correct that it is the end of the world. But we doubt it. A few points we would make with respect to all this:

1.       Recent investor surveys reflect a very low level of bullish sentiment currently, levels that many times in the past have proven to be a bullish contrary indicator for stocks.

2.       Stock valuations are not excessive and many sectors in the market remain attractively valued.

3.       Monetary conditions, namely Federal Reserve policy, remain accommodative, which historically has been positive for stocks.

4.       The U.S. corporate sector, reflected in profit margins and cash flow, is very healthy currently, and corporate earnings are forecast to grow this year and next.

5.       We believe Congress will address the fiscal cliff issue.

6.       We believe Europe will find a way out of its ugly morass.

7.       No question, the general risk environment is higher than normal, but ‘twas ever thus…..there are always risks in investing and no one has a perfect crystal ball, but historically the best time to invest is when there is rampant fear and uncertainty.

So should we all be like my friend and be all in cash now? From a financial planning perspective, we believe there are ways to capture what we believe is an attractive risk/reward for stocks while being able to sleep at night. How?

1.       Have a solid financial plan that provides sound spending, savings, and investment roadmaps.

2.       Diversify your investment holdings in order to capture returns of multiple market sectors and also reduce portfolio volatility.

3.       Establish an asset allocation that allows you to capture the growth opportunity in equities while also reflecting your risk tolerance.

4.       Focus your equity investments on quality, dividend-paying and undervalued sectors of the market.

5.       If you are baffled by the market and are uncomfortable with handling your own investments, seek the advice of a qualified and experienced financial planner or advisor.