Advice & Dissent

Jack Calhoun | Principal

Examining the common (non)sense that causes investors to fail.

Flight or Freeze?

August 2012

“Don’t just stand there – do something!”

That is the refrain of anxiety, fear and panic. It is the fight-or-flight survival instinct put into words – a plea to do anything other than stay put.

Sometimes the notion of taking action makes perfect sense. If, for instance, your car stalls out on the railroad tracks and a freight train comes barreling around the bend, then staying put is clearly unwise.

When it comes to investing, however, the notion of “taking action” during times of perceived danger in the market is misguided and dangerous. And it is precisely the sort of counter-intuitive concept central to investment success that very few people who manage their own portfolios are ever able to understand or embrace.

Before we explore this notion in more depth, a caveat: The wisdom of staying put during periods of market turmoil depends entirely on the soundness of your current strategy. Investors with portfolios heavily concentrated in individual stocks or invested in narrow market sectors should indeed take action to diversify their portfolios, but the time do this is before the market volatility swoops in and knocks your portfolio value in half or more. (See: Wachovia, Delta, GM, et al.)

For those who are invested in a well-diversified portfolio strategy, it is vital to stay the course in times of turmoil. Unfortunately, the “blink moments,” as we call them, always coincide with the exact moment of maximum stress in the market. The greater the stress, the harder it is to say put, because every time we pick up the paper, click on the financial web site or turn on the TV, we hear the “experts” urging us to “do something.”

But what, exactly, is the “something?" This is the logical next step in this progression and the one that people usually fail to consider. When panic sets in, as it did in the fall of 2008 and again in the summer of 2011, investors become obsessed with “fleeing from” without considering what they are “running to."

With that in mind, let’s examine what investors historically have considered the safe havens in times of turmoil to see if they really are a safer alternative to stocks:

Gold: Gold is often touted as a safe haven in turbulent markets and as a way to moderate volatility or even generate healthy returns. The reality, however, is that gold is a more volatile asset than common stocks. Over the past 10 years, the volatility of gold (as measured by standard deviation) was 19.06% versus S&P 500 volatility of 15.99% -- and this was during a decade that saw three significant market declines! Many people fled to gold following the downgrade of the U.S. debt rating in August 2011. And yet from September 2011 through June 2012, the price of gold plunged from $1,884 to $1,599, a decline of 15.13%. During the same time, the S&P 500 rose 16.01% from 1174 to 1362. Those who fled stocks for gold and thought they were getting “safety” actually suffered a cumulative loss of more than 30%!

Bonds: Fixed-income is the traditional asset class used to moderate equity volatility. In the past four years, however, individual investors have flooded into fixed income as a refuge from the perceived risk of investing in stocks. In just the second quarter of 2012 – and despite a 30% gain in stocks the prior six months – volatility-weary investors pulled $35 billion from stock funds and plowed $59 billion into bond funds.

Unfortunately, many such investors are only trading a perceived risk for a guaranteed risk. Having found the extremely low yields of high credit quality bonds to be unattractive (the current Barclays Aggregate Bond Index yield is 2.01%), many investors are running to high yield, low credit quality bonds in pursuit of returns. Unfortunately, these junk bonds will suffer significant losses of principal when interest rates rise, exposing their investors to significant volatility. As seen in the chart below, high yield bonds have risk more closely aligned with equities than high credit quality bonds.

On top of this, the low interest rate environment and high demand for safer assets has driven bonds to significant premiums when compared with equities. The Price to Earnings ratio of the Barclays Aggregate Bond Index has skyrocketed to 49.75 vs. 13.88 for the S&P 500.

Cash: There can be a temptation to throw one’s arms up, pull out of the market and seek the safety of cash amid uncertainty. However, there is a very real risk of loss of purchasing power if fleeing exclusively to cash. Inflation in the U.S. as measured by the Consumer Price Index has been 3.57% over the past 80 years. With current average money market rates at 0.48%, inflation will rapidly erode a pure cash position’s real value.

Often times investors view a move to cash as temporary, vowing to get back in the market once volatility subsides. Unfortunately, such investors usually make a move to cash after they have experienced the downturn and then fail to get back in the market in time for the subsequent rebound. Investors pulled billions from stock mutual funds last fall and fled to cash after the market’s dramatic plunge following the downgrade in the U.S. credit rating. Those who waited just two months to get back in the market, however, missed a 13.44% gain in the S&P 500, and if they waited six months they missed a 29.09% gain.

The bottom line is that investing involves risk. The best way to mitigate that risk is to have a well-diversified portfolio and a proper balance of stocks and bonds appropriate to your risk and return needs. After that, the best strategies you can employ are time, patience, faith and fortitude. History shows that market downturns have always worked themselves out over time – if you stayed put.

As one of the industry’s most respected and revered figures, Vanguard founder John Bogle, says about market downturns:

“Don’t just do something – stand there!”

Data sources: Morningstar Direct,,,, Dimensional Returns 2.0

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Is the Rally for Real?

March 2012

A recent article in the Atlanta Journal Constitution featured an angle that I have seen frequently in the media in the past few weeks, which can be summed up in five words:

“Is the rally for real?”

In other words, are stocks going to continue to climb, or are we due for another downturn?

My first thought whenever I read these articles is: What do they mean by “real”? When I look at the gains stocks have enjoyed going back to the recent market low in October, they certainly seem real to me:

So the actual question that is being asked in these articles is: Will the market keep going up?

Now we get to the heart of the issue. The folks who are really worried about whether the stock rally is real are the ones who didn’t participate in it. They are the investors – and investment managers – who got out of the market back in the summer, or never got in it at all after bailing out in 2008-09. Those investors are terrified of buying high and enduring another downturn in the market, which would further compound their losses. They are stuck in the never-ending spiral that is market timing: Always wondering when to get out and when to get back in.

The intrepid investors who have stayed put are enjoying their double-digit gains going back to October – and triple-digit gains going back to March 2009 – and aren’t as anxious about whether the rally is “real”. They have much to show for their discipline, and they know that if the market does go down in the short term it will, sooner or later, reverse its course again. They don’t have to worry about buying high and selling low, because they don’t engage in that loser’s game.

The simple fact is that the market just gained between 20% and 30% in about five month’s time. And the bulk of those gains came in October, when the European debt crisis was in peak frenzy and things were a long way from “calm.” Folks who got out of the market just until things “calmed down” now have their wish, and they have a conundrum. While they were waiting for things to calm down, the market took off. And now they sit on the sidelines wondering what to do.

The rally is for “real”, because it “really” happened. Whether the market goes up, down or sideways from here is beside the point. The lesson is that gains happen in the stock market right when you least expect it, and you want to be sure you are there when they happen.


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Is The Recent Market Volatility Really "Unprecedented'?

November 2011

I attended a symposium in Austin, Texas recently where the esteemed finance professor, Gene Fama, addressed our group. If you aren’t familiar with Dr. Fama, he is one of the pioneers of Efficient Market research, is often referred to as “the father of modern finance,” and has been a candidate for the Nobel Prize in Economics. So, to borrow the old E.F. Hutton line, “when Dr. Fama speaks, people listen.”

After his presentation, Dr. Fama took some questions from the crowd, and his response to one of them caught my attention. When asked for his perspective about the extreme volatility that has been plaguing the financial markets since August – and, really, since 2008 – he had an interesting response.

“The volatility we have seen is not unusual from a long-term historical perspective,” Dr. Fama said. “But it is unusual compared to the volatility we became used to over the past few decades.”

This may be hard for you to believe, but it’s easy to see looking back at the historical record. While volatility in recent years has spiked, it is consistent with other times of turbulence, notably the 1930s and ‘40s (and in truth, it has been a good deal less volatile than the Depression era). This may not exactly be comforting, but it is at least informing.

“But wait!” you say. “Why do I keep reading about the ‘unprecedented volatility’ we are seeing in the market today?”

The answer is that the media isn’t interested in perspective, it is interested in drama. Financial reporters love to focus on point declines in the market, because it draws people’s attention. And when reporters get to go on air and breathlessly tell us that the Dow experienced, say, its fourth-largest point decline ever, that makes for some captive viewers.

Point declines, however, are very different from percentage declines, and percentage declines are really the only logical way to judge volatility. After all, a one-day drop of 500 points at Dow 12,000 is not nearly of the same significance as it was at Dow 2,200, which happened in October 1987. At Dow 12,000, that decline was about 4%; at Dow 2,200 it was about 23%.

In that regard, consider the following list of the 20 largest one-day percentage declines in the Dow Jones’ modern history:

Notice anything interesting about this chart? That’s right – not one of the declines from recent weeks even made the top 20 largest percentage declines. And even at the height of the panic in 2008, only one day cracked the top 10. So I take exception with the argument that these swings in the market have been unprecedented.

This isn’t to say, however, that the recent swings haven’t been unusual. Referring back to the table, it is interesting to note that fully 50 years passed between the 1937 downturn (at #11) and “Black Monday” 1987, the mother of all one-day percentage declines that is #1 by a large margin.

Looking back at a timeline of one-day percentage swings of 3% or more in the Dow from 1928 – 2008, we can see this trend in which volatility took a long holiday during middle part of the century: So while we can’t say the market volatility we have seen in the past few years has been unprecedented, we really have to go back to the Depression era to find a time that rivaled our current market environment. This is consistent with a central reality: Financial crises lead to extreme volatility in the financial markets, and until the crisis is resolved, the volatility will likely remain. And we are in the midst of the worst financial crisis we have seen since the 1930s.

While politicians trade in rhetoric, markets deal with realities. And the reality the market sees right now is a heavily indebted developed world that can’t meet its obligations. And so, in its own heavy handed way, the market is forcing the issue by essentially voting on the policy moves that European and American governments are making to improve their balance sheets. The market is applying pressure to politicians by giving a Bronx cheer to any efforts it deems ineffective in getting our debt crisis under control, and the same thing is happening overseas in Europe. And this is serving to force our politicians to deal with things they’d just as soon kick down the road to the next crisis.

In the short- to intermediate-term, therefore, stock volatility may well be like the relative who drops by and then just keeps hanging around, wearing out his welcome. In the long run, however, issues and crises have a way of resolving themselves. As the old economic saying goes, “If something can’t continue, it won’t.”

This is where long-term investors need to be extremely careful about the dangers of, as financial writer Nick Murray refers to it, “Volatility Fatigue.” After years of enduring wild swings in the market, it can be easy for investors to throw in the towel and flee the market “until things calm down.” But the stock market is a leading economic indicator, and things turn decisively upward in the market long before crises resolve themselves.

We saw this coming out of the bear market lows in March 2009, and no doubt we’ll see it again as events in the developed world resolve themselves in the years ahead. Alas, just as we saw two years ago, most of the investing public will be on the sidelines when it happens.

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Muni Bond Mayhem, Or Just Another Version of "A Nightmare on Main Street"?

February 2011

One of the most painful things about my line of work is watching the investing public commit one grievous mistake after another and being unable to do anything about it. I can help my clients avoid the emotional, reactionary missteps that are so tempting in times of turmoil, but there is nothing I can do for the masses who seem predestined (hey, I’m a good Presbyterian) to destroy themselves in every conceivable market cycle. No matter what the situation, the majority of investors do the wrong thing every time. It’s like being forced to watch a horror movie in slow motion, over and over and over again…

So, as I look at the recent happenings in the municipal bond market, all I can think is: “Here comes A Nightmare on Main Street, Part 214.”

First, for some context, here is a brief review of the average American investor (we’ll call him “John Q. Public”) and his experience over the past 15 years:

• In the late 1990s, John Q. Public loaded up on technology stocks, especially “dot-com” stocks. When the bubble burst in the spring of 2000, he lost about 80% of his investable assets.

• After the tech bubble burst, Mr. Public took whatever funds he had left and fled to the “safety” of cash investments. And he did indeed feel safe there for awhile, until the market suddenly took off in the spring of 2003, gaining 50% in 12 months while he earned 1% in money-market funds.

• In the mid-2000s, Mr. Public then tiptoed back into the risk pool, but he was still wary of stocks from his frightening experience in the 2000-03 bear market. So he split the difference and went mostly into bonds, just in time for interest rates to go up, which caused his bonds to fall in value. He lost money here, too.

• With the stock market back to record highs by 2007, John Q. Public realized what a fool he had been. The recovery was complete and all was safe with stocks! And, oh, what returns those financial and real estate stocks had delivered! He loaded up on rock-solid banks and financial service companies. Then the subprime financial crisis hit. The Dow fell nearly 60% over the next two years, and many financial stocks went under entirely. By early 2009, Mr. Public was once again completely fed up with “losing money in stocks” and went back to cash, locking in catastrophic losses.

• Right on cue, the market enjoyed its strongest gain in 80 years. From its March 2009 low, the Dow gained 90% in 18 months, but Mr. Public missed it. By late 2009 – fed up with making literally nothing in cash – John Q. Public went, not to those risky old stocks, but back to bonds. Safe, secure bonds. Except the safe, secure bonds weren’t delivering returns much higher than cash. So Mr. Public went searching for “yield”, moving farther out on the yield curve and lower down in credit quality. He invested in the supposed safety of municipal bonds, but opted for the higher-yielding, longer-term variety – never stopping to wonder why those bonds were producing such high yields in a low interest-rate environment.

And that brings us, inevitably, to today’s “muni bond crisis” that has been heavily touted in the headlines. Last fall, famed analyst Meredith Whitney issued a dire forecast for municipal bonds, and small investors panicked en masse. Municipal bond funds were swamped with redemption requests, forcing many of the funds to dump their bonds on the market at discounted prices to raise cash. That created a huge glut of bonds on the open market, and prices dropped accordingly.

Most experts believe that the muni bond market overall remains extremely secure. In a report last month, ratings agency Standard & Poors noted, “We believe the crises that many state and local administrators find themselves in are policy crises, rather than questions of governments' continued ability to exist and function… (The crises) are more about tough decisions than potential defaults." (See: Standard & Poor's, U.S. States and Municipalities Face Crises More of Policy Than Debt.)

S&P went on to say in the report that, for significant defaults to occur, state and local governments would have to face revenue declines roughly double to what they were during the Great Depression – an unlikely scenario to say the least.

Unfortunately, small investors have not grasped this reality and are selling muni bonds without regard to risk or return. That has forced yields higher because new issues coming to market must be competitive with the existing issues being sold at fire-sale prices on the secondary market. And that, in turn, has sent prices lower for all existing muni bonds.

What is lost on most investors is that municipal bonds come in almost as many flavors as Baskin Robbins’ ice cream. Consider this: While there are only about 8,500 publicly traded stocks in the U.S., there are millions of municipal bond issues in a wide variety of structures. There are general obligation bonds, revenue bonds, pre-refunded bonds, insured bonds, taxable muni bonds, escrowed-to-maturity bonds, and many others. The type of bond, the maturity of the bond, and the credit worthiness of the issuing municipality all play heavily into the risk and return characteristics of the bond.

Not surprisingly, therefore, the selloff in the muni market has not impacted all bond prices the same. Muni bonds of high credit quality, and with short- to intermediate-term maturities, have not been much impacted by the so-called crisis. Many of these are general obligation bonds, backed by the taxing authority of the municipality and insured against default. Some even have “pre-refunded” features in which Treasury Bills have been escrowed to ensure that the principal is there to be repaid when due.

The spread in performance between these types of bonds and the lesser quality, longer term bonds that enticed small investors with their higher yields has been eye-popping. For example, while the Pimco High Yield Muni Bond fund declined a whopping 9% from mid-November to mid-January, the DFA Short-Term Muni Bond fund only declined about 1%.

Unfortunately, most individual investors once again succumbed to return chasing and followed their quest for yield out to the edges of the yield curve, ending up in high-yield funds that they have now sold for 10% losses, or, worse individual issues like 30-year munis that have sold for losses of 20% to 30%. It has been a jarring realization for these folks that “safe and secure” bonds can be as volatile as stocks – perhaps even more so – if you are in the wrong bonds at the wrong time.

Alas, all of this pain could have been avoided if the investing public had subscribed to our philosophy about fixed income at Capital Directions: “Bonds are a risk-reducer – not a return-juicer.”

In other words, if you want “return”, let stocks do that for you. If you want “stability”, let short- to intermediate-term, high quality bonds do that for you. And never get those two objectives confused.

If only John Q. Public could get the memo…

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