Third Quarter 2016 Letter to Clients

It is often observed that the point of maximum extreme in a volatile market is the point of greatest danger to an investor, because market extremes trigger emotional decisions that seldom work out for the better. This is true both on the upside – such as the over-heated market of the late 1990s, when investors threw caution to the wind and plowed their money into dot-com stocks – and on the downside, such as the financial crisis in 2008, when investors fled the market in a full-on panic.

Interestingly, the same could also be said about times of extremely low volatility for stocks. After watching the market move sideways for a prolonged period, investors start to get antsy. They look at the recent performance of their stock-heavy portfolios and see returns that aren’t significantly better than less volatile asset classes like bonds and cash. Consternation ensues.

There is even a term for this in the investment industry: “performance fatigue.” The term speaks to the feeling investors experience when they don’t see substantial gains in their stock portfolio for prolonged periods of time. In such environments, the temptation to go off in pursuit of the hot strategy du jour can be overwhelming.

While prolonged periods of sluggish returns can be frustrating, the reality is that such periods are not out of the norm. In fact, they are the norm, more often than not. Here are three points to keep in mind when the market appears to be moving sideways:

  1. Stock gains come in short bursts: When stocks tread water for a prolonged period of time, it often feels as if something is “wrong” with the market. The reality, however, is that such periods of time are just business as usual. Stocks rarely experience a prolonged upward climb; to the contrary, stock gains are typically generated in short bursts.

    The table below illustrates this reality vividly. It shows the negative impact to an investment portfolio of missing out on just a few of the market’s best days over time.

    While this chart is typically used to reinforce the risks of trying to time the market (and it does that very effectively!), there is another observation that can be gleaned. Most of the stock market’s gains over the long term are generated on just a handful of days. It’s hard to believe, but it’s true – removing the 40 best days from the market over a period 20 years is the difference between an 8.19% annual return and a -1.97% annual return.

    When we see the outsized returns of stocks compared to bonds and cash, those returns are attributable to the impact of those few days of huge gains averaged out over time. The rest of the time, stocks typically bump along for extended periods without much to show for the ride. 
  2. There is no such thing as a free lunch: Much of the consternation that investors experience in sluggish market environments is attributable to the fact that there is always something out there outperforming the market. Some strategy or sector or guru is always out there gaining notoriety for generating stellar returns when most investors are seemingly stuck in neutral.

    One of the strategies that has garnered a great deal of attention in the financial media in recent years is a strategy known as “risk parity.” These strategies were devised to boost returns during low volatility environments by borrowing money to leverage bond and cash positions, allowing the fund managers to take more risk in equities without seemingly taking on more volatility.

    That house of cards was exposed in September, when stock and bond prices fell simultaneously over the course of a few days. Risk parity funds were forced to liquidate huge chunks of their holdings, experiencing severe losses as a result.

    The bottom line: If a strategy is generating outsized returns, it is assuming out-sized risk. When it comes to investing, there is simply no way around that reality. While it can be tempting to go off in pursuit of the day’s hot strategy that seems to defy the current market environment, rest assured that, sooner or later, there will be a reckoning.
  3. Chasing returns is a losing game: Sadly, most investors do engage in constant “performance chasing”, jumping from strategy to strategy in a never-ending search for better returns.

    This behavior has dire consequences for investors. In a 2016 study, the investment research firm Dalbar, Inc. found that the average holding period for equity mutual-fund investors is four years! Not surprisingly, investors typically shift their assets into the day’s hottest funds after the outsized returns have been generated, just in time for a return to reality. As a result, the long-term investment performance for the average investor trails the market substantially.

    The chart below from Dalbar shows the average 20-year return for the S&P 500 index compared to the average equity fund investor’s return for the same period. Year after year, equity investors’ long-term returns trail the market by half or more – all of it attributable to failed efforts at market timing and return chasing.








It is not exactly a news flash, but it bears repeating when stocks go into the doldrums: Long-term investment success is principally about patience. It is a simple concept but decidedly difficult to put into practice. Investors must resist the temptation to abandon their long-term investment strategy and stay the course in both high and low volatility environments. For more than a century, the discipline to stay the course regardless of the market environment is what has separated the winners from the losers in investing.

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It never fails to amuse us when we see the market analysts on television opining about what the future holds for a particular sector of the economy. They make their forecasts and predict the winning and losing companies in the sector in the coming years, all with an air of authority that sounds so compelling and, well, actionable.

These segments always leave us wishing we could ask the so-called experts a single question, one that would no doubt cause a considerable amount of squirming: What’s your prediction about the companies that don’t exist yet?

In today’s rapid-fire economy, companies are forming and emerging into economic giants in a matter of a few years. Facebook, Google and Amazon are some of the past decade’s most notable examples of this. Today, we can add the ride-hailing company Uber to the list. Founded in 2009, Uber today has a market value of $51 billion. Almost overnight, the company has transformed many aspects of the American transportation industry.

The fact that Uber didn’t even exist just a few years ago illustrates the futility of trying to forecast winners and losers in the economy and make investment decisions based on those forecasts. The global capital markets today are more dynamic than they have ever been, and the pace of innovation is unparalleled. Companies are founded and emerge into market giants in short order, while once venerable titans of industry fall into obsolescence just as quickly.

This is why we embrace a market-based investment philosophy at Capital Directions – one that is devoted to capturing the return of the global capital markets as efficiently as possible. In our opinion, it makes much more sense to let the market sort out the winners and losers than it does to make subjective investment decisions based on an unknowable future.