Dear Clients and Friends:
You’ve most likely just received your investment statements and will be pleased to see that the markets have come a long way since 2008. In this letter, I will provide a brief recap of the first quarter, along with my thoughts about the importance of expecting the unexpected. Finally, I will encourage you to contact me to schedule a time to review your portfolios and discuss any changes to your financial plans.
First Quarter Review
Following a strong end to 2010, the U.S. stock market, as measured by the S&P 500 Index, continued its march higher to begin 2011 with a gain of 5.9% in the first quarter. The Index’s first quarter gain was its best first quarter since 1998 and the third best first quarter of the past 20 years. Bonds hit some speed bumps in the first quarter, but a middle-of-the road return in the low-to-mid single digits by year-end still seems likely.
For stocks, it was a relatively smooth ride, higher in the first six weeks of the year through mid-February when the Index peaked at 1344, a gain of nearly 7%. March saw a setback and the earthquake and tsunami in Japan on March 11 took a dreadful toll on human life. The scope of the tragedy and its final impact on the economy may not be fully known for some time.
Learning to live with uncertainty
Market analysts spend many thousands of hours each year looking at stock and bond fundamentals, economic forecasts and company earnings, among a cast of other data. Presently, solid consumer spending, a resilient global economy, healthy manufacturing data and better-than-expected earnings bode well for investors. But, even with enough time and data, the analysts can’t anticipate exactly how the markets will perform.
What can’t be anticipated are developments that are by their nature unpredictable. We’ve had several of these events in the past year:
- Last April’s volcanic eruption in Iceland that caused the shut-down of 100,000 transatlantic flights, and cost the airlines $2 billion 1
- Last year’s explosion of the Deepwater Horizon oil rig that resulted in dramatically higher oil prices
- Recent street protests in Egypt and other countries that resulted in changes of leadership, and direct military action in Libya
- And, of course, the earthquake, tsunami and nuclear-reactor crises in Japan.
Expect the unexpected. The only way to deal with uncertainty and manage the impact of unforeseen events is to build strict risk controls into portfolios, similar to those used by the most sophisticated pension funds. While the risk of one-time incidents can't be eliminated, through diversification and risk management we can try to limit the damage when negative events occur—whether they be massive frauds such as Enron, sudden bankruptcies like Lehman Brothers, volcanic eruptions, oil rig explosions, or earthquakes.
By creating diversified portfolios, we help reduce risk to your investments. Different asset classes like stocks, bonds and cash equivalent investments don’t usually act in the same way at the same time. Investing in different geographical areas means that you aren’t subject to the same political events or natural disasters which may affect companies differently. While diversifying doesn’t eliminate risk it can help reduce the effects of volatility.
Next, your portfolios need to be rebalanced back to the target asset allocation, and some of the positions that have outperformed might be trimmed to stay within risk control limits. Some investors find this very difficult—after all, you're selling exactly those investments that have done the best. But remember, the objective is to buy low and sell high. Plus, it's the only way to stay truly diversified and control the risk that accompanies overexposure to any one stock, industry sector, or geographic region. And it's also the only way to get some protection from things that simply can't be anticipated.
Lesson Two:
Avoid overconfidence. Over short and mid-term time periods, rebalancing means that there will always be someone who's made a big bet that has paid off and who is doing better than you as a result. Rebalancing your portfolio as described above eliminates big bets and will seldom give you bragging rights on the golf course. Investors who take the big-bet approach typically have a high degree of confidence in their investments; after all, if you're absolutely certain about a company or industry, why bother to diversify? On the other hand, research by the University of Chicago's Richard Thaler has demonstrated that overconfidence is among the most costly traits an investor can have.
Look no further than the many employees in Silicon Valley during the tech boom. They were 100% confident about the future of their firms and often had all of their retirement accounts invested in the companies they worked for as a result. These investors saw sterling results for a while—right up until the tech bubble collapsed.
"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."In other words, the sources of trouble aren't the things we've identified as question marks and causes for concern. Rather, what causes portfolios to crater are the things that we're absolutely positive about right until unanticipated occurrences catch us by surprise.
We've always had unexpected events and always will. And despite these unforeseen events, economies have grown, companies have prospered, and stock markets have generated positive returns. The key to benefiting from this long-term growth has been to diversify so that no single event can create permanent damage to your portfolio.
I believe that we will work through the recent events and that investors with a balanced approach and a long-term view will be well rewarded. The approach to risk management I've described may not be fun or sexy in the short term, but all the evidence at hand suggests that over time it will serve you well, getting you to your goals with the least amount of stress and distress along the way.
Let’s talk
Please give me a call to schedule a meeting to review your accounts. Should you have any questions in the meantime on your portfolio, the contents of this note, or any other issue, please give me a call. I'd be happy to deal with your questions on the phone or at our next meeting.
As always, thank you for the opportunity to work together.
1 "Airlines' Losses Top $2 Billion from Eruptions," Washington Post, 16 April 2010
