Tuesday, October 20, 2009

History Is Full of the Wrong Lessons

“Reload” said Bill. I had just pushed a drive out of bounds on the eighth hole at the Valley Club in Ketchum Idaho. “Dammit” I replied. “I really had a good round going.” (For the record I was one over par after 7 holes). “Yup, you have it goin’ today.” said Bill. “Too bad we’re history after the next hole.”

“We’re not playing 18?” I said as I re-teed.

“Fraid not. Check out the saddle between those two mountains ahead of us. See that whitish cloud that looks kinda like fog? It ain’t fog. It’s snow, and it should arrive in about 20 minutes.”

Sure enough, as we putted out on the ninth hole the snow flurries arrived and we were done for the day. Snow was the furthest thing from my mind when I packed up from South Florida to enjoy a little Indian summer in Sun Valley.

The statistics for Sun Valley in September are actually quite compelling. The average high temperature in September is 74°; the average low is 38°. The average precipitation is just 8/10 of an inch.

What actually happened was quite different…highs in the low 30s, lows in the teens, and 7 inches of snow. Looking at averages can be misleading when it comes to weather and of course investing.

“Reload” said Bill. I had just pushed a drive out of bounds on the eighth hole at the Valley Club in Ketchum Idaho. “Dammit” I replied. “I really had a good round going.” (For the record I was one over par after 7 holes). “Yup, you have it goin’ today.” said Bill. “Too bad we’re history after the next hole.”

“We’re not playing 18?” I said as I re-teed.

“Fraid not. Check out the saddle between those two mountains ahead of us. See that whitish cloud that looks kinda like fog? It ain’t fog. It’s snow, and it should arrive in about 20 minutes.”

Sure enough, as we putted out on the ninth hole the snow flurries arrived and we were done for the day. Snow was the furthest thing from my mind when I packed up from South Florida to enjoy a little Indian summer in Sun Valley.

The statistics for Sun Valley in September are actually quite compelling. The average high temperature in September is 74°; the average low is 38°. The average precipitation is just 8/10 of an inch.

What actually happened was quite different…highs in the low 30s, lows in the teens, and 7 inches of snow. Looking at averages can be misleading when it comes to weather and of course investing.

Arithmetic Lesson

However, there are times when looking at averages can be helpful. Consider the following example. Let’s assume that your investment portfolio returns over four years were:

Year 1 (+15%)
Year 2 (+15%)
Year 3 (+15%)
Year 4 (-15%)

What is your average rate of return? Many people are surprised to find out that it is just 6.9%.

The more important question is what must you gain in year five to get back to a 15% average rate of return? The answer? You need to be up 54% to get back to a 15% average return.

Home Runs vs. Singles and Doubles

The point is that it’s not how much you make when the market is going up that’s important. It’s what you don’t give back when the market declines that determines how well you’ll do long term.

Put another way, as the Dow crosses 10,000 many are thinking about upside potential and how long the rally can last. The smart money is concerned with down-side protection.

Cash Is Trash

With over $3 trillion sitting in money market funds it’s clear many investors have been sufficiently frightened into holding an “investment” paying less than 1%. Many have professed that “cash is king.”

I don’t buy it. With very few historical exceptions, cash has simply been a parking place for money with no real returns above the rate of inflation. To beat inflation you have to consider stocks.

Does buying an S&P index fund make sense here? We don’t think so. You don’t want to own “the market”.

But remember, it’s not the stock market… it’s a market of stocks. It’s not the bond market… it’s a market of bonds. Security selection will be critical going forward.

Cash Is Trash

With over $3 trillion sitting in money market funds it’s clear many investors have been sufficiently frightened into holding an “investment” paying less than 1%. Many have professed that “cash is king.”

I don’t buy it. With very few historical exceptions, cash has simply been a parking place for money with no real returns above the rate of inflation. To beat inflation you have to consider stocks.

Does buying an S&P index fund make sense here? We don’t think so. You don’t want to own “the market”.

But remember, it’s not the stock market… it’s a market of stocks. It’s not the bond market… it’s a market of bonds. Security selection will be critical going forward.

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