Cornerstone

Why Our Advice is Always the Same- Our Message is Not Wavering Despite the Market

Overview: It can be hard to hear the best course of action during tough market times- to do nothing.  It can be even harder to hear the message repeatedly as things seem to get worse.  But it is a message we would not repeat if we did not truly beleive it was in your best interests.  The following discusses why our message is not wavering despite the market.

Buy and hold. Rebalance. Stay the course. That is the advice we repeat again and again. Over the long term, that advice has served our clients well. Yet, in the face of the persistent bear market, a common refrain from investors has gone something like this: “Yes, that advice has worked in the past. However, this time is different. It obviously isn’t working now! The market just keeps going down and down. There must be a better alternative than to sit and do nothing.”  

While we empathize with investors who feel a great sense of loss, we don’t believe we are being stubborn. Our advice has always been (and will always be) based on the scientific evidence, not on our opinions about where the markets may be headed. And while this crisis is certainly different in some ways than other crises, we see no reason to change the investment advice.

 

Market Efficiency
For us to believe that we should abandon a long-term, buy-and-hold strategy, we would have to be first convinced that markets were no longer efficient. In other words, the market was now mispricing assets and was slow to react to new information.

 

It is hard to imagine that markets have gotten slower at reacting to news. In fact, markets incorporate news into prices almost instantaneously. After Treasury Secretary Timothy Geithner unveiled the Treasury Department’s plan to clean up toxic assets, the market reacted immediately, as evidenced by several indexes leaping to their highest one-day gains since last fall.

 

We see no evidence that active managers were able to predict this bear market. In fact, while there was a wide dispersion in individual stock returns (some stocks, like Wal-Mart were actually up), almost every single diversified mutual fund produced large losses. This would not be the case if markets were somehow inefficient. It is also important to note that there is no evidence that active managers consistently outperform in bear markets.

 

We believe that the market was and continues to be highly efficient. It is just that the news has been persistently worse than expected, causing prices to fall. This is what causes bear markets.

Market Timing
As to trying to time the market, we again rely on the historical evidence. When a client suggests just getting out until things are clear again, we point out that the evidence on market timing is even worse than on stock selection. For example, the publication Timer Digest showed that of the 112 market timers tracked from 1991 through 2000, only one managed returns that beat the S&P 500 Index. We don’t like those odds. Neither should investors.

 

 

One reason that market timing fails is that so much of the market’s return occurs during very brief and unpredictable periods. Another reason is that investors have to be right not once, but twice. Deciding to get out is easy compared to deciding when to get back in. Investors that go to cash may be “whipsawed.” They will get out after a severe drop, miss a big rally and jump back in only to experience another severe loss. They end up worse than if they simply stayed the course. That is why we believe going to cash is not the winning strategy.

 

The Difference Between Information and Wisdom
We can define information as facts or opinions. In terms of investing, wisdom is information that can be exploited to generate excess (above market) profits. When we ask people why they are so willing to abandon their well-designed plan, they say something like: “Isn’t it obvious that the situation is terrible?” Then they give a laundry list of negative items. The question they fail to ask is this: If it is in fact obvious, isn’t the bad news already built into prices? After all, that is why prices have already gone down.

 

They also fail to understand the following: If things are so bad, that must mean the market is perceived as risky. If the market is risky, expected returns are now higher. Why would investors decide to sell now when expected returns are higher than when they originally bought?

 

Many investors have considered selling because of concerns about the “Europeanization of our economy.” Should investors sell? To answer that question, one must understand that these concerns are well known by the market. While concerns about government intervention, higher taxes and an increased ratio of debt to gross national product can all affect stock prices, those concerns are already reflected in prices. That is why stock prices moved lower as the new administration unveiled its policies. As Bernard Baruch stated, “Something that everyone knows isn’t worth knowing.”

 

Investors feeling the need to sell should also consider the following. There is a “universe of risk.” Since all stocks must be owned by someone, someone must hold the market risk. For everyone who wants to sell, someone else must be willing to buy at the same price. And they will only buy in a time of distress if they believe the market price fully reflects the high risks.

 

The Relationship Between Risk and Expected Return 
If the perception of risks are high (which they are during bear markets), so must be the expected return. And the historical evidence is that investors persistently demonstrate a pattern of buying high (after bull markets when risk premiums are low) and selling low (after bear markets when risk premiums are high) when acting on their own. This destructive behavior is evidenced by the fact that investors typically underperform the very mutual funds in which they invest.

 

“Defensive” Strategies
Investing history is filled with examples of strategies that try to benefit from observable patterns of past market performance. Unfortunately, the realized returns haven’t matched the promise.

Vanguard examined the performance of several different signals based on “conventional wisdom” to see if they actually translated into better risk-adjusted returns.1 As one example, the authors studied whether investors could improve portfolio performance by defensively shifting equity exposure toward less-cyclical, lower-beta sectors (such as health care, consumer staples or utilities). This strategy is based on documented evidence that certain sectors tend to thrive in different stages of the business cycle. Unfortunately, they found that “a defensive investment strategy based on the leading signals of bear markets and recessions (focusing primarily on recessions) would not have resulted in better results than a buy-and-hold strategy.” Among the problems they found are “the low predictive power of even the best signals of bear markets and recessions as well as potentially high transaction and tax costs.”

 

Another signal they examined is the presence of an inverted yield curve (short-term interest rates exceed long-term rates), which is a well-documented leading indicator of recessions. Vanguard found that the yield curve signal is noisy: “For the period 1952 through 2006, the yield curve inverted 19 times, but the U.S. economy lapsed into recession only nine times.”

They also examined the forward-looking price-to-earnings ratio. The concept is based on the idea that a bear-market signal is given when the ratio is at historic highs. Unfortunately, this indicator is also noisy and, thus, has provided no value.

 

While the historical record shows that various sectors tend to outperform during tough times, Vanguard reached the conclusion that, “Even the most reliable indicators have low predictive power when used to execute real-time strategies. Investors seeking to mitigate equity market risks are better served with a strategic allocation to fixed income investments.”

 

Summary
Noted author Peter Bernstein provided this insight: “Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty.”2 Thus, our advice will continue to be the same, because that is what the science demonstrates is the most likely way to achieve one’s goals. When we find compelling evidence, published in peer reviewed academic journals, that there is a superior alternative strategy, we will do what smart people do; they change their strategy in the face of new evidence. Until then, our advice remains: buy, hold, rebalance and stay the course. 

 

1 Joseph Davis and Christopher Philips, Noisy Signals: A Challenge to Tactical Strategies. Vanguard Investment Perspectives, Spring/Summer 2008.
2 Peter Bernstein, Wimps and Consequences. Journal of Portfolio Management, October 1999.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice.

***NEW Presentation*** What Should Investors Do Now?

Six months after we posted Dimensional's first comprehensive survey of the market downturn, Weston Wellington returns to the topic with a multi-part series on what investors should consider as they move forward.  The videos include an examination of capital markets, the effects of recession and government policy on stock prices, how the current market stacks up to previous downturns, and the reasons why Dimensional's core beliefs have not changed in light of these events.

*Click here* to go the new presentation via Dimensional's website.  Look for the "click to launch full screen" button.  The presentation is in six parts, each lasting around 7 - 12 minutes.

The Educated Investor: Is Inflation Inevitable?

The significant amount of stimulus being injected into the economy may have investors wordering what this will mean for inflation.  The following article discusses why inflation fears may be premature. Click Here to view the article in PDF format. 

IMPORTANT UPDATE ON THE ECONOMY AND THE STOCK MARKET

Larry Swedroe talks about "Current Conditions in the Market and what, if anything, Investors Should Do In This Situation."  Approximately 45 minutes.  This is an excellent presentation in which Mr. Swedroe discusses why there is a lot of hope for our economy and how we have learned from our past mistakes.

Mr. Swedroe is the author of several books on investing, including Wise Investing Made Simple. Mr. Swedroe is also Director of Research for Buckingham Asset Management, LLC and BAM Advisor Services, LLC.  Press play below to hear the meeting.

Risk Tolerance and Diversification- More Important than Ever

Know Your Risk Tolerance

Investors should never take more risk than they have the ability, willingness, or need to take.  Violating this rule is what led to the failure of Lehman, Bear Stearns, AIG, and others.  They all took on so much leverage that they had to be right in their predictions all of the time, not just in the long run.

Diversification is the Key

Low correlating risky assets have a nasty tendency to have correlations rise just when those low correlations are needed the most.  Thus, investors should make sure their portfolios have sufficient, high-quality fixed income assets to reduce portfolio risk to an appropriate level.  Also, it is important to ensure the fixed income used in the portfolio is of the highest quality.  Investors should stick only with Treasuries, bonds of government agencies and the highest rated municipal bonds.  Also, municipal bonds should be judged based on the underlying rating, not the credit insurance.

Other fixed income investments such as high-yield (junk) bonds, convertible bonds, emerging market bonds and preferred stocks should be avoided, as their risks do not mix well with equity risks, thus could have the risk show up at the wrong time.  Those willing to take incremental risk should do so by increasing their equity allocation.  The incremental expected returns can then be earned more tax efficiently, and the risks can be for effectively diversified.

Active Managers Cannot Protect Investors from Bear Markets

All crystal balls are cloudy, which is why Warren Buffet concluded:  “The only value of stock forecasters is to make fortune tellers look good.”  Active investment firms tout their ability to protect investors from bear markets, but some of the largest demonstrated they could not even protect themselves.  If their money managers could protect investors, why did firms like Lehman Brothers and Bear Stearns go belly up and Merrill Lynch have to be rescued by Bank of America?  As evidence of their lack of ability to forecast events, consider that in 2008 Lehman spent $761 million buying back its own stock at an average price of $49.60 and Merrill Lynch spent $5.27 billion buying back its stock In 2007 at an average price of $84.88.

There is no reason to think that they would manage their clients’ risks any better.  Investors don’t need to pay large, Wall Street fees to have their money managed.  Large fees are only likely to make managers rich, not investors.

Large individual funds fall in the same category.  In 2008, the hardest hit sector was financial stocks.  Financials comprise a significant portion of the asset class of value stocks, so let’s look at the performance of some well-known actively managed value funds:

 

Value Mutual Funds

Active Managers	%
Legg Mason Value Trust	-55.1
Dodge & Cox	-43.3
Dreman Concentrated Value	-44.9
Weitz Value	-44.9
Schneider Value	-55.0
Columbia Value and Restructuring	-47.4
Benchmarks
Russell 2000 Value Index	-28.9
Russell 1000 Value Index	-36.9

Of course, some actively managed value funds beat the benchmarks.  However, how would you have known ahead of time which ones they would be?  As the SEC’s required disclaimer states:  Past performance is not indicative of future results.  Thus, the prudent strategy is to use only passively managed funds.

Cornerstone Wealth Advisors Selected as a FIVE STAR: Best in Client Satisfaction Wealth Manager (SM)

  

For the second year in a row, Cornerstone Wealth Advisors, LLC has been selected as a FIVE STAR: Best in Client Satisfaction Wealth Manager (SM).  The following is a press release posted January 15, 2009:

Press Release

Kansas City, KS (January 15, 2009) - In the January issue of Midwest CEO and the April issue of KC Magazine, the 2009 FIVE STAR: Best in Client Satisfaction Wealth Managers (SM) are announced.  Midwest CEO and KC Magazine formed a partnership with Crescendo Business Services, an independent research firm, to identify the "best in client satisfaction" wealth managers serving the Kansas City area.  In June, Crescendo surveyed, by mail and phone 25,000 high-net-worth residents in the Kansas City area and subscribers of Midwest CEO and KC Magazine.  An additional 3,500 surveys were sent to leaders of financial service industry companies.

On the surveys, recipients were asked to select only wealth managers whom they knew through personal experience, and to evaluate them based upon nine criteria: customer service, integrity, knowledge/expertise, communication, value for fee charged, meeting of financial objectives, post-sale service, quality of recommendations and overall satisfaction.

By July, stacks of surveys had arrived and Crescendo began carefully scoring each wealth manager.  Both positive and negative evaluations were included in the scoring.  Only wealth managers with five years of experience in the financial services industry were considered.

Next, each wealth manager was reviewed for regulatory actions, civil judicial actions and customer complaints as reported by FINRA (the Financial Industry Regulatory Authority) and other regulatory agencies.

Then, before finalizing the list, wealth managers were reviewed by a blue-ribbon panel.  The blue-ribbon panel was comprised of knowledgeable individuals from within the financial services industry.  Although panelist comments were incorporated into the final score, safeguards were built into the review process to reduce the ability of panel members to influence the composition of the final list on the basis of company affiliation.

The resulting list of 2009 FIVE STAR Wealth Managers is an elite group, representing less than 2 percent of the wealth managers in the Kansas City area.  Only 215 of the top-scoring wealth managers made this year's list.  We hope this list serves as a referral network for the 135,000 readers of Midwest CEO and KC Magazine.  Is this list exhaustive?  Of course not.  There are undoubtedly many other excellent wealth managers who, for one reason or another, are not on this years list.

_______________________

Research Declarations: As with any research or recognition program, it is important that we provide you the following declarations: 1)The 2009 FIVE STAR Wealth Managers to not pay a fee to be included in the research or the final list of the FIVE STAR Best in Client Satisfaction Wealth Managers. 2) The overall evaluation score of a wealth manager reflects an average of all respondents and may not be representative of any one client's evaluation.  3) The FIVE STAR award is not indicative of the wealth manager's future performance.  4) Wealth managers may or may not use discretion in their practice and therefore may not manage their client's assets.  5) The inclusion of a wealth manager on the FIVE STAR Wealth Manager list should not be construed as an endorsement of the wealth manager by Crescendo Business Services, Midwest CEO or KC Magazine. 6) Working with a FIVE STAR Wealth Manager or any wealth manager will be awarded this accomplishment by Crescendo in the future.  For more information on the FIVE STAR Award and the research/selection methodology, go to: fivestarprofessional.com/wmresearch.

Four Steps to Protect Your 401(k)

For many American workers, just thinking about the damage done to their retirement accounts can be a little painful.  So what can you do to stem the flow of any more money out of your 401(k) or other similar plans?  Here are four ways that might help ease your pain.

Patience is a Virtue

First off, let's start with what you shouldn't do.  Don't stop contributing to your retirement plan or cash it out entirely.  Remember that you are in this for the long run, in most cases you won't need all your savings immediately and your investments should have time to rebound.  If you stop contributing to your plan you will miss out on the wonderful world of compounding income.  In addition, you could also miss out on free money if your employer matches your contributions.

Study Your History

Markets can go up and down, but history has shown that in the long term they go up.  After each big drop througout the years, stocks have rebounded and markets avhe reached new highs.  In addition, for long-term investors a severe bear market can be a good thing.  You can buy more stocks or funds at cheaper prices, and then reap the rewards when the market recovers.

Review Your Investment Plan

The reason you probably set up your 401(k) account was for buying and holding investments, and not for day-trading stocks.  However, it never hurts to review your plan based on your changing personal situation and risk tolerance.  A solid, long-term strategy that involves a well-diversified portfolio should protect your 401(k) or other retirement accounts during rough times (depending upon your risk tolerance and asset allocation).  Also, don't forget to assess your risk tolerance.  Figure out hom much you need to save for retirement and calculate how much to set aside each month to reach your goals.  If you're young, your 401(k) portfolio should hold almost entirely stock funds.  While stocks carry greater risks they also provide greater returns than bonds and money market funds.  Be sure you diversify through funds though funds of large, small, domestic and international companies, as well as growth and value stocks.  In addition, use fixed income securities to reduce your portfolio's volatility.

Avoid the Big Mistake

Working for a company does not mean the stock is a safer investment because you feel like you "know" the company.  A September 2008 article in the Wall Street Journal noted that employees of Merrill Lynch, Morgan Stanley and Lehman Brothers had lost significant amounts of their retirement holdings because of they had substantial amounts invested in their company's stock.  If you haven't done so already, think twice before you load up on your company's stock, no matter how comfortable you are with your employer's current financial situation.

Current Market Conditions and Your 401(k) Retirement Plan Frequently Asked Questions

From the December 2008 The Educated Investor, this article explores and lays to rest some concerns people are having regarding their 401(k) plans and the current markets.  Click here to view the article.

The Educated Investor Newsletter: Black Swans by Nassim Taleb

"When the market experiences significant swings, some investors may be tempted to try to time the market in an effort to boost returns.  The following explains why it is extremely difficult, if not impossible, to enhance returns through market timing efforts."

Please click here to view the article.  You will need Adobe Acrobat reader or compatible software to view.