Investing Within the Context of Volatility

Since 2000, the volatility in the stock market has been staggering, with the 10-year return on the S&P 500 Index virtually flat. So what are investors to do? What steps should be considered? Are there any lessons to be learned? Doug Keegan of Harris SBSB is here to explain.

Doug, there’s no denying that this past decade has been fraught with volatility. From the tail-end of the tech bubble to the bursting of the housing bubble, it has been an incredible ride. What’s your take on all this and what can investors do?

Lowman, this past decade has been horrific. And a lot of people did a lot worse than the averages. At least if you had held on to the S&P 500 for the past ten years you’d be close to breaking even. But the scary thing is people panicked along the way and either sold at the bottom or bought at the top. I mean, many investors don’t even earn the charts because nobody can stay in when the herd is running off the cliff. Investors tend to pull out right at the worse time and they only buy at the top because that’s when they love it, they hate it at the bottom. You couldn’t get anybody interested in the markets in February and March of 2009. Yet we had a tremendous rebound. So my point is when you see those index returns, they’re illusionary because unless you hold on to them for the long run, you won’t get those returns. You’re better off with an investment that isn’t going to scare you out of the market and that produces a more stable return because then at least you’ll earn that return.

Isn’t that because investors tend to focus on individual investment performance, not overall portfolio performance?

That’s it. Investors tend to pick apart their portfolio to the point where they don’t have true diversification anymore. You see you need investments in your portfolio that mask the volatility. Let me give you an example. From 1982 to 2000 the stock market experienced an unprecedented bull market run, with the S&P 500 increasing over 1,200%. At the tail-end, investors started taking on more and more risk, chasing returns and ignoring diversification. But let me ask you this, just before the whole tech bubble burst and the stock market imploded, did you hear anyone on TV telling you to diversify into gold? No. But gold’s up 300%. What about bonds? Who wanted to buy boring bonds back in the late 1990s? But the U.S. Aggregate Bond Index is up over 80%. Now you tell me. Looking back, wouldn’t you now look like a genius if you had told investors to diversify into gold or bonds? Sure you would. But back in 1999, gold was coming off a 20-year losing streak. If you had told the average investor to put 20% of their money into gold for diversification, I think most people would have fired you or at best questioned your advice.

But isn’t that human nature?

You’re absolutely right. You see, people act in the stock market very differently then they act in the supermarket. When we observe people in the supermarket, they’re individualistic and strong in their opinions. But in the stock market, people tend to herd, it’s ridiculous. There’s so much risk and there’s so much of their future involved, yet they tend not to think independently and they don’t stay with their convictions. Think about it Lowman, people spend their whole lives living as frugally as they can, clipping coupons, driving beat up cars, and then stock market comes along and takes it all away. To me, you’re right. You’ve got to really think of the behavioral side.

My point is this: what good is theory if you can’t implement it? Most people can’t stomach volatility. Drs. Shiller and Akerlof and a host of other Nobel laureates who work on the behavioral side are right. If investors can’t psychologically deal with volatility, then it doesn’t matter.

So what can investors do?

I’m a big believer in keeping portfolio volatility down. And that means getting investors to do uncomfortable things that payoff in the long run. For example, we know that when an investment is in a bear market it may go down 20, 40, or even 60%, but when an investment is in a bull market it can go up 100 to even 200%. So during any broad period of time, the investments that are doing well will have a far greater impact than the ones that are doing poorly. Yet investors tend to pick apart a portfolio and complain why certain asset classes aren’t performing. Then they get anxious and sell the losers, just at the moment when they shouldn’t. They listen to the news or others and think that have to act. And remember, professional money managers fall into this trap too, but for different reasons. What most retail investors don’t understand is that you truly need uncorrelated asset classes, meaning investments that don’t all move in the same direction at the same time. But uncorrelated asset classes are hard to deal with because it means that you’ll always have a big part of your portfolio that’s losing and not working. And that’s what makes people uncomfortable, because you could have a big loser inside your portfolio for a long period of time. But like I said, during any broad period of time, the winners tend to outpace the losers, so overall you should come out ahead while experiencing a lot less risk.

I understand portfolio diversification, but what causes volatility in the first place and the need for asset allocation?

Lowman, this is a very good question and it can get quite involved because there are a number of things that cause volatility, both inside and outside the financial system. But let me explain it in general terms. At any moment, we can be in any of four economic environments: prosperity, inflation, recession, or deflation. And there are asset classes that respond well to each of those four economic environments. So using those asset classes, you’ll want to create an asset allocation such that your portfolio can weather any economic storm. To learn more about this approach, I recommend reading Harry Browne’s Fail-Safe Investing. His argument is don’t concern yourself with the individual investments, it’s the total package that gives you the safety. He says tear apart the package and you tear apart the safety.

Can you give us an idea as to the framework? What would be inside the portfolio?

From my point of view, what you want to own are five asset classes: stocks, bonds, commodities, real estate, and cash. And you’ve got to invest globally, because if you just think U.S. centric, and we lose our leadership in the world, you’re going to lose everything. So when it comes to stocks, we know that a country’s economic output and stock returns track together, so I’d create a diversified global stock portfolio based on a country’s percentage contribution to world economic output. I’d use the same approach with bonds. It’s so important to understand that U.S. debt is not as safe as it used to be. We know this from the pricing on credit default swaps, which is the cost to insure a bond from defaulting. Lowman, did you know that California bonds rank 9th, just above Lithuania and right under Greece, as one of the most expensive credit default swaps on the market. So you have to have global bonds otherwise you put yourself at risk. For real estate, I’d recommend owning non-traded real estate in addition to publicly traded global real estate. With commodities, you can use a fund that tracks a commodities index, representing energy, precious metals, industrial metals, livestock and agriculture. And finally, cash. In the old days we’d say keep U.S. dollars, not anymore. Now you need to diversify by owning a basket of currencies from countries with sound monetary policies.

Those are the investments. Let’s talk about the asset allocation. To keep it simple, allocate 20% to each of the five asset classes I mentioned. Now, I know that this asset allocation is conservative, but that’s precisely why I want it. My goal is to build a portfolio to protect me no matter what happens. Because even at its worst, no investment has more than 20% of my assets, so it won’t devastate my portfolio. Now will this portfolio guarantee me a return each year? No. Will it outperform the best investment of the year? No. But can it give me safety and stability. Yes. And it’s that safety and stability that keeps you in the market and makes you less vulnerable to mistakes in judgment.

So when is the best time to start? Can you time to buy in?

When you try to time what you’re doing, you’ll screw it up as sure as night follows day. Timing is so deadly because you have to make all the right calls. And no one can consistently do that. Just put 20% in each of the five asset classes I mentioned. Remember, it’s the package that provides the safety. You tear apart the package and you tear apart the safety.