How Quickly Markets Can Change

Just a few months ago, we were talking about the decline in credit rating of U.S. Treasury debt for the first time and worries of a recession “spreading” to the U.S. from the ongoing crisis in Europe. Its impact was volatile and pronounced, causing 2011 to be a year of flat to negative returns for most stock investors. This caught many off guard, in particular, because things seemed to be going well since the great recession that hit the world’s economies in 2008. It was an excellent reminder of the volatile nature of the financial markets, even when things are moving in the right direction.

In a previous Market Commentary from last summer, I reminded investors of the “potential for more declines in store for us” and to “grab some popcorn and sit back…because we’ve seen movies like this before”. For those of you that followed our advice, you had a bumpy ride indeed. From the writing of that document through the end of the 3^rd quarter, the U.S. stock market declined 14.33%, with many international markets performing worse than that. And yet the same investor would have just as quickly recovered those losses in early 2012 in an almost as fast rise. Except, on the way up, no one seemed to be proclaiming how good stocks were as an investment as they were bad on the way down.

This is, in fact, the exact scenario we are to protect ourselves from. When we meet with clients individually, we prepare a financial plan that is to serve as a strong guide for future investment decisions for years to come. It’s a core framework that guides us in good times and in bad, and drives the daily decisions investment choices we must make. Without it, we would be just as prone to succumb to the emotions of the daily events of any given moment in time. Instead, we make decisions with two goals in mind: your long term growth and income needs, and your short term tolerance for volatility (decline in value). A delicate balancing act it is indeed, particularly so given the unique environment we’re in today.

Our investment philosophy starts out broadly, only considering the varying and unique objectives of each of our clients. Our clients regularly ask us to evaluate assets of varying types (relying on our absence of any conflicts of interest), and includes stocks, bonds, bank accounts, real estate and many derivatives of these four. Their characteristics of risk and return can be widely different, but we ultimately buy them all for the same reason- to return more money back to us than what we started with.

We therefore build investment portfolios as a whole and not by its pieces, believing different types of investments can complement another. This couldn’t be truer today than with investments with a fixed rate of income. Bonds, for example, like a certificate of deposit from any bank, generally pay a fixed rate of interest for a fixed period of time. Simplified, their value is generally guaranteed by the entity issuing the bond, along with a commitment for the stated rate of interest.

This steadier pattern had historically made the frantic herd of media and investors find it a little too boring for their tastes. Maybe they just prefer the excitement or story of stocks to bonds. But bonds, and more significantly their interest rates, actually serve as the core of our valuation of all of our other assets. This is because all investment returns must be thought of in the context of what we can get without bearing additional risk- or the rate of interest we can earn on some government’s guaranteed offering. In reality, it is the interest rate implied by these very bonds that can tell us the most information about the rest of our investments.

It is this more than anything else that will influence the rate of return you receive on your stocks, bonds, savings and real estate. While it is not necessarily the cause, it is certainly the effect. Consider the yield on U.S. Treasury bonds just 12 years ago, where they yielded 5-6% greater a year than that of today, across almost all investment time horizons. While the risk premium we pay for stocks has been volatile, it has been interest rates that influence overall expected returns. It is therefore interest rates that are more important in determining what the financial markets are telling us.

This difference causes tough decisions. It has forced us to make more realistic expectations for our long-term rates of return, but also makes the probability of achieving it likely greater (since it turns out our expectations were just an illusion, anyways). If we are to earn a positive “real” rate of return (that is, after taxes and inflation) on our money, it also means we must invest for longer time commitments in our bonds, and expect more volatility in our stocks (implied by other factors). If nothing else, the inverse relationship between the two investment classes may serve as a better hedge than any of the others we have available today. This has forced both aggressive and conservative investors alike to make a decision: do I accept more economic risk or inflation risk.

So it turns out we can’t have our cake and eat it too, but that was the case all along. It just seems there is no way of denying it anymore. Now that that is out of the way, we can really do the heavy lifting and get serious about preparing for our future.