Second Quarter 2008 Letter to Clients

Ask anyone who has spent a few winters up north and they will tell you an interesting thing about the experience. It isn’t the depth of the winter that gets to you; it’s the length of it. It’s easy enough to ride out the occasional deep freeze, but that’s not the real challenge. The real test of your psyche is to be able to withstand the long run of ups-and-downs – warmer, then colder, then warmer, then colder still. It just goes on and on and right when you think you can finally see the light at the end of the tunnel – wham! – a spring blizzard hits and you’re back to the snow shoveling. And that is often the point that people throw in the towel and head south.

In our experience, this is exactly the same emotional slog that investors experience in protracted down markets. Most stock investors are practical enough to know there will be occasional tough times in the market. When such times arrive, they gird their emotions, summon their resolve and commit to staying true to their investment strategy until the turmoil has passed. And, given the roller-coaster nature of the market, those times often pass fairly quickly.

Sometimes, though – as in the current market environment – the market makes its recovery only to resume another swoon. And then it happens again. And again. With each cycle, the hole gets a little deeper, the despair a little greater. The news gets worse and worse. Pretty soon even level-headed investors can find themselves emotionally drained and frustrated, not unlike the poor souls in Chicago still salting the driveway in April. It’s enough to make one want to throw in the towel and…well…do something! This is when we see all the stories in the media about how millions of investors have “fled to the safety” of cash investments. There are quotes from individual investors about how they just couldn’t stand to lose any more money, how they are just trying to keep what they have. Quotes about how people have lost faith in the stock market.

It is an inescapable truth that stock investing – even for prudently diversified investors – is not always easy. This is why stock investors earn higher returns than bond and CD investors – they are compensated for the additional risk they are taking. But there are times such as October 1987, July 2002 and the current market environment in which things seem hopelessly broken and there is no hope on the horizon. Bear markets are like that; it is, after all, why they are bear markets – because the news is overwhelmingly negative. The names of the day always change – oil embargo…tech stock collapse…subprime mortgage implosion – but the results are the same. Economic downturns and bear markets are simply a fact of life.

That doesn’t mean we have to like it, of course, but the real question is what can we do about it? When times get tough in the market, is there some realistic course of action investors can take that will make the pain go away?

Individuals who are not prudently invested – such as those who are concentrated in only a few stocks or market sectors – should indeed consider abandoning ship for a prudently diversified portfolio, lest the hole they have dug themselves gets impossibly deep. A disciplined, buy-and-hold mentality with such a concentrated portfolio is not only inadvisable, it’s down right dangerous. One might buy-and-hold such a portfolio into dust, as investors in everything from Bear Stearns to Wachovia can attest.

The same is not true, however, for investors in well-diversified portfolios such as those we construct for our clients at Capital Directions. When you have a portfolio that is spread across dozens of asset classes and thousands of securities, you have effectively neutralized the risk of any one stock or sector blowing up your portfolio. You then have the luxury of allowing the 200-year-old success story that is the stock market to work its wonders on your portfolio over time.

History shows that making any moves with a well-diversified portfolio in response to market turmoil is a loser’s game. The margin for error is so slim that even a few wrong guesses over time will put you well behind the returns the stock market would have given you if you had stayed put. This was validated in the recently updated study from Dalbar, Inc. that found that stock-fund investors have dramatically trailed the returns of the stock market for the past 20 years.

There is one reason – one single reason – for this wide disparity in the returns the stock market generates vs. what individuals earn in the market. When times get tough in the market, investors blink and bail out of their strategy. Then they try to get back in well after the market has started back on its road to recovery. Looking at the monthly asset flows of stock funds and money-market funds through the first five months of this year, we can see vividly this mindset in action. Here is a comparison of the net asset flows between stock funds and money market funds through May, courtesy of the Investment Company Institute:
You will recall that the year began with the S&P 500 plunging more than 10% in the first three weeks of January. Individual investors reacted in typical fashion, pulling nearly $50 billion from stock mutual funds and putting all that and more into money-market funds after the losses had been incurred. But then stocks recovered somewhat in late January into February, and investors again began shifting money back into stocks. Then the market volatility returned, reaching a crescendo in early March. In response investors again pulled more than $10 billion from stock funds that month and piled back into money-market funds. Unfortunately (for them), the market began a rapid recovery in late March and early April and investors pulled nearly $40 billion back out of money-market funds after the fact and headed back to stock funds in April and May. Alas, the market began to plunge again in mid May and hasn’t really stopped since, insuring that all those individual investors were back in the market just in time for the fall.

Though the data for June isn’t out yet, we’re going to go out on a limb and predict that, once again, individual investors went screaming for the exits after the market tanked, realizing yet more losses in the process. This never-ending penchant of individual investors to buy high and sell low is not a new trend; to the contrary, it is one of the oldest truisms in investing. It is emblematic of just how emotionally driven most investors are, and how disastrous their investment experiences are. It is how people lose their life savings in the stock market and become convinced that “stocks” are the problem, when really their behavior is the problem – the fruitless quest to avoid the volatility that is an inherent part of stock investing.

In contrast, well-diversified investors who summon their resolve and remain committed always benefit from their fortitude, enjoying the long-term returns the market is trying to give them while – as evidenced previously – most individuals are experiencing all of the downside and none of the upside of being a stock investor.