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Affluent Christian Investor | September 19, 2017

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Investing When Euphoric Part 2

Last year a good friend Theo was bending your ear at the coffee shop about how he’d made an absolute killing in his investments. He shows you the returns and, sure enough this guy, whom you’ve apparently not given enough credit to, has doubled his money a few times in the past years! Theo kindly offers to let you in on his strategy. It sounds like a great way to really grow your long term assets, so you go for it. A few months later your statement shows your investment has lost more than half its value. What happened Theo?!? On the way back to the coffee shop you turn it over in your mind. He was doing so well…doubling every few years…his strategy was to, um…he made the money by, er…wait, how was he making the returns!?!…totally don’t remember how we were expecting to make money…Did we even talk about that?… OMG, I’ve lost more than half my investment and I don’t even know what we were counting on to make money!!!

{back to Theo in a minute}

In the first article of the series, we discussed how investors are über-bullish today. In actions, if not words, they are buying like never before in history. Compounding the problem is that central banks are buying assets and selling volatility—essentially spraying lighter fluid on a parched forest to keep it damp. These are the times when even the best investments are priced for disappointment, and it’s crucial to prepare for what comes next. In the first article of the series (HOTLINK) I outlined the initial step of an all-weather approach to investing that begins by separating your assets into three levels based on the timing and amount of future cash flow needs. Levels 1 and 2 are the money you expect to spend in the next 7-10 years plus any amount you want for cushion to be conservative or avoid volatility. If ever in your life there was an impulse to be more conservative, bump up your Levels 1 and 2 now. Level 3 assets are for long term growth. Historically that’s meant compounding at maybe 8-12% annualized over the decades. You expect to take more risk in Level 3. You have less liquidity in Level 3 assets. You have more volatility in Level 3. Each of these is required to make growth returns. But the combination creates its own set of problems. And here’s the big problem—you don’t get the true scorecard until you actually convert to cash. Which means the strategies you employ have to work over the course of many years, all the way to the end. Take for example, the following charts for investment strategy A-1:

Things look great!  Up 26% per year means you’ve tripled your money in five years. But then, the strategy hits a rough patch and drops in half before gaining back some ground by the end of year ten. For this second half of the decade, returns are down, -3.6% for five years.

So how’d you do if this was your Level 3 strategy? If you were fully invested from the very beginning, you compounded at 10% for the decade. Certainly not what you expected after the initial five-year run, but nice growth returns nonetheless (using 7% as our ten year threshold for “growth returns”). In fact, if you invested anytime in the first couple years, you averaged 8% annually for the next ten years. But what if you invested in year three?  Or year four? We have the historical data on this strategy, so we know the actual forward 10 year returns from each point on the graph.  Here’s how it turns out:

From the GREEN area, 8% average annualized 10 year return

From the BLUE area, 5% average annualized 10 year return

From the TAN area, 1.5% average annualized 10 year return

From the RED area, -2.5% average annualized 10 year return

It’s worth focusing to be sure you really understand what this chart is saying. If you invested in years 4, 5, or 6, you lost money over the following ten years (note that years 11-20 are not shown on the chart, but are used for the calculation).  Even if you invested in blue years like 2 and 10, you only averaged about 5% per year for the next ten – not growth numbers.  In fact, the only time you’ve gotten ten year growth numbers in this strategy over the past couple decades is if you invested in the first year and a half!! (sadly, this extraordinarily-popular Strategy A-1 is again primed for another major decline. There’s a good chance that the 20 year numbers for investments starting in years 4-10 will actually be negative!!)

Consider this scenario: you meet with your advisor who says that if you earn 7.5% annually, you’ll be all set for retirement in ten years. He tells you that Strategy A-1 has had a great track record and should have no trouble with that target. If you’re unlucky enough to have this meeting in the red time frame, your retirement shows up way quicker than the promised returns.  You’ve actually lost ground for the decade! In fact, if you’re having that meeting any time after year two, your retirement goal would be missed. Ouch! What happened Theo?!!

This is a good time to bring up a popular view I hear way too often by euphoric investors who don’t want to believe the current bull market is long in the tooth. IMPORTANTLY, it’s not the fact of the statement, but the implication for future returns that is totally missed:

“Stocks are cheap because interest rates (bond yields) are so low.” or “The market’s not expensive because it hasn’t yet reached the valuation peak of 2000.” If you don’t clearly understand how you expect to make your returns compound over the next decade, these statements may give you a lot of comfort about present conditions.  Below the blissful surface, however, starting conditions matter a lot for future returns. Say your portfolio is counting on a blended 7.5% return over the coming years.  That’s based on a conventional 60/40 mix of stocks/bonds with historical returns of 9% on the stocks and 5% on the bonds respectively. Then let’s assume stocks and bonds aren’t in a bubble, however you define that. Does the current pricing give us any indication of the mathematical limits of conventional market performance?  I think so.  The starting point for your diversified bond portfolio is a yield of about 2.5% today.  It’s priced in at today’s levels. Unless you believe interest rates can go deeply negative and stay there for the next decade, there is no reason to expect you will make anything more than 2.5% on that 40% of your portfolio. Best case, that’s HALF of what the historical averages show for bonds. Remember, much of the 5% historical returns in bonds were generated in periods of very high and falling interest rates! So, mathematically, historically and probabilistically, 40% of your ten year portfolio return has been cut in half.

On the stocks, keep in mind that even if today’s pricing doesn’t look historically expensive relative to interest rates, it’s still pricing in a lower-than-historical return for stocks. Here’s how: stocks tend to trade at a “risk premium” to bonds.  Simply stated, if bonds yield 5%, stocks should be priced to return more like 9%. The 4% difference could be called the historical risk premium. In this environment, you could say that if bonds are priced to yield 2.5% and stocks are priced to return 6.5%, then stocks are not “expensive” compared to where they’ve traded over bonds historically.  But even on that simple math, stocks are priced to return what they are priced to return…6.5%. That’s almost 30% lower than what your model portfolio needs on over half of the money.

Put the stocks and bonds together, and even an optimist would only see 4.9% expected returns for the whole portfolio. (2.5%x40% Bonds + 6.5%x60% Stocks)  AND, that assumes interest rates, inflation, and market multiples stay constant. If any of those change toward more normal conditions, this conventional portfolio will be lucky to make 2% compounded over the next decade. If you’re counting on 7.5%, it’s going to be very cold comfort that today’s market was “cheap relative to interest rates.”

For Level 3 assets, the true scorecard is in the out years—that’s when you’re going to want to convert more of those growth assets to Level 2 and then Level 1. The whole point of Level 3 is that you have more time and can afford to take on more risk and volatility with the objective of making higher returns. Long term averages are just that—long term. Even if Strategy A-1 in the previous charts averaged 8% returns over the past 100 years, there have been huge periods of time when it didn’t come anywhere close to that average. Strategy A-2 below is similar in many respects. Just as popular in its day. How would you feel about the 20 year result below?

Realizing that the scorecard for Level 3 is in the future—10, 20, 30 years out—how can you have confidence that your strategy will deliver? You need growth returns; what approach should you take?

First, know exactly what you’re counting on. Investments aren’t random blips on a screen that somehow, someway, go up in price. Investment strategies are based on something. What if Theo told you that his successful strategy involved rolling dice? He had a deal with a gambler who would double his money every time he rolled fives or sixes and take half every time he didn’t. Theo had been rolling well before your coffee meeting. Then, after you invested, he just couldn’t get a five or six to turn up nearly as often. Had you known he was counting on beating the odds with dice to make money, would you still invest? How much more do you know about your own growth strategy?  Maybe just a vague notion of “market returns?” Let’s take it up several notches while the bull is still running.

There are a handful of primary investment strategies used today for Level 3 assets in the public markets. Certainly many variations and combinations of these approaches, but the driver of success for most breaks down into one of the following:

Strategy A – Riding the Market.  By far the most common form of investing today, Strategy A is investing in a large, diverse, group of stocks in order to profit from dividends and an increase in prices over time.  In effect, capturing the return of the stock market, plus or minus. Strategy A rises and falls based on the broader corporate environment as well as investor sentiment. Index funds, ETFs, and most stock mutual funds (passive and active) fall into this category. Important differences exist between the implementations of Strategy A, and I believe low costs and active manager skill can add value over the Level 3 horizon.

Strategy B – Deep Value.  This is a contrarian strategy that focuses on buying unpopular and overlooked stocks that are selling at prices way below intrinsic value. The strategy has a multi-year horizon and is often out of step with what is working in the broader market. You know those stocks that everyone is talking about with enthusiasm at cocktail parties? Strategy B doesn’t have any of those. Although Strategy B has common sense, business wisdom, and solid historical results on its side, investors have to be able to stomach volatility as well as being “different” from the market for long stretches of time.

Strategy C – Momentum. This is a “quant” or “black box” strategy that seeks out trends in price movements. Strategy C uses hundreds of metrics and algorithms to invest in those trends across different asset classes (stocks, bonds, commodities, currencies), hoping to capture the gains from riding the wave.  As is the case with all rules-based systems, Strategy C must constantly adapt to account for changes in the environment as well as the actions of other momentum strategies (i.e. as trends are understood on a broader basis, more investors look to take advantage, and the trend gets arbitraged away). By the way, a poor imitation of Strategy C is what many amateur investors believe they are good at—buying while something is in an uptrend and then selling once it starts to dip. More detailed accounting would show the true results, but I’ve seen a lot of blissful ignorance in this area. Our memories are long on the winners and short on the losers. In the modern era, momentum as a successful strategy is always accomplished with massive computing power and PhD’s hard at work.

Strategy D – Absolute Return. This is a combination strategy that uses elements of the other three but has an overriding, absolute return objective over a fixed time horizon. By comparison, Strategy A is hoping to get the market averages over the long term (whatever “long term” means), and it will be considered successful if it does a little better than “the market” at points along the way.  So, if the market is down -40% over three years and Strategy A is only down -30%, it will have achieved its objective. Strategy D, however, has a fixed objective and time frame such as “inflation + 8% over 3 year periods” or “positive returns on an annual basis.” In order to accomplish this objective, Strategy D requires tactical allocation to cash and/or hedging techniques. During extended bull markets, Strategy D will almost certainly lag behind the more popular strategies. Its merit is realized in the downturns.

Private Investments.  Many investors have access to non-public investments in businesses, real estate, etc.  Or better yet, they are entrepreneurs who have the skill to build a private company. This has the potential to be the most financially rewarding form of Level 3 asset. Of course with its own share of burdens and risks. I mention it here just to emphasize that over 10 year periods, private investments experience many of the same factors as public—they just don’t get priced on a daily or monthly basis. This is a psychological boost in the tough times, and probably keeps the investor focused on what matters most even in the good times. But don’t be confused; price discovery happens when you go to buy/sell. Private investments carry an illiquidity and control discount that only the experienced understand. With the scars on our backs to prove it. And don’t forget that history (and media coverage) is written by the winners. For every Facebook, there are hundreds of MySpaces and for every AirBNB, hundreds of Theranos’ that sucked in a lot of capital and lost it. Level 3 investments can’t afford a goose egg at the end of ten years. Private investments are best evaluated by experienced operators on a case by case basis, and we’ll not cover them further in this article.

Each of the four public strategies shown above can be successful for Level 3 investments. But not in every time period or every system of implementation. There are differences. And infinite combinations and customizations used by investors and their advisors to get the preferred mix. It can be hard for the layperson to identify which is which given the myriad wrappers created by Wall Street marketing departments.  However, a knowledgeable review of most would show that the dynamics of either Strategy A, B, C, or D can be expected to dominate the ten year performance. So, first we want to be clear about how we expect our Level 3 assets to make money.

Second, don’t screw it up by responding emotionally to things that shouldn’t be a surprise!  Almost as regularly as the dentist recommends you get your teeth cleaned, you should expect some discomfort in your Level 3 asset performance. For instance, almost every year in history the S&P 500 has gone down at least 10% at some point. It may be hard to remember just now, but how did you feel the last time the Dow dropped 2000 points?  If you’re counting on Riding the Markets (Strategy A), this will be uncomfortable, but you don’t have to ask “What happened, Theo?!!” You already know. Strategy A will have major ups and downs over time, with the expectation that long-term economic growth and capitalism will prevail to take your Level 3 assets higher over the 10, 20, 30 year periods. If you’re invested in Deep Value (Strategy B) and the latest fad in tech stocks (say, with the acronym F.A.N.G.) are exploding higher in price while your portfolio is down, you don’t have to ask “What happened, Theo?!!” You already know. Your portfolio holds undiscovered, out-of-favor stocks that are much more likely to reflect the current business environment than the unbridled enthusiasm of the masses. If markets have been listless except for a few jerky moments here and there, your Momentum (Strategy C) won’t be working. If asset prices around the globe are grinding higher from super-elevated levels while volatility and interest rates are at historic lows, your Absolute Return (Strategy D) will probably be losing money.  Properly executed, I believe each of these strategies has the potential to give growth returns over 10 year cycles. The key is that none of them will do it in every three or even five-year time frame.  There are also some longer term periods where you don’t make growth returns. However, over the market cycles I’ve witnessed, the big losses happen to people who freak out about something they should expect, and sell out to switch from say Strategy C to Strategy A after a long period of momentum underperformance.

A helpful way to evaluate any of these strategies is looking at rolling 10 year returns like what we’ve done in the shaded chart above. This is much easier for Strategy A since the data tends to be more uniform and readily available. Another useful approach is trying to capture a full business/market cycle by looking at peak-to-peak and trough-to-trough returns.  So, for example, looking at results from the last market peak in the fall of 2007 through today would give you a view of long term returns in the S&P 500.  Using the trough in 2002 as a starting point through the bottom in 2009 would give you the latest trough-to-trough. If you can get good data, this is probably the best way to evaluate Strategy A vs B vs C vs D.  Of course, this assumes that the investment manager is applying his/her strategy consistently over time.  Not always a good assumption.

Consider diversifying across strategies. If you have enough money, it can be really beneficial to invest part of your Level 3 assets in one or more of the strategies discussed above. You’ll still have to fight the natural urge to sell the lagging investment and buy more of what’s hot. (start by realizing that the opposite tack is probably the right course of action!!) That’s where a trusted advisor can be indispensable.  And you’ll still need to periodically evaluate whether or not your investments are performing well within their categories.

For the do-it-yourselfer, mutual funds and ETFs give access to invest across strategies at very low account balances today.  This assumes you understand and have confidence in your investing abilities and can maintain that confidence in the tough times.  You probably need at least $1 million in assets to hire a quality advisor with the experience and skill to manage a multi-strategy portfolio for you.  Without a trusted advisor or significant skill yourself, my strong recommendation is to only invest in strategies you can understand.  Everything is tougher on your own, and when the chips are down—which they will be at some point—it’s going to be your understanding and conviction that allows you to weather through without permanent capital loss. For example, if you understand businesses and the idea of buying when they are cheap and holding until the price goes up, Strategy B might be the one that allows you to maintain your discipline in a bear market.

Lastly keep your expectations reasonable—don’t get greedy.  Anyone who has lived through multiple bull/bear markets should recognize, for example, that Strategy A typically “borrows returns” from the future during the good years. Look back at the first chart in this article – remember being up 26% per year for five years? You give a big chunk of that back in the bear markets. In fact, it is consistent with history to assume that up to half of the gains in a Strategy A bull market will be surrendered in the back half of the cycle.  Don’t ignore this statement as we enter the 8th year of the current bull market. Don’t expect the massive returns in the up part of the cycle to be replicated or even maintained in the years to come. It’s impossible to time the market cycles, so the best you can do in Strategy A is discipline your emotions and plan accordingly. All the fancy presentations and growth charts in the world don’t matter if you buy at the highs and sell at the lows.  Many investors do.

Investing your Level 3 assets is a multi-decade pursuit. The returns of the past years only matter to the extent they can be maintained and enhanced over the coming years. When investors turn euphoric, the future is way more treacherous than most believe. Only in hindsight will it become clear to the masses—and the media. Now is the time to understand your strategy and set your expectations and your discipline appropriately.

_____________________________________________
Some readers will recognize that the charts in this article are actual results from two very popular investment strategies.  In fact, Chart A-1 is the 1995-2005 history of the S&P 500, probably the most popular benchmark and actual investment for growth investing today. Chart A-2 is Japan’s Nikkei Index which back in the late ‘80s was probably more popular than the S&P 500.

Alan Gotthardt is the Chief Investment Officer of TriniD, a private investment company, and is the author of a comprehensive work on Christian philanthropy, The Eternity Portfolio, Illuminated.

 

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