Should I Be Making a Change?

Being an investor is rather simple when the market is trending upward. However, when there is a pause in growth and the financial markets begin to trend downward, honest questions begin to emerge. They take various forms, but in essence they all seem to come down to one question and that is “should I be making a change?”

Benjamin Graham, who was Warren Buffett’s friend and mentor, wrote a book titled The Intelligent Investor. One of the most important chapters in the book is titled "The Investor and Market Fluctuations." Within this chapter he mentions that common stocks are almost certain to fluctuate in the short-term and that investors should be prepared for them both financially and psychologically. When it comes to price fluctuations he asserts that “price fluctuations have only one significant meaning for the true investor." They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.” Notice that he does not describe selling because of, or in reaction to, a short-term decline but rather sees price declines as an opportunity to buy.

Price volatility is inherent to investing and the most successful investors in history are on record time and again warning against selling just because it seems like everyone else is. Following the herd is a dangerous approach to investing. Mr. Graham points out that “the true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation.”

What can we learn from history regarding market fluctuations?

Looking back at the long-term data we can see patterns within the financial markets that can help to set expectations and guide long term investment policies. One of the patterns that we see by looking at the S&P 500 index since 1946 is that corrections, a decline in prices of at least 10 percent, occur on average about once a year. In other words, we should fully expect the equities in our portfolios to decline, on average, at least 10% every year. We should be prepared for this both financially, by perhaps maintaining an emergency fund, and mentally. Sometimes it will be more and sometimes less, but at a minimum we should view a 10% decline as nothing out of the ordinary.

For example in 2012, 2013 and 2014 we did not experience a decline of 10%. This marked a period of over 3.5 years without a meaningful correction and, as pleasant as that might have been, this poses a possible danger. It is possible that long periods of below average downward volatility can alter our expectations and leave us less prepared for the next inevitable correction. In short, we can become complacent to the inevitable volatility that drives long term returns.

Fast forward to today and, in contrast to the period mentioned above, we have already seen two 10% declines since last summer. We experienced the first in August of 2015 and the second in the beginning of 2016. Again, corrections are not unusual, but the fact that prior to last summer we had not experienced a correction for more than 1,300 days may affect our view of what is normal historically. 

To put our view to short term volatility into perspective, let’s take a look at what we believe to be timeless advice from one of the most successful mutual fund managers of all time. Following the terrorist attacks of 9/11, Peter Lynch, the famed former portfolio manager of the Fidelity Magellan Fund, provided his advice as to what investors should do following the attacks.

“My advice hasn’t wavered from two weeks ago, two years ago or 20 years ago. It won’t two or 20 years from now. The money you need for the short term to pay for a wedding or put a down payment on a house or send a child to college next year shouldn’t be in the stock market. But if you’ve set aside adequate funds for your short-term needs, time is on your side and the stock market has historically been the place to be. And when I say long term, I don’t mean three weeks from Wednesday. I mean a minimum of 5, 10 or 20 years. The market goes through difficult times; this is one of them. But if you’d been in the market for the past 15, 30 or 50 years, you’d be quite happy despite the many painful periods.

It’s no secret that traders and market timers who come in and out of the market will miss some of the bad months, but they will also miss some of the good ones as well. When the market goes up, it often goes up rapidly. If you jumped in and out of the market and missed the best 40 months during the last 40 years, you would have reduced your average annual return from more than 11% to around 3% (less than you would have gotten from a money market fund.) Market timing is speculating and it rarely, if ever, pays off.

As I said earlier, which way the next 1,000 to 2,000 points in the market will go is anybody’s guess, but I believe strongly that the next 10,000, 20,000 and 40,000 points will be up.”

Mr. Lynch went straight to the issue and that is the impossibility of timing the markets successfully and consistently. This is a mistake in judgement, when investors turn into speculators and attempt to time the financial markets.  Market timing requires continuous decisions and to be successful one must be right on both the exit and the future entry point. This is much more difficult than one might think.

For example, an investor could have a simple rule that if the markets decline by 10% from their previous peak that they will get out of equities. The problem with this strategy is that this happens, on average, once every year and when it does occur the markets do not go down much further. In this case the investor is out, but there is nothing more to avoid. The bigger issue is when to get back into the market as investors feel the mounting pressure over time to do so when markets trend upward once again.

Could we solve this problem by making our sell range a bit larger? One could consider selling equities when the market’s decline 20% from a previous high or when the markets hit official “bear market” territory. The problem with this approach is that the average post World War II bear market decline is about 30%. Using this as a rule might save you from another 10% decline, but that leaves you with the same significant problem. You still don’t know exactly when to get back in.

What one finds is that no matter what they use as a trigger, there is tremendous difficulty applying this approach to investing consistently and successfully over the long term. You must know when to sell, when to buy and you must repeat this for the rest of your life. If one finds that there are points in time when investing for the long-term (doing nothing on the dips) is difficult, one can only imagine how much more difficult it would be to contemplate buy and sell decisions on a daily, weekly or monthly basis.

There certainly are times when being an investor seeking long-term growth is difficult and requires patience, but that does not mean that becoming a speculator is any easier. The long-term investor needs to make a decision once and that is to buy into a diversified portfolio that given enough time and enough money is quite likely to provide the growth needed. The speculator, on the other hand, needs to make buying and selling decisions at every dip and turn and must be right on most of them. The odds are not in favor of such an approach.

We believe in our process and our approach and have seen the benefits for our clients as we consistently apply them. Regardless of what 2016 holds, we believe that proper planning and disciplined investing in the midst of uncertainty will continue to reward long term investors.

A properly constructed portfolio is one that supports your long term goals and that is appropriately invested according to the time horizons associated with those goals. If your goals have not changed and you are still a long term investor then the best strategy in the midst of market swings, as uncomfortable as they can be, is to stay the course. The alternative might feel better today, but fleeing the market often opens the door to many other problems down the road.

If you would like to schedule a time to visit about your portfolio, or if your financial goals have changed, please contact your financial advisor. We hope that you find this message to be helpful and reassuring as we move through a difficult start to the New Year.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.  This information should not be relied upon by the reader as research or investment advice regarding any funds or stocks in particular, nor should it be construed as a recommendation to purchase or sell a security.  Past performance is no guarantee of future results.  Investments will fluctuate and when redeemed may be worth more or less than when originally invested.  The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S. Please note an investor cannot invest directly in an index. 1398109/DOFU 1-2016