07-23-2009 by dan
I’ve been thinking a lot about being an “individual investor” lately. By which I mean someone who doesn’t have a financial advisor, uses an online discount brokerage account (like Etrade or Scottrade), and tries to use an asset allocation model (or random choice model, depending on who you are) to buy securities. Most of the time, an individual investor will use a buy and hold strategy, with a rebalancing once a year or so. This whole idea, which has always been one of the “bedrock investment ideas”, seems to have developed some cracks lately (at least in my mind).
Why are individual investors in trouble from a capital appreciation standpoint?
The Game Has Changed. The long held belief that “the long term” would always give you decent returns if you just held on for long enough has always been based on an economy in which financial products (ie, those things you are investing using) were becoming a larger and larger portion of GDP.
These products are unlikely to continue to increase at the levels we have seen for the last 50 years, and the credit markets that increased consumer demand are also unlikely to grow so quickly. We have also been inflating a housing bubble since WWII, and have had several other bubbles along the way. These bubbles profoundly affect the “average return” numbers that we see plastered all over everything. (More on this problem in a later post). Here is an article that claims the long term treasury bonds have outperformed the S&P 500 over the past 5, 10 and 25 year periods.
Will buy-and-hold start working again? Probably. But in the meantime, something fundamental has changed. The claim that the S&P index returns 7-10% on average could be an overestimate. The real return might be closer to 5-6%, or, in other words, closer to the long term treasury bond rate. After all, if you diversify your portfolio, all you are carrying is the overall market risk — so the difference between long term treasury bond and long term S&P returns should be the reward for bearing of that risk.
Financial Managers Need to Get Paid. A value investor would watch her individual stocks, and if one of them became a bad value, would sell it — placing the cash into a new stock if a good value could be found, or a bond or plain cash otherwise. A mutual fund (or even index fund) manager would possibly sell the stock, but would almost certainly put the money into a new stock (after all, they might not get paid if they are in cash!). This is a major losing strategy if the entire market is tanking, and you are just trading crappy stocks for less crappy (but still crappy) stocks. I believe that an actively monitoring value investor during this crisis would have pulled out of certain stocks as they became bad values, but would NOT have gone into new stocks, thus avoiding a lot of the loss that us buy-and-hold types have incurred.
Goldman Sachs (et al) Will Win No Matter What. I saw a blog post about the “Goldman Collar“, which essentially means that to enable trades to happen (aka, provide liquidity), investment banks can operate on both sides of the buy/sell transaction. This enables an investment bank to sell TO YOU at the highest price out there, while buying FROM YOUat the lowest price out there. You will always lose part of what you could have made to Goldman Sachs (et al). The longer you hold a stock, the lower this risk is, but you will be taken advantage of at both ends of the trade.
Diversification Only Removes Uncorrelated Risk. Diversification is always touted as the panacea to a portfolio, making it safer for the amount of risk. But, as the math shows, you are only removing the risk that is NOT correlated to the market at large. When a bubble is going on, that correlated risk heavily outweighs the uncorrelated risk you so carefully tried to remove through diversification. Just put everything into bonds, you might shout at me — fine, but a lot of the companies that issued debt are going bankrupt, or giving out debt haircuts like a beauty salon, so your money wouldn’t necessarily have been safer there. Treasury notes were one of the other viable options, but as we’ve seen, this drove the interest rates to near 0 — not very helpful, you could just stay in cash.
I’m nervous about this whole thing. I’ve been plowing retirement money into these sorts of accounts for years. Have I been doing the right thing?
I wish there was more info from the article on 5, 10, and 25 year treasuries outperforming the S&P. My gut reaction is that comparing the two right after a big drop in the S&P is unfair. Any competent individual investor who expected to draw down on his investments in 2009 would not be 100% (or even 50%) in the stock market. It’s mostly people like you and me in our 20s (or 30s and maybe 40s). We have a few decades before drawing down. Thus, we get all the benefits of dollar cost averaging in the stock market. And if you are putting in a constant amount of money into your retirement fund, this downtown happening when you are under 30 will probably be very profitable in the long term.
My layman understanding of the 7-8% total stock market return was that you were being rewarded for the volatility of stocks compared to other investment vehicles. And that volatility can be tamed by dollar cost averaging over very long periods. But that’s really just me spouting back A Random Walk on Wall Street.
What I don’t see in the article cited above is a reason why the stock markets would have a different long term return after this recession than before it. Until I find a good reason for such a belief, I lean toward the view that stocks are pretty much “on sale” right now and investors would be wise to buy low, sell high.
Comment by Adam — 07-23-2009 @ 10:46 am
Funny you should mention about the treasuries data. I have something I’m working on that I will probably post tomorrow that might let you dig into that a bit.
I’m really teeing up for the next article here, but what I was writing was getting way too long and cumbersome, so I broke some of the example stuff off this post.
My view is that returns on stocks have never been that good, and the decent rates we see for funds are either bad math or related to the past few bubbles. It’s just something I’m starting to worry about, rather than a firmly held conviction, but there do appear to be some facts out there that might support the view.
Comment by dan — 07-23-2009 @ 4:53 pm