Thursday, January 14, 2016

Stock Market Declines Represent an 'Un-fun' but Integral Part of a Successful Long Term 'Risk Management' Investing Strategy ... We're All Risk Managers

Risk is --- and the simple fact is that throughout life we're all risk managers.

We show up, participate, try hard and improve rapidly and continuously at whatever it is that we decide to do or we don't. When defeat comes to us occasionally, we accept it fatalistically and stop competing or we choose instead to hang in there and fight until we win. We exercise too little or too much. And we eat and drink too much of the wrong things and gain too much weight or we don't. A big piece of life is all about long term goal oriented time and risk management.

For instance, we attend school regularly, study and manage to graduate with solid grades or we don't. We then are in a position to go on and get and keep good jobs or we aren't. We then decide to borrow and spend excessively to enjoy today's pleasures or we instead elect to save a part of what we earn to take care of our future needs and responsibilities.

And we invest what we save in a diversified blue chip portfolio of dividend paying stocks for the long haul or we don't. As a result, we are able to retire with adequate financial resources or we aren't. And so on.

The stock market is obviously off to a rough start in 2016. Nobody knows what will happen to prices for the rest of the week, for the month of January, or for the year as a whole. So we panic and sell or we look to the long term and don't panic and sell. It's part of risk management.

Based on history and the current improving economic situation in the U.S., I'm still an optimist and highly confident about the market, but I have no crystal ball. It's part of my personal risk management assessment and approach to life.

And when it comes to long term investing success, I'm extremely confident. That's because I've 'participated,' albeit painfully, in the severe and 'risky' bear markets of 1973-1974 and 2000-2002. Neither was fun. Nor was the 23% one day meltdown in October of 1987.

And perhaps for the next few weeks, months or even years this market will prove to have been an 'un-fun' time as well. The fact is that nobody knows what's going to happen until after it's happened or hasn't happened, as the case may be.

So here's the deal and the reason for buying and owning stocks for the long haul --- it results in superior risk adjusted market returns over time when compared to all other investment alternatives. Intelligent long term personal risk management includes a large stock ownership position.

Why Investors Need to Embrace Bear Markets tells the story we all need to hear:

"Suppose you had a friend whose lifelong dream was to travel overseas. But this friend was deathly afraid of experiencing turbulence on an airplane. So he decided to forego his trip until a new plane was invented, one able to guarantee with absolute certainty that passengers would never feel turbulence. You might be thinking, “Good luck with that strategy. It’s just going to keep you from going anywhere at all!”

Yet investors who view bear markets as something that must be avoided at all costs are falling into exactly the same type of limited thinking. Here’s why the best way to make it through current market volatility is to actually “befriend the bear.”

A core concept of basic economics is that risk and expected return are related. The most common benchmark in the U.S. for a “riskless” investment is the one-month Treasury bill. Because stocks are considered riskier than one-month T-bills, the only reason a rational person would ever take on that extra risk is if they could reasonably expect (over the long run) to receive higher returns than what they would earn in the riskless investment.

However–and this is key–if the expected always occurred, there would be no risk. For example, if stocks always generated a higher return than T-bills, then stocks would be a sure thing. Thus, they would warrant the same lower long-run return as T-bills.

Let’s look at the year-by-year returns of the S&P 500 from 1926 through year-end 2015. During that 90-year period, the S&P 500 index generated an annual negative return 24 times. That means 27% of the years, or more than one in four, have been negative ones for the S&P 500 index. Looking at rolling, multi-year periods within that time frame, we find several in which the S&P 500 index generated very significant losses:
  • January 1929 – December 1932: The S&P 500 index lost 64%.
  • January 1973 – September 1974: The S&P 500 index lost 43%.
  • April 2000 – September 2002: The S&P 500 index lost 44%.
It is the very existence of these kinds of losses that allow investors to expect significantly higher returns from stocks than from the one-month T-bill. The academic term for this extra return is “equity risk premium.” For the period from 1927 to 2015, the S&P 500 has provided an annual risk premium (expressed as an annual average) over the one-month T-bill of about 8%.

Had these annual and multiyear losses been smaller, investors would have viewed stocks as less risky. They would then have bid up the price/earnings (P/E) multiple, a common valuation metric, on stocks. And the higher the P/E, the lower the future expected return. (Just like with buying a bond, the higher the initial price you pay, and the lower the yield, the lower your future expected return)....

So yes, if you want your portfolio to truly soar over the long run, you’ll likely have to experience some amount of turbulence. If you insist on a guaranteed smooth ride, you will never get off the ground. I’ve found the better way to protect yourself is to make sure you always have your financial seat belt buckled.

Your financial seat belt is your long-term, carefully thought out investment plan–ideally one that is written down in the shape of a formal investment policy statement so you can reread it in times of turbulence. A proper plan will already have incorporated the inevitability of financial turbulence, and will have made provisions for how your day-to-day cash flow needs will continue to be met during such a period.

If this is not the position you are in, you may want to change financial pilots and work with a different adviser. One that’s guaranteeing you a turbulence-free ride and doesn’t see the need for seat belts is not one I’d want to travel with. Perhaps you shouldn’t either."

Summing Up

Risk is.

And risk management is a lifelong process.

Falling stock prices from time to time are an integral part of successful long term investing. They are never fun, but they are inevitable. 

In sports winning is always fun. Losing always sucks. That said, we know we most likely aren't going to win 'em all before the first game of the season even begins, and that we won't ever win even one game unless we show up, make the effort and play hard.

So we go out there and play to win every game, even though we know we'll lose from time to time. We fully realize that we will have to suffer some losses on our way to a winning season.

It's the exact same thing with investing. Enduring some unavoidable short term pain is well worth experiencing in order to reach the long term gain.

That's my take.

Thanks. Bob.

No comments:

Post a Comment