Aug. 21 Memo to Clients re: Stock Declines

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The past few days have seen sharp declines in US stock prices, but as of August 20, the S&P 500 stock index is down all of 1% for the year, and still above its January 30th low by approximately 2%.  The current problems for the market range from slow world-wide economic growth; to more specific problems in China, and certain European countries ( eg, Greece);  to sharply declining commodity prices (which has a mixed impact on various countries, depending on whether they are primarily producers or consumers of commodities); to the likely beginning of interest rate increases in the US. Having stated the problems, it is important to note that none of them are new to the markets.

It is also worth noting that US interest rates on high credit bonds have declined modestly during the recent stock price declines, which means those bond prices have increased modestly.

As a context for the current stock declines, since the more than 50% declines that ended in March, 2009, the S&P 500 index has tripled in value (low of 677 to current 2,036). During this six plus year time frame  there has been only one period with serious stock price declines, from April 2011 through October 2011, when the S&P 500 declined  20% (1,362 to 1,100).  Since that 2011 decline ended, the index is up more than 80%.   Many of these historical figures can be found in our regular Monthly Comments.

In considering our message for the current stock price declines, we thought a repeat of portions of our August 2011 memo would be appropriate.

“We want to reemphasize our commitment to the idea that properly developed asset allocations, designed specifically for each client’s goals and risk tolerance, provide the basic rationale for not changing investments during periods of extreme downward market volatility….”

After presenting various figures, and a discussion of the problems of that time, we concluded as follows:

“As usual, we make no predictions as to whether these problems can be solved in a reasonable or timely manner. The future is always unknown. However, to the extent your financial goals require investments in what are by definition uncertain markets, we continue to advocate that your best defense is to maintain an asset allocation that allows you to get through times of high volatility without making changes that involve selling the poorly performing asset class.”

We would also add that it should not be surprising for stock prices to experience some period of decline, given the remarkable gains of the past six years.  There is no avoiding the investment truth that stocks can provide both significant gains, as well as uncomfortable declines. Trying to time these price moves we believe cannot be done consistently. Relying on your established allocation continues to be the best way to navigate the inevitable periods of downturns.

Is “picking winners” actually a loser’s game?

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For decades, Wall Street firms have marketed their ability to beat the market with their active investing strategies. The claim hinged on each firm’s ability to “pick winners,” stocks whose returns would beat the market’s. This market-beating ability would, in turn, justify the firms’ high fees.

But in fact, active management rarely provides better investment results than what could be earned simply by owning and holding broad market indexes. A recent “Your Money” column by the New York Times’ Jeff Sommer (“How Many Mutual Funds Routinely Rout the Market?  Zero,” March 15, 2015) cites a substantial body of research showing that, over the past five years, not a single actively managed mutual fund has “actually managed to outperform the rising market.”

Sommer’s column discussed recent research that looked at the following: Starting with 2,862 actively managed domestic stock mutual funds in operation through the 12-month period between April 2009-March 2010, the study selected the top quartile of funds for those 12 months, then analyzed which of those funds continued in the top quarter for each of the next four 12-month periods through March 2014.

The answer: two. Out of the total pool of 2,862, only two – less than 1/1000 of the total pool – had consistently beaten the market. Keep in mind: all of these funds are run by smart, sophisticated investment professionals, yet they could not keep pace with market returns. Sommer notes that the two funds that had done well for the four years through March 2014 have since experienced “a mediocre stretch, at best.”

In Sommer’s concluding words: “The study seems to support the considerable body of evidence suggesting that most people should not even try to beat the market: Just pick low-cost index funds, assemble a balanced and appropriate portfolio for your specific needs, and give up on active fund management.”  

This customized allocation approach, using low-cost indexed investments, has been PPA’s consistent strategy since its founding in 2003. Sommer’s column can be read in its entirety here:

Why We Don’t Use Active Funds

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We’ve never believed that “actively managed” investments can reliably outperform index funds over longer-term timeframes. (NOTE: when we use the term index funds, we mean mutual funds and Exchange Traded Funds (ETFs).) Turns out, the evidence is on our side: over the past decade, the vast majority of actively managed funds – large-cap, mid-cap, and small-cap alike – underperformed their benchmark indices (source: S&P Dow Jones Indices, SPIVA 2014 Year-End Scorecard). See also Prof. Burton Malkiel, A Random Walk Down Wall Street: the Time-Tested Strategy for Successful Investing; John Bogle, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor.

Given actively managed funds’ underperformance, why do they cost so much? Interestingly,  it is those extra costs associated with active management that end up being the main reason for their long term underperformance when compared to a benchmark index, which is one of Bogle’s main points.

Some of the extra cost goes for research, the goal of which is to pick stocks that will do better than the aggregate investment result of the stocks in the benchmark index. Then there are the trading costs that arise when stocks are bought and sold by the fund managers. Taxes on gains also add to the cost of owning the fund. Some funds add their own distribution costs to the fund, paid by the investors. And sometimes there are sales commissions, referred to as “loads,” paid to brokers for selling the funds, which would add another cost.

By comparison, the investor in an index fund pays a very low fee to the fund, which does no research, has few trading costs and few taxable distributions, adds no distribution costs, and has no loads. The index fund invests in all the stocks that meet the definition of the index the fund has developed (e.g., various emerging market indices), or invests in an existing index the result of which the fund is designed to match (e.g., the S&P 500 index). There is no picking and choosing of certain stocks to the exclusion of others, within the universe of stocks in the index.

Over time, many in the investment community have come to realize that all the smart people, and sophisticated strategies, trying to pick the outperformers adds up to an exercise in futility. We think the better approach is to buy all the stocks in the various sectors of the markets that you are interested in, using low-cost index funds, and then let the aggregate result of those sectors be your result, absent the unnecessary, and, over time, self-defeating costs.

What’s the most important thing to you?

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Chances are, money was not the first thing that crossed your mind.

Make no mistake: money is extremely important in our lives and our world: it shapes our behavior, often drives our decision-making, and colors the way we think and speak. But money, at core, is just a tool. We don’t earn money for money’s sake. We do it to have a home, support the educational pursuits of our children and grandchildren, retire comfortably, see the world, invest in our community. Money, at core, is a vehicle to express our deeply held values, goals, and priorities. The purpose of our financial advisory work is always to achieve something more than money.

At Park Piedmont Advisors, a big part of the work we do is to help our clients envision and plan for their future. We understand that, for virtually everyone, the future is full of both promise and uncertainty. And the timeframe for measuring success is long.

So: what do you want your money to help you accomplish?