Friday, December 31, 2010

Investing PART 7: “To every thing there is a season.”

Some know it as the words to “Turn! Turn! Turn!”; others as Ecclesiastes 3:1-8.

For those who feel the Byrds ruined a good folk song: “The first one now will later be last” according the Bob Dylan, and for those who prefer classical music, remember Vivaldi wrote of “Four Seasons.” Doesn’t matter how you come to the realization, but change is inevitable.

Rebalancing is one response, but it too has its season. An autopilot annual cycle does fit with Turn! Turn! Turn! One reason autopilot rebalancing doesn’t work is that you can’t REbalance into an asset class that didn’t exist or wasn’t accessible to you before. Things change including investment options. Also, even within classes that have existed for decades, remember that looking backward has its limitations. Fitting the history in order to show optimum returns is an abuse of looking backward. Better to look at conditions today.

You can look at market conditions. Here are a couple of discussions I ran across lately. The first leans toward looking at conditions today, but uses history to interpret them. From a website entitled “Early Retirement Planning Insights” an article entitled “Shun Rebalancing” says: “The argument in favor of rebalancing rests on a series of flawed assumptions. The most important is that there is no meaningful way to measure valuations. Our research has shown otherwise. Professor Shiller’s P/E10, the dividend yield equivalent of P/E10 and Professor Tobin’s q all work well.”

The second reference takes a different approach that advocates nothing but looking at recent history. From the WALL STREEET JOURNAL, December 11, 2010 Personal Finance section an article by James Stewart entitled “As the Nasdaq Rises, Consider Trimming Some Holdings” proposes what the author describes as a common sense system for buy and sell decisions.

What’s curious about this is that these type of articles are still being written. Going back to Graham’s THE INTELLIGENT INVESTOR there are piles of books and articles on the topic. However, the intelligent reader might come away concluding the essence of Graham’s book is do a lot of analysis, then guess. More recently, ACTIVE VALUE INVESTING by Vitality N. Katsenelson takes up the intelligent investor mantel and tries to present some more mechanical rules. (As an aside, those two books and WHAT WORKS ON WALL STREET by James P. O’Shaughnessy offer far more useful insight than most of what’s written. That isn’t intended to disparage the articles cited above. They are much briefer and quite useful).

The deadly flaw in EVERY discussion of rebalancing and market timing that I’ve seen hinges on the interpretation of the statement that rebalancing should reflect current conditions. They all focus on the wrong current conditions, namely market conditions. What is far more important is your condition.

So, to change music genre “I just stopped in to see what condition my condition was in.” To illustrate with an extreme, if you don’t have a cash cushion, you should only be rebalancing within cash equivalents. Does that even count as rebalancing?

Similarly, to use an example the financial industry beats to death, the assets appropriate to young investors and older investors are different. However, look at the spreadsheets in PART 5 and PART 6 of this series on investing. If you can / will take advantage of the opportunities available to you, age is only a minor factor. By the time you’re approaching retirement you should be managing a portfolio of over a million dollars. So, even if Rod Stewart was singing about you in “Forever Young,” new options should become relevant with time. However, it relates to your portfolio not just or even mainly the market. Further, as discussed in PART 2, the annual changing of the calendar has nothing to do with when and what to rebalance.

Now let’s introduce some more looking backward. However, this time let’s discuss history from the perspective of personal circumstances. Table 1 shows data the media and some in the financial service industry like to misinterpret. It shows annual changes in the S & P 500.

Come the end of 2010 you can grab an update from any of many websites. With or without 2010, it is data worth having around. I only went back to 1975 because that covers the same period as the discussion of IRAs. It’s useful to keep data like this in mind when viewing the long-run IRA returns.

The 9.71% average is a number you might hear people throw around. Since a 50% decline requires a 100% gain to get even, don’t pay too much attention to it when planning for anything important. Personally, the 8 down years out of 35 seems more interesting. The more important issue is the compound annual rate of growth (CARG). However, before proceeding to CARG, a few observations about this table are warranted.

First, the data in this table ignore dividends. Hopefully you just shouted, “WHAT?” Many people, who have an axe to grind, leave out the dividends and talk as if they were saying something. They’re not. As a result, I’ve been in some amazing conversations. People will insist that if dividends are reinvested, that constitutes putting new money into stocks. I’m pretty indifferent to the exact form I get the return on my capital. Dividend or cap gain, doesn’t matter to me. Either way it’s the compounded growth that matters.

In fact, I confess, I’m partial to dividends for a number of reasons not the least is what they say about the management’s philosophy, and usually, the financial health of the company. I’m also sufficiently familiar with accounting to know cash flow beats increased book value. That’s true in your own account and a company’s books.

Second, the data show volatility in a way never conveyed by a few statistics. I’m continually amazed by the fact that volatility surprises people. I think it was J. P. Morgan who when asked what the market would do answered “fluctuate.” He probably wasn’t the first. Yet, people plan as if JP didn’t know what he was talking about.

I know a number of successful investors who time the market quite well. When I express my preference for buy-and-hold investments, they counter by pointing out the “don’t lose the capital” rule. They are fond of showing how much better the return would be by avoiding down markets. The attached spreadsheet Table 1 will let you do the exercise using annual data. Pick any criteria you want. For example, without the 8 down years the simple average return is 13% verses the 9.7% actual. That’s significant any way you look at it. If monthly or peek to troth data are used, the difference is even bigger.

However, I point out the Vinik problem. Jeff Vinik managed the Fidelity Magellan Fund from 1992 to 1996, where he averaged 17% annual returns. But, he was severely criticized for missing some up years. Some would argue that missing up years cost him his job at Fidelity. (After leaving Fidelity, he started a hedge fund called Vinik Asset Management. He made investors about 50% a year for about four years. Before closing down the fund to manage his own funds.)

To see the importance of not missing up years, take out the 8 best years on Table 1. The the average return drops to 3.15%, mirror image of the change resulting from taking out the 8 down years.

So, the issue of rebalancing out of assets that are falling in price is important, but it’s equally important not to make the opposite error, being out of rising markets. If you’re interested in what happen if you’re out of down markets and miss the 8 best years, the result is a 6.4% average. However, remember the more years you’re out of the market the more years in which you have to replace the dividend flow.

Well, all that’s fun with numbers, but “So what?” you ask. Well, Vinik’s experience at Fidelity and his decision to retire his fund illustrate the real problem. Worrying about timing the market can be hard work. It’s pretty clear that in most years you’ll make money being in the market. Maybe you can’t guess how much or when the down years will be. That’s no reason to give up. You’ll make money in most years. So, stocks should be a major part of your portfolio.

It would be nice if your fund manager could avoid down cycles, but it seems that ever since Vinik’s experience at Fidelity, mutual fund managers have considered it a sin to venture far from fully invested, a fixed ratio by asset type, or some other benchmark. So, don’t look to your mutual funds for help. No, the money you pay them won’t get you any benefit of insight about overall market direction.

Keep in mind that annual and especially calendar years are really irrelevant. Looking at annual results is just a way to compare two arbitrary points in time. It isn’t a good way to look at results over time. Looking at reesults over time immediately shifts attention away from changes in levels at different times. So, let’s look at returns over time. Dividends are earned over time. So, let’s include them and just let them compound. Now we’re talking about CARG.

CARG varies by what time frame is covered because dividend payouts change and stock prices change. Table 2 shows the CARG for periods running from every year since 1975. They all end with 2009. It covered the same period as the IRA spreadsheet and Table 1. In many respects it is the stock market data relevant to retirement planning.

Over this 35 year period there were 5 years where if you invested in the stocks of the S & P 500 at the beginning of the year, you’d have less money as of the end of 2009. The other 30 investments would have grown at compound annual rates ranging up to 12%, (ignoring 2009 a one year period). It’s also no accident that the longer the holding period, the more likely there is a gain and the larger the gain. As much as some people would like to ignore and deny it, over time economies grow, societies progress, and the market goes up.

Many people have jumped to the wrong conclusion based on the facts Table 2 demonstrates. More on that after the market closes on 2009.

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