The most important lesson for investors
(MoneyWatch) Every year the markets provide us with lessons on what constitutes prudent investment strategy. Many times markets provide remedial courses covering lessons it had provided in prior years. That's why one of my favorite statements is that there is nothing new in investing, only the investment history you don't know.
This year, we're covering the lessons in two parts. This coming Monday we'll look at what we can learn through the returns provided by various asset classes and investments. Today, we'll focus on some of the principles of good investing. If you've been following my blog for a while, some of these lessons may look familiar. Unfortunately, most investors fail to learn and instead follow the definition of insanity: Do the same thing repeatedly and expect different results.
Discipline is key
Many forecasters have been recommending that investors stay out of short-term bonds, as interest rates have stayed at low levels. For example, PIMCO's Bill Gross announced in March 2011 that PIMCO had eliminated government-related debt entirely from its flagship fund, saying that bond yields had reached unsustainably low levels given the scale of government debt obligations and the chance of a correction when the Federal Reserve ended its quantitative easing program. At the time, rates were about where they were back in November 2008.
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Investors who listened to the experts have paid a steep price. They not only missed out on the ensuing bond rally, as rates fell sharply, but they also missed the chance to earn the term premium that existed (since longer-term rates were higher than short-term rates).
It has now been four full years since the federal funds target rate was set at 0 to 0.25 percent and the 10-year bond yield has dropped to just 1.76 percent, having fallen by more than 2 percent. This is well below the level it was when Gross made his now infamous forecast (one for which he ultimately apologized to his investors for making).
The historical evidence is very clear: There are no good stock or bond market forecasters. Thus, the winning strategy is to have a disciplined approach, one that balances the risks of rising or falling yields. One way to do that is to build a laddered bond portfolio with an average maturity of perhaps 10 years. Those who are less exposed to the risks of unexpected inflation might consider adding a few more years to the ladder. Those more exposed to that risk might consider a bit shorter ladder.
The economy and the stock market aren't the same
One bit of investing conventional wisdom is that high country growth rates means high stock returns in those economies. Many investors associate this bit of conventional wisdom with China, which had a growth rate of 7.7 percent in 2012, or 3.5 times that of the U.S. In fact, the past five years have seen China experience an economic growth rate about 9 percent, about 15 times that of the U.S.
However, despite the faster rate of economic growth, the iShares Trust FTSE China 25 Index Fund (FXI) lost 4.8 percent a year over that period, while Vanguard's 500 Index Fund (VFINX) gained 1.1 percent a year.
Ignore all forecasts
While we could provide an almost endless list of forecasts from so-called experts that went wrong, we'll limit our discussion to two of the more infamous ones:
- Meredith Whitney's proclamation of major bond defaults
- Bill Gross's prediction of the New Normal
We'll begin with Whitney. In late 2010, the noted banking industry analyst predicted "between 50 and 100 'significant' municipal bond defaults, totaling 'hundreds of billions' of dollars." And each time we experienced a default, including highly publicized ones in Jefferson County, Ala., and Stockton, Calif., we were reminded of Whitney's forecast, with the idea being that perhaps she was just a bit early.
While city and state budgets certainly looked to be in dire straits, they simply worked to get their acts together financially and balance their budgets. (Remember, unlike the federal government, all states except one are required to balance their budgets.) As a result, budget gaps have been closed, and these actions have gotten results. Vanguard's Intermediate-Term Tax-Exempt Fund (VWITX) returned 9.6 percent in 2011 and 5.7 percent in 2012.
Regarding Gross, he coined the term the "new normal" to define the economic landscape for years to come, a future that would likely include a lowered living standard, high unemployment, stagnant corporate profits and disappointing equity returns. So what are the returns to U.S. stocks since then?
From March 2009 through December 2012, the S&P 500 Index returned 21.5 percent per year And profits for the S&P 500 companies rose from about $65 in 2008 to about $102 in 2012. If that's the new normal, pray for more of it.
Crises will occur, so plan for them
One of the few sure things in investing is that you will experience many crises over your career as an investor. Just this past year meant dealing with the fiscal cliff, the ongoing eurozone crisis and slowing U.S. growth, among many other negative items. Yet despite all the bad news, 2012 was a very good year for stocks. That shows how important it is to be able to ignore the news, or what we call "the noise" of the market.
Over the past 40 years we have lived through a serious economic crisis of some kind about once every two years. Although we know they'll occur, we don't know what form they will take, when they will occur, how deep they will be or how long they will last. We also know that the key to successful investing is to be able to live through these crises with equanimity, adhering to your plan. To give yourself the best chance of doing so, you must be sure to avoid taking more risk than you have the ability, willingness or need to take.
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