Introduction
The global stock
markets are probably not priced with a lot of bargains. High quality, fixed
income markets are full of fears. All markets including commodities and real
estate are likely to be more volatile for the next couple of years than what we
have recently experienced. If you disagree leave the worrying to the rest of
us.
Our concern is based on
the volatility that won’t be constrained and lead to panic-driven major
disruptions. Since we don’t know what our next investment voyages will be like,
we should examine our navigational tools. In our lives we know from our own or
observed experiences that frequent changes rarely produce optimum results and
in many cases deplete resources substantially. Thus the key to using the
appropriate tools is the discipline to use them correctly and even when
periodically they produce sub-optimum near-term results. Nevertheless there may
be times when changing tools makes sense. Usually the best time to make
switches is whenever a tool is too successful and not when it is
underperforming. This reliance on intelligent discipline is one of the may lessons
that I learned in the US Marine Corps.
Our basic four
investment philosophical tools are:
1. Reliance on Simplistic Approaches
2. Recognition of Complexity
3. Goal focused Strategies
4. Timely Tactical moves
Simple
A study of most very successful
individual investors appears to demonstrate that large wealth is generated by investing
in ownership of equity, usually very concentrated to the point of a single
investment. It takes an unusual person
that can tolerate the cyclicality involved in a single or even a highly
concentrated portfolio. This cyclicality produces too much trauma for most. So
they start to diversify. The problem with diversifying is that almost every day
a new potential threat to one’s wealth shows up, particularly in the media. The
standard risk control measure for new risks is to add some new protective
investment. Over time this approach leads to a large number of investments.
In the modern world,
people and institutions seek comfort in becoming part of the masses and either
directly or indirectly index their portfolios. The thinking behind this is that
all of these investors can’t be wrong, but equally they can’t be as right as
the successful wealth-builders. Other simple philosophies are to only invest in highly credit rated stocks and bonds which produce similar upside
and downside results. It is like someone who goes to the racetrack to bet on
winning horses, so they bet on almost every horse in the race. Quite often they
will have a winning ticket, but most of the time the money received will not
pay for all the losing tickets. The nice part of simple moves is that they do not
require additional thinking or analyzing.
Recognizing
Complexity
There are no two people
exactly alike. Even my twin grandsons, not only are they different, but they strive
to be different. While each market has on the surface similar characteristics of
prior market cycles, there are enough differences so the past is a bit
instructive but not totally predictive. I believe that each portfolio and
investor are different than others. One of the risks that some investors face
in dealing with live managers and brokers as well as the so-called robo
advisors is that at times one’s needs and preferences are not utilized in
portfolios. One of the ways I recommend dealing with this is to divide an
investment portfolio in terms of expected payouts. I start often with four
timespan portfolios.
Each portfolio can be
selective in terms of levels of aggressiveness/conservative as well as many
other selection functions. Because consultants want to deliver the past to
clients, they ask about the dispersion of performance within a manager’s book
of business. To the extent that there is
little dispersion, there is little attention as to the differences between
people and institutions. All 401(k), pension plans, endowments, and families
are different and deserved to be treated
that way. However, there is an expense to managing complexity. The difference
is similar to buying off the rack versus custom produced and fitted clothes.
Each has its place, but overtime the old rule of getting what you pay for
generally works.
Goal Focused Strategies
Almost every physical
and investment trip has bends and turns with occasional reversals. Those who
successfully complete their trip do so because they have a navigational tool of
an effective compass. We all understand that prices go down as well as up. While
there are relatively few complete wipeouts, we have seen 90% declines in
leveraged, highly speculative stocks in the 1960s and the 1930s. These are
rarities. Most general stock market declines in a single generation are on the
50% variety. Within each rolling ten year period there is a 25% fall, and often
within a ten year period there are three years of greater than 10% decline.
Strategies should recognize the downside potentials, but also be aware and
positioned for the upside.
Since 1926 the general
stock market has on an annual basis gained in the range of 9%. We have
experienced gains of three or four times the average and have seen a number of
concentrated funds with speculative holdings post annual gains of over 100%.
Some may feel that
because the number of publicly traded stocks is down by a factor of 50%, the
institutionalization of trading, and the growth of index funds that past
upsides will be curtailed. I would argue eventually the reverse. Periods of
extreme concentration as we have been in, lead to lack of focus on securities
that are not part of the highly valued concentrated portfolios particularly in
the market capitalization weighted indices.
A very important point
in assessing long-term investing is the power of reinvesting cash distributions
(interest, dividends, and capital distributions). The great Sidney Homer, the
long term head of Salomon Brothers fixed income research pointed out that for
the long term bond investor there are three returns of cash over the life of
the bond: (a) proceeds from maturities, (b)
current interest coupon payments, (c) and interest on interest.
Most people don’t fully
appreciate that the third element produces the most cash. For example a bond
with a 4% coupon held for a twenty year maturity will receive 100% of its issue
price, 80% of its issue price for twenty years in interest payments, and if
they can reinvest the interest payments at the same 4% for the period they will
receive 119% of the issue price. The message here is that by buying and holding
solid bonds and reinvesting the income, the return to the investor is larger
than most believe. The key is not spending the interest and reinvesting it at a
similar rate as the initial issue. (If you sense a certain rhythm to this approach
it is worth noting Mr. Homer’s parents were both professional classical
musicians.)
The interest on
interest example is actually more powerful in investing dividend stocks and
funds. Today they are many solid equity companies who are yielding 2% to 3%
that over the next twenty years are likely to raise their current dividends at
least at the rate of inflation, if not higher. Many of these stocks’ twenty
year dividends will be higher than a 4% coupon on a high quality bond. Both
many dividend paying stocks and all mutual funds have reinvestment mechanisms,
so the equity investor does not have to look for current income opportunities
the way the bond investor does. I am biased, but I believe the reinvestment
potential through good mutual funds is better than many individual stocks. The
US and UK regulators do not value the reinvestment mechanism in their
assessment of the value to investors. Dividend paying stocks and mutual funds
could represent a significant part of endowments and individuals long term
portfolio segments.
Timely
Tactical Moves
The first thing is to
determine is whether the investor has trading skills. Can they recognize the
difference between intra day and daily volatility vs. a meaningful change in
price trends? There are some that believe that they posses this skill and a few
may. It is very definitely an art form that requires the right personality
approaches with extreme discipline.
Others attempt to be
anticipatory and get ahead of new trends. As someone that has been known to be
premature, too soon is often equivalent of being wrong. At times one may have
to concede that one is premature and reposition for closer to fruition trends.
Contrarians can
identify where they think the crowd is wrong and take a contrary view. Most of
the time these moves don’t have much price risk as the market doesn’t believe
in them.
My Dilemma
My dilemma is to find
the correct communications with potential clients as to which of these tools
should be used with all or a portion of their accounts. Any thoughts would be
appreciated.
__________
Did someone forward you this
blog? To receive Mike Lipper’s Blog each
Monday morning, please subscribe using the email or RSS feed buttons in the
left margin of Mikelipper.Blogspot.com
Copyright © 2008 - 2017
A. Michael Lipper, CFA
All rights reserved
Contact author for
limited redistribution permission.
Posts
No comments:
Post a Comment