As we write this letter the US Stock market is down ~ 9% year-to-date and off ~16% from its all-time highs in September. Times like these tend to remind investors of the inherent risk in investing. However, the volatility evidenced by recent market returns, while at times harrowing, is not, in our opinion, the truest definition of risk.
Real risk is the likelihood of permanent capital impairment. There are many ways to permanently impair capital, including paying too much for an investment that never recovers its value, investing in penny stocks or “fraudulent” entities with little or no real prospects of success, starting a small business that fails, etc. There is a long list of ways to lose capital, but in our experience the most frequent, and under the radar, is “policy abandonment”.
Policy abandonment occurs when a well thought out investment policy designed to generate long-term returns is abandoned for short-term reasons. This typically happens when markets decline, fear takes hold and investors want to stop the “losses” they see mounting in their portfolio. So they sell and feel more comfortable and safe for a period of time. But inevitably, markets rebound and the investor is caught in a difficult position. Buy back in? Wait for a larger decline then get in? Wait for the news to get better? The long-term investor has now un-intentionally become a short-term speculator.
Policy abandonment misses a key point on how markets work. Financial markets in aggregate are driven over the long run by the aggregate ingenuity, work ethic, intelligence, and innovation that working people put in to their jobs every day. As he so often does, Warren Buffett richly describes this long-run wealth effect:
“This country is incredible. I mean if you think about it, if you put three of me end to end, at 87, it’s 20 years before Thomas Jefferson wrote the Declaration of Independence. Three life times like mine and you’ve transformed a prairie land— basically nothing was here — into $92 trillion.That’s the most recent estimate of American wealth. From nothing. And the good news is the game has just started.”
The trade-off for participating in this long-term growth is the acceptance of asset price volatility. At ~ 23,000 today, Dow 50,000 seems like an almost impossible objective. But to get there would only require a ~4% annualized rate of return over the next 20 years, roughly ½ the long-term return of the market. At the market’s long run average rate of return we would hit that level in just 10 years.
If you have any reasonable degree of time horizon in your portfolio, the odds are in your favor to ride through the volatility rather than try and speculate on the “market’s” next move. If your time horizon is significantly shorter than this, then your investment policy should reflect this via some degree of allocation to more conservative assets like investment grade bonds and cash.
To be clear, we don’t wish for bear markets or recessions any more than anyone else. But, they are a basic fact of investing in the financial markets. We can either approach them from a rational, long-term point of view – or we can panic and speculate. We choose the former.
At AMM we will continue to manage your money adhering to our firm’s 5 core principles, and with a focus on the long-term. Over time we believe this will provide us the best opportunity to achieve the goals you hired us for: to protect and grow your wealth.
If for some reason you are considering a policy change, please contact us immediately so we can discuss and determine if it is appropriate for you. While policy abandonment is a real portfolio risk, it doesn’t mean there aren’t good reasons to change policy (i.e. change in life circumstance, income, etc.).
As we near the end of 2018, we wish you a very happy holiday season and a prosperous 2019!