Plan for Success

Terry Hartigan | Principal

Developing a road map to achieve financial success.

Presidential Elections and the Stock Market

October 2016

Next month, Americans will head to the polls to elect the next president of the United States. While the outcome is unknown, one thing is for certain: There will be a steady stream of opinions from pundits and prognosticators about how the election will impact the stock market.

As we explain below, investors would be well served to avoid the temptation to make significant changes to a long term investment plan based upon these sorts of predictions. 

Short-Term Trading and Presidential Election Results 

Trying to outguess the market is often a losing game. Current market prices offer an up-to-the-minute snapshot of the aggregate expectations of market participants. This includes expectations about the outcome and impact of elections. While unanticipated future events—surprises relative to those expectations—may trigger price changes in the future, the nature of these surprises cannot be known by investors today. As a result, it is difficult, if not impossible, to systematically benefit from trying to identify mispriced securities. 

This suggests it is unlikely that investors can gain an edge by attempting to predict what will happen to the stock market after a presidential election. 

Exhibit 1 shows the frequency of monthly returns (expressed in 1% increments) for the S&P 500 Index from January 1926 to June 2016. Each horizontal dash represents one month, and each vertical bar shows the cumulative number of months for which returns were within a given 1% range (e.g., the tallest bar shows all months where returns were between 1% and 2%). The blue and red horizontal lines represent months during which a presidential election was held. Red corresponds with a resulting win for the Republican Party and blue with a win for the Democratic Party. This graphic illustrates that election month returns were well within the typical range of returns, regardless of which party won the election.

Long-Term Investing:  Bulls & Bears ≠ Donkeys & Elephants 

Predictions about presidential elections and the stock market often focus on which party or candidate will be “better for the market” over the long run. Exhibit 2 shows the growth of one dollar invested in the S&P 500 Index over nine decades and 15 presidencies (from Coolidge to Obama). This data does not suggest an obvious pattern of long-term stock market performance based upon which party holds the Oval Office. The key takeaway here is that over the long run, the market has provided substantial returns regardless of who controlled the executive branch. 

Conclusion

Equity markets can help investors grow their assets, but investing is a long-term endeavor. Trying to make investment decisions based upon the outcome of presidential elections is unlikely to result in reliable excess returns for investors. 

At best, any positive outcome based on such a strategy will likely be the result of random luck. At worst, it can lead to costly mistakes. Accordingly, there is a strong case for investors to rely on patience and portfolio structure, rather than trying to outguess the market, in order to pursue investment returns.

 

Email A Friend Print This Article

Should Investors Sell After a Correction?

October 2015

Stock prices in markets around the world fluctuated dramatically for the week ending August 27, 2015. On Monday, August 24, 2015 the Dow Jones Industrial Average fell 1,089 points— a larger loss than the “Flash Crash” in May 2010—before recovering to close down 588 points. Prices fell further on Tuesday before bouncing back on Wednesday, Thursday, and Friday. Although the S&P 500 and Dow Jones Industrial Average rose 0.9% and 1.1%, respectively, for the week, many investors found the dramatic day-to-day fluctuations unsettling.

Based on closing prices, the S&P 500 Index declined 12.35% from its record high of 2130.82 on May 21, 2015 through August 24, 2015. Financial professionals generally describe any decline of 10% or more from a previous peak as a “correction,” although it is unclear what investors should do with this information. Should they seek to protect themselves from further declines by selling, or should they consider it an opportunity to purchase stocks at more favorable prices?

Based on S&P 500 data, stock prices have declined 10% or more on 28 occasions between January 1926 and June 2015. Obviously, every decline of 20% or 30% or 40% began with a decline of 10%. As a result, some investors believe that avoiding large losses can be accomplished easily by eliminating equity exposure entirely once the 10% threshold has been breached.

Market timing is a seductive strategy. If we could sell stocks prior to a substantial decline and hold cash instead, our long-run returns could be exponentially higher. But successful market timing is a two-step process: determining when to sell stocks and when to buy them back. Avoiding short-term losses runs the risk of avoiding even larger long-term gains. Regardless of whether stock prices have advanced 10% or declined 10% from a previous level, they always reflect (1) the collective assessment of the future by millions of market participants and (2) the expectation that equities in both the US and markets around the world have positive expected returns.

Our research shows that US stocks have typically delivered above-average returns over one, three, and five years following consecutive negative return days resulting in a 10% or more decline. Results from non-US markets are similar.  Contrary to the beliefs of some investors, dramatic changes in security prices are not a sign that the financial system is broken but rather what we would expect to see if markets are working properly. 

The world is an uncertain place. The role of securities markets is to reflect new developments—both positive and negative—in security prices as quickly as possible. Investors who accept dramatic price fluctuations as a characteristic of liquid markets may have a distinct advantage over those who are easily frightened or confused by day-to-day events and may be more likely to achieve long-run investing success.

Adapted from “Should Investors Sell After a Correction?” by Weston Wellington, Down to the Wire column, September 2015. 

 

Email A Friend Print This Article

A Look at the University Endowment Model of Investing and the Individual Investor

February 2014

Over the past decade there has been a great deal of hype in the financial press about the superiority of the so-called “endowment model” of investing. What is the endowment model you ask? At the risk of oversimplifying, it is diversifying beyond traditional, publicly-traded stocks and bonds to include a significant allocation to “alternative” asset classes such as private equity and hedge funds. The term “endowment model” is descriptive because many major university endowments have embraced this strategy of investing.

Conventional wisdom holds that the endowments of our prestigious universities have long-term performance records worthy of emulation. Many of the chief investment officers of these endowment funds have become rock stars of the investment industry and are often paid higher salaries than the university presidents. Wall Street tries to sell individual investors on the notion that they also need “special access” and “complex” strategies to replicate the same success. But is the endowment model something the individual can or even should pursue?

Let’s take a look at the five year track record of some of the largest university endowments for their fiscal years ending June 30, 2013:
 
Keep in mind, the five years ending June 30, 2013 includes a significant portion of the 2008 market downturn, which is a period where we should expect to see lower returns than the historical average. But is this not when the endowment model is supposed to reveal its superiority and deliver great returns? Apparently not.

Even if an endowment model proved to provide superior returns, should an individual investor expect to be able to implement the same strategies and structures with equal results? I would argue that it would be very difficult, for several reasons.

1. Income taxes. University endowments are tax exempt, while individual investors are not. Many of the strategies endowments implement are extremely tax inefficient due to high turnover. The tax bite alone would substantially reduce the after-tax returns for an individual investor.

2. High Costs. Investing in alternative asset classes is an expensive proposition. A typical hedge fund may charge a 1.5% asset management fee plus 20% of profits. Large endowments are often able to negotiate more favorable rates due to the large sums of money they invest. The individual investor is not likely to be able to negotiate the same terms.

3. Illiquidity. In theory, endowments have an infinite time horizon and are able to forgo liquidity in pursuit of investment returns (whether or not this is rewarded is another issue). The typical individual investor has a more finite time horizon and requires a more liquid portfolio.

4. Resources and investment minimums. A university endowment investment staff may include dozens of professionals who do nothing but research and perform due diligence on investment opportunities (again, whether or not this is rewarded is another issue). Also, a manager with whom the endowment invests may require a minimum investment of between $5 million and even $50 million.

But let’s suppose you could have replicated the performance of the best-performing endowments over the past five years with similar strategies. How would you compare to an individual investor who used a more traditional, less complex diversification strategy?

During the same five-year period, Capital Directions’ Moderate Growth model portfolio, net of fees, generated a 5.5% annualized return*. This would place it number two in the above performance ranking – behind Columbia and ahead of Penn. Our Moderate Growth portfolio is broadly diversified, with 60% allocated to global equities and 40% allocated to diversified fixed income. This type of strategy is implemented using low-cost, tax-efficient mutual funds and exchange traded funds. It is a simple implementation on the surface, but it is based on the science of investing built upon decades of academic research and institutional application.

While there are some similarities between the endowment model and our approach at Capital Directions, it is the commitment to using illiquid, high cost alternative assets that separates the two approaches. And even some of the endowment experts side with us on this.

David Swensen, the Chief Investment Officer of Yale University’s endowment, is arguably the most famous manager for his success implementing the endowment model. However, in his book “Unconventional Success: A Fundamental Approach to Personal Investment”, he says (and I agree) that insurmountable hurdles confront ordinary investors and they are best rewarded by utilizing investor friendly, low cost, market-based portfolios to gain access to broad diversification. This is advice from the individual who is considered a pioneer in the use of alternative asset classes. Not what most investors would expect to hear from Mr. Swensen!

Leonardo da Vinci said, “simplicity is the ultimate sophistication.” We could not agree more. You may not have great stories of exotic investments to tell at your next party, but your probability of achieving your investment goals will likely be higher.

* Disclosure Statement & Portfolio Construction Data
Performance numbers are blended historical returns for the mutual funds used in the model portfolios, or the representative index for the periods prior to commencement of operations by the selected fund, net of its corresponding expense ratio. This portfolio commenced operation in January 1999. These hypothetical returns were calculated after the end of the periods shown and reflect the reinvestment of dividends and other earnings. Returns are shown net of fund fees, the maximum advisory fee for CD and estimated transaction costs for a typical client portfolio. Estimated transaction costs for initial purchases and rebalancing in a $1 million typical client account are approximately 0.05% on an annual basis. These model portfolio returns do not represent actual investment decisions by CD and, thus, may not reflect the impact that material economic and market factors might have had on our decision-making if CD were actually managing the money. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

Email A Friend Print This Article

How Much Risk Are You Taking?

July 2013

As wealth managers, there are numerous ways in which we identify and measure risk. We may look at the volatility of your portfolio, the potential downside loss, over concentration in a particular security or asset class. We may look at the amount you are saving or the amount you are withdrawing from your portfolio. These are all very useful and valid measures of risk.

However, at Capital Directions we believe the single best measure of risk for an investor is the risk of not achieving your goals.

Most investors think of risk in terms of short term, downside fluctuations. We certainly understand the discomfort and uneasiness this can cause. But in reality, this is largely an emotional reaction. A properly constructed investment strategy is one that enables an investor to endure the short term fluctuations that will occur, yet provides them with a high probability of achieving their goals.

Very often we see investors who believe they are not taking much risk because they have low exposure to stocks. Since they do not have a lot of volatility in their portfolio, they are not taking a lot of risk, right? Maybe……maybe not.

Remember, your portfolio exists to help you achieve a certain goal either now or in the future. At some point, you will need a certain amount of dollars each year to provide for retirement living expenses, travel expenses, education expenses or healthcare expenses. If your portfolio has very low downside risk and therefore, a very low return expectation, the likelihood of achieving your goals may be very low. You may be sleeping well at night today, but you may not realize you will be forced to accept a much lower standard of living in the future.

Many sophisticated tools exist to measure your probability of success. A solid planning process should incorporate your values and your priorities to design a strategy to achieve your goals with a high level of confidence. The plan should clearly and simply communicate the trade-offs among different strategies. Allowing your planning needs to drive your investment strategy will lead you to make smart financial decisions.

Email A Friend Print This Article