Di-Worsification

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Much as it feels good to get rich quick, the reality of successful financial investing is much less dramatic. It’s about steady accumulation of profits. And profits on those profits, through the “power of compounding.”

But to make it all work, you also must avoid “ruinous losses.”

Imagine you make 10% a year for 10 years after all taxes, dealing costs and other fees. If you reinvested the profits every year, it works out at a total profit of over 159%. $100,000 becomes $259,374, in other words.

Now imagine you make 20% every four years out of five. But you lose 30% every fifth year. Over 10 years you have eight years with 20% gains and two years with 30% losses. This time you make a total profit of only 7.5% – or an average of 0.7% a year. Your original $100,000 has become just $107,495.

Standard investment dogma says bonds are less risky than stocks. I’ll come back to this later. But let’s assume for now it’s true.

So when you talk to your financial advisor for the first time, he’ll want to do a “risk assessment” on you to see what suits. Let’s call our man “Bob.” (No offense to anyone named Bob. Some of my friends call me Bob from time to time. Let’s just say “Bob” is short for “Broker or Banker.”) In doing his assessment, Bob is basically trying to work out how much money you expect to make and how much you will be able or willing to lose without firing him.

This is tough, because every single one of us wants huge profits with zero risk. Bob has to work out where you really stand. Typically, younger investors and “expert” investors are reckoned to be able to take more risk. Older investors near to retirement and/or rookie investors usually get put into a “low risk” strategy.

Since bonds are meant to be less risky…and stocks are meant to be more risky…Bob’s recommended allocation is where he thinks you fit on the risk spectrum. If you are a “high risk” investor, you may get a recommendation to put, say, 30% into corporate bonds and 70% into “growth stocks.” If you are a “low risk” investor, Bob may advise you to put 70% into government and municipal bonds and 30% into “value stocks.”

Either way, Bob has put you into a mix of stocks and bonds. Mix together a few mutual funds…some of which might individually contain dozens or even hundreds of stocks…and you end up with a portfolio of hundreds or even thousands of stocks. The same goes for bond funds. Since you own “the market” you are likely to get market-tracking returns.

So there you are: You now have a “balanced” portfolio. Part of it tracks stocks in general; the other part tracks bonds in general. Bob has assured you that historical analysis proves that this is the best thing to do. It shows that this “balanced” approach will deliver excellent returns in line with your risk assessment and, of course, with little risk of major loss.

Sounds great, but it could be dead wrong.

Let’s be charitable here. Bob genuinely, honestly and from the bottom of his heart may think that he’s giving good advice. He’s a family guy. And he’s just trying to do his job, so he can put his kids through college. All his 20 years of experience tells him that this kind of balanced portfolio has worked out well in the past.

But there’s the rub. Even if Bob has been in the investment game for 20 years, he’s only seen a snapshot of the bigger picture. Investment returns move in long cycles. Bob has only seen about half of an up cycle. Even if he’s been around 30 years, he still hasn’t seen a time when bonds and stocks have both gone down at the same time over many years or decades.

And the impressive risk model that his rocket scientist colleagues came up with only has good data going back 15 years. Large volumes of price data have only been computerized since the early to mid 1990s. This of course is the same problem that hedge funds and investment banks ran into in 2008. All their risk models were telling them exciting things about uncorrelated asset classes and the low probability of “tail events” ever happening. That’s why so many of them thought it was a good idea to leverage themselves up 50 times or more. It’s also why so many of them went bust in 2008.

A little more time studying history and a little less time with fancy math, and they would have been okay.

Luckily, there is information out there that can help guide us. And help us avoid these kinds of costly…even ruinous…mistakes.

I recently finished reading the “Credit Suisse Global Investment Returns Yearbook 2011.” As Credit Suisse put it, this “provides 111 years of data on financial market returns in 19 countries, from 1900 to date, making it the definitive record on long-run market returns.”

One of the really useful things in this report is its study of “drawdowns.” A drawdown is the difference between the value on a particular date and its high water mark (the highest value in the past). The “recovery period” is how long, adjusted for inflation, it takes to get back to the previous high water mark.

Put another way, the folks at Credit Suisse are looking at periods where prices of stocks or bonds fell and how long it took them to get back to even again, after adjusting for inflation. In both cases the report’s authors assumed the income received – stock dividends or bond coupons – was reinvested on a tax-free basis. (Taxed returns would be worse.)

Let’s start with some stock examples – and in particular US stock examples. After the Wall Street crash of September 1929, stocks fell in real (inflation adjusted) terms by 79% until July 1932. They took until February 1945 to recover fully. So the recovery period was 16 years.

From January 1973 to October 1974 stocks dropped 56% in real terms. And they were underwater until April 1983. So the recovery period was 10 years, taking account of inflation.

Since March 2000, when the tech bubble burst, stocks fell 52% in real terms until October 2002. Eleven years later, and they are still underwater despite ultra-low interest rates.

There was also a serious episode either side of 1920, which also lasted about 10 years (with a maximum drawdown of about 50%). So in 111 years there have been four times when stocks have fallen hard and taken over a decade to recover, after inflation and before taxes.

What about bonds? Surely these “low risk” investments would have done much better?

Wrong.

As the Credit Suisse report puts it: The scope for deep and protracted losses from stocks makes fixed-income investing look, to some, like a superior alternative. But how well do bonds protect an investor’s wealth? […] For those who are seeking safety of real returns, [the data] are devastating. Historically, bond market drawdowns have been larger and/or longer than for equities.

The report highlights two major periods when US bonds were in bear markets in real terms. The first was between August 1915 and June 1920. Bond values declined 51% and then remained underwater until August 1927. The recovery period from start to finish was 12 years. Or about the same as the recovery periods for stocks.

But far worse was the second bear market. Between December 1940 and September 1981 bonds fell 67% in real terms. And they took until September 1991 to get back to even. In other words, the bond market recovery period was over 50 years!

Ah, but Bob would point out that his “balanced portfolio” strategy would sort this out.

Wrong again. Credit Suisse also worked out the data for a portfolio split evenly between stocks and bonds over that time. On the plus side, losses in the US portfolio never exceeded 50% at any point in time. But in the 1920s you still lost about 45% at one point; about 20% on three occasions during the 1930s and 1940s; 30% in the early 1950s; and about 35% in 1970s and 1980s.

The point here is simple: A traditional stock and bond portfolio may have worked quite well in the past 20 or 30 years. But there are frequent and long periods of time where it hasn’t.

Losses can still be large. And recovery periods can still be long. And the reality for most investors is worse. Remember I said that the Credit Suisse analysis was all done assuming zero taxation? In reality, investors would have to pay income tax on stock dividends and bond coupons, making the recovery times much longer.

What to do? Tread lightly in stocks and very lightly in bonds. At the same time, maintain a healthy allocation to gold and other hard assets. The stocks that you do hold for the long run should consist mostly of value investments in fast-growing economies, as well as commodity and energy stocks that should benefit during inflationary periods. And keep a high allocation to cash, in the short run at least. Cash equals “bullets” that you can use to pick up risk assets when prices are more attractive. You just need to be patient.

As for bonds, forget it. Consider the current situation… Interest rates are ultra low. An activist Fed is creating unprecedented volumes of new money. Inflation is ticking up in most parts of the world. Government spending in most of the developed economies is still out of control. Developed country governments and banks need to borrow vast amounts in coming years. Both to refinance maturing loans and to increase their already high debt levels. Who will buy all these bonds?

I’d bet that we’ve either started or are near to starting a long bear market in bonds – of all stripes. After 30 years of bull market, it certainly seems likely we’re nearer the end than the beginning.

This isn’t the “balanced portfolio” Bob would recommend to his clients. You absolutely need to stay diversified, now more than ever. But you need to get your diversification in a different way.

Regards,

Rob Marstrand
For Daily Reckoning Australia

Rob Marstrand
Rob Marstrand worked for UBS for 15 years, mainly in corporate strategy, before escaping the banking world and moving to South America. His ex-employer was the largest global wealth manager and world's biggest stock trader. The strategy job involved all areas of the business in all parts of the world. Reviewing current businesses, developing entry strategies for new businesses and countries, and working on acquisitions and joint ventures. This work involved detailed review and valuation of competitors and takeover targets. Rob lived in Hong Kong, China from 2002 to 2005, where he was particularly involved in negotiating joint ventures and acquisitions in China. He has also worked on projects, acquisitions and joint ventures in Japan, India, Saudi Arabia, the US, Switzerland, Indonesia and South Korea, amongst others. He is British, married to an Argentine wife, and emigrated to Buenos Aires, Argentina with his wife and two children in 2008.
Rob Marstrand

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prozak
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Hiliarious. An article like this on a website that peddles its snake oil with statements like:

“But in the same year Aussie stocks conspired to make you poorer, one Australian investment service made a cumulative 57% return for its members. That’s pretty surprising in a market that ended the year down 2%.”

Hey. But i’m sure they provide a comprehensive trade plan and not just a few buy and sells right?

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