What to do now?

  • Written by David
  • April 23, 2008 at 7:17 am
  • 0
  • With first quarter 2008 now ‘in the books’ combined with the headlines of the day such as bank loan write-offs, mortgage wows, recession possibilities etc, there can be an urge from investors to “change” their investment allocations whether it is the correct action or not.

    That might seemingly be a good idea for an investor who has had no direction, or has been poorly advised. However, for those of us that have properly constructed our portfolios the question still remains, should we do something different right now, if so, why?

    In my twenty year investment career, I find going back to the basics during unsettled markets really works well for me. It is a bit like yoga for the mind… it calms, it relaxes, it creates clarity…lastly, it strengthens our resolve and commitment to the investment process which we undertook. It is that process that ultimately leads to the creation of a proper investment allocation and the ensuing investment choices we implemented.

    With that said, let’s touch upon on the following topics to further strengthen our commitment to the investment process during these times.

    The DALBAR Study
    •The Penalty for Missing the Market
    •The Myth Behind the “Normal” Market Prediction
    •Stock Market Performance Following Recession Lows

    The DALBAR Study

    DALBAR is a research firm providing studies on markets and investor behavior.

    Perhaps DALBAR’s most famed work is their study on “Quantitative Analysis of Investor Behavior”. This study looks at the S&P 500 index over twenty years and compares investor results to the S&P 500 index. DALBAR does this by measuring the dollar flows of money in and out of mutual funds over this twenty year time period.

    Average annual twenty year returns:

    S&P 500 Index: 12.98%
    Average “buy and hold” investor: 3.51%
    Average “market timer” investor: -3.29%

    Inflation: Typically annualized from 3.00% to 3.50%

    The average holding period for these mutual fund investors was only 30 months in duration over this twenty year study. How can one achieve their long term goals by holding investments for such a short time frame? So many investors wish to outperform such indices as the S&P 500 index; they have not even outperformed inflation.

    Why is this you may now ask? Emotions to be sure, but why?

    The Penalty for Missing the Market

    I will recast work from my January 7, 2008 blog to help answer the question, why such poor investor behavior?

    ‘The Penalty for Missing the Market’ is a study frequently created by Wall Street investment firms reflecting the S&P 500 index over long time periods and what happens to returns by missing just a few days in the market. I have referenced a January 2007 Goldman Sachs report.

    Simply put, when markets move, they do so in short, quick, explosive measures. If investors are not in the market on those very few powerful, explosive days, annualized returns will suffer greatly. As the Goldman report states, “Two Potential Keys to Success: Patience and Commitment” Enough said! Hey if investing was so easy, we might all be retired by now, right?

    Average Annual Total Return: 1985-2006

    S&P 500 Index 12.12%
    Missing the 10 Best Days 8.56%
    Missing the 40 Best Days 1.87%
    Missing the 70 Best Days -3.02%

    If I express the above data on a one year time frame rather than over twenty years, by just missing the best 4 days annually, our returns would, on average, drop from over 12% per year to a -3%!

    So what does this mean to us as an investor? It means that we have most of the year to talk ourselves out of being invested in the market. Now you can begin to see how the DALBAR study of investor behavior might occur. Behavior is often based upon emotion without the insights of patience, commitment or fact.

    The Myth Behind the “Normal” Market Prediction

    We professionals tend to do a bit of disservice for the investing public when we quote ‘average annual returns’. As you can now see, if you miss 70 days in a twenty year time frame, returns are anything but ‘average annual’. The work below is, well, dated, as I cannot seem to find a newer source. However, the data is over a 50 year time period so I feel the work is still relevant. Data comes from CDA Wiesenberger now known as Investment View from Thomson Financial Company.

    The 50 year study looked at the average annual returns for the S&P 500 index and found that eight out of ten times, the returns were much greater than, or much less than, the 50 year average annual return. So in most years, one’s investment return will be anything but the ‘average annual’ return of the index, historically speaking.

    Market Average Quiz:

    Q. What was the S&P 500′s average annual total return from 1951 to 2000?
    A. 12.63%

    Q. How many times has the market ended a year up exactly 12.63% between 1951 and 2000?
    A. Zero.

    Q. How many times has the S&P 500 index finished within 5% of that average?
    A. Only eight times.

    Stock Market Performance Following Recession Lows

    Are we in a recession? As my blog of February 22, 2008 illuminates, not only can the ‘experts’ not agree on the definition of a recession, most ‘experts’ can only label a recession after the fact.

    As an investor, I know recessions will come, I know recessions will go. It’s a bit like weeding the garden. Not too much fun, but it needs to be done periodically. What is important, in my mind as an investor, is what happens after a recession.

    Ned Davis research provides us with some insight into that question.

    S&P 500 Index Returns following recession lows

    Average of the past ten recessions from 1949 to 2001.

    3-months later 16%
    6-months later 24%
    9-months later 32%
    1-year later 32%

    If we are in a recession, will the future returns be exactly like above? No probably not. As the graph below illuminates, each time period is different as I assume this time period will be as well.

    Where do you go from here?

    As a client of David Gratke Investment Advisors, LLC, then it is our collective role to continue communicating about your lifetime goals and insure that current investment strategies are reflective of such goals. My role as an advisor is to help clients remained focused on those lifetime goals. It is especially important during unsettled markets as we now have which can be quite disconcerting and quite distracting to one’s long term success.

    Summing it up.

    Markets do go up and down, and over time, we will benefit from the results of long term investment performance. The key is to stay focused, weather the intermittent storms that blow through, and achieve the success that we all wish for.

    I hope you have found this work useful in understanding more about the nature of financial markets and the miss-guided steps many investors take with ill-advised actions based upon nothing more than raw emotion and little fact to support such actions.

    I have been posting on my blog since then end of last year. I would invite your feedback on the work posted in the blogs. To send me feedback, click on the small envelope below, lower right..

    Thanks for reading!

    Dave Gratke.


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