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False Expectations

     So I’ve been waiting for the right opportunity to say this for quite a while. I think the time has come. Investors have been deceived by the financial services industry by setting false expectations regarding the relationship between risk and returns.

 

More Risk Does Not Equal More Return

     

     2016 is staging to be a great opportunity to explain this reality. Investors have been told from their very formative years, that if one is willing to accept more risk, then one can expect more return – over time. I think this is really a structurally flawed relationship, which may be why so many investors have a long lasting sense of disappointment when it comes to their investments. Let me explain and give you a bunch of examples. As always, I’ll finish with a short statement about why this understanding is relevant to you or why you should care.

 

     First, let’s get clear on some definitions. When we say risk, people think about two things; the natural volatility of whatever you own as well as the more permanent risk of lost capital. These two are often confused as the same thing. They are not. There is no investment that does not carry some risk of permanent loss of capital with a lifetime of experiences to prove it. Most recently, we’ve seen real estate, once thought of as an investment that never declines, prove otherwise. Technology and internet in the late 90’s was said to be almost impervious to loss following a “new era”. That didn’t work out either. Nothing is free from risk of loss over time. Conversely, volatility is a variable that any investor can dial in or out of depending on your comfort level. Holdings that have higher daily swings in value will necessarily increase your portfolio’s total volatility in terms of swings in your daily, weekly or monthly balance. So the two concepts of “risk” are really quite different. For this discussion, we are talking about risk in terms of the risk of losing significant investment capital by staying invested in the wrong things at the wrong time.

 

     Also on the definitions front, we have to determine what we mean by “over time”. Over time, in the financial service industry, is really an excuse to justify relationships that have little bearing on your actual investing experience. “Over time” means you will not be alive long enough to recognize a promised outcome. “Over time” means, I can’t back this up with data in modern times but it fits my theory.

 

     So today, we see several glaring examples to support the notion that taking on more risk with your investments does not necessarily yield more return. This is the case over short and longer term periods – Over time.

 

Bonds versus Stocks

     

     Let’s pick on the very long lasting mantra that stocks are higher risk asset class than bonds and therefore they should produce higher returns. Is that the case?

Let’s take a look at a few statistics over different time frames. I’m going to compare two specific investments for this very dirty analysis, which should always be viewed with skepticism as anyone can curve fit an outcome using selective securities. But, in this case, I think we’re pretty safe. My two securities are the Pimco Total Return Bond fund (one of the largest in the world with the longest history) and the S&P 500 stock index. Pimco TR is about as close as you get to a pure aggregate bond index. The S&P 500 is of course representative of the US stock market. Here are the numbers through yesterday looking at long windows “over time”. Standard Deviation is a measure of regular volatility and Max Loss measures the largest loss from an all time high to a significant price low.

 

 

Security    Inception 9/1/1988    10 yr return    Standard Deviation    Max Loss
Pimco Total Return      7.92%      6.07%         1.31      -6.44%
S&P 500 Index      7.88%      4.84%         5.14      -55.1%

 

     Our keen eyes recognize that over time, the promise that the much higher risk environment for stocks has not, at least back to September of 1988, in fact produced higher returns. Of course, the future will not repeat the past and it is quite likely that the near 30 year outperformance of bonds over stocks will switch back to favor stocks. But 30 years is a long long time! The point is that models and expectations built on the premise of these false relationships can and will again disappoint you over long, long periods of time in the investing world.

 

Growth Stocks Versus Value Stocks

  

     Here’s another one that is especially relevant right now. Investors in things that are designed for growth like technology/ internet/ Biotech companies, etc. assume that they will be rewarded for taking on these additional risks. That is definitely the case during select periods of time, like the late 90’s. But, there are also very long time periods when value styles of investing, like boring consumer staples and other dividend paying stocks, wildly outperform growth. One could certainly even consider oversold sectors like materials, industrials, metals and energy services as value plays after the drubbing of the last 4-5 years. 2016 is beginning to shape up as a year where we’re seeing the market show a strong rotation from Growth and towards Value. Again, the promise of higher returns associated with growth investments is already busted this year. Investors in names like Netflix, Amazon and Apple are already starting to see and feel real selling pressure with those holdings. These are great companies and they are not going away anytime soon. But, the prices of their shares may not go anywhere for a while following the last several years of healthy gains. Companies that are showing better valuations or those in actual value based sectors continue to pick more and more investor interest and that applies to international indices as well. The point I make regularly in this update is that every investment has its time to shine and its time of falling out of favor. Assuming that the best returns will always come from the same areas of the market – like stocks or growth – is a set up for disappointment.

 

Why Should You Care?

 

     As clients, most of our households understand the dynamic nature of what we do. That is, we are trend followers always watching for leadership and significant asset class rotations. As the financial environment completes this Transition Period (of which I have spoken at length) of moving from a system dependent on support from the Federal Reserve to one that is capable of growing on it’s own, we are sure to witness some very significant changes. These changes are likely to challenge less dynamic investment models, or those which rely on the types of relationships described above. For instance, as we continue to see growing evidence that inflation is coming, older investors with substantial holdings in Treasury bonds might need to find a new home for their life savings. Similarly, younger investors who have substantial holdings in lime light technology stocks like Apple and Netflix, might also need to reallocate to more cyclical value oriented positions among industrials, materials, commodities and energy. Knowing when to make significant changes among investment themes, asset classes and sectors is one of our strengths and one of the key value propositions we bring to our clients. 2016 is shaping up to be an important year to recognize and act on new leadership. Don’t let this opportunity slip away. Feel free to call us anytime if you would like us to consult with you regarding any of your “outside” holdings. We’re here to help.

 

Sincerely,

 Sam Jones