Posted: April 08, 2013

The bear, the bull—and the 10 lessons learned, Part 1

Long-term investment challenges faced and overcome

Peter Mustian and Eric Overbey

Long-term investors face constant challenges. Their emotional fortitude and their net worth are constantly being tested by the painful losses of market crises, as well as the ensuing allure of pleasurable profits. Perhaps no back-to-back calendar years in the last seven decades tested investors quite like the equity bear market of 2008 and the subsequent steep bull market (most of 2009).

Here are some of the enduring principles of investing that have recently come into sharp focus. We firmly believe that acting on these lessons is essential for successful long-term investors.

1. Be Patient and Do Not Panic

The often-cited proverb, “Patience is a virtue,” is applicable to many facets in life and can be particularly helpful for investors during challenging economic times. History has shown that market declines are inevitable. Since 1900, there have been 32 stock market declines of 20 percent or more. Understanding that declines, some quite prolonged and steep, are part of investing can provide some necessary perspective, thereby helping investors avoid the temptation to overreact. As Portfolio Manager Howard Marks of Oaktree Capital recently said, "Investment performance in a single year should matter principally only to people who are going to liquidate their portfolios at the end of that year."

While maintaining a long-term perspective through down times can be difficult, it can often lead to significant rewards for long-term investors. The five-year average annual return following the 32 declines of 20 percent or more was +11.4 percent. It is also important to keep in mind that the market has gone up more often than it has gone down.

From 1928 to 2009, the U.S. stock market delivered positive returns in 60 out of 82 one-year periods, or 73 percent of the time. After the equity market bottomed in March of 2009, large cap stocks gained 77 percent through March 31, 2010. This strong rebound was enjoyed by those who remained patient and didn’t panic. As one portfolio manager recently opined, “Often times the best investment is the hardest one to make at the time.”    

2. Downside Risk and Leverage Should Not be Ignored

The credit crunch from the end of 2007 to 2009 reminded consumers, companies, and investors of the painful consequences of risk and leverage. As markets recover and credit becomes more available, investors must keep in mind that debt and risk are not just a means to generate excess returns, but come with very real costs. Corporations, and more importantly investment strategies, that employ excessive leverage must be scrutinized and closely monitored.

Many market pundits have urged companies, as well as hedge fund managers, to realign managers’ compensation with the interests of shareholders. If a manager is compensated for near-term results, that individual is more likely to take on excessive risk to achieve those goals. Even if this approach may lead to short-term success, in most cases it will result in long-term failure.

Investors should reevaluate their risk aversion, including the maximum downside loss with which they are truly comfortable.  Although we anticipate that markets will trend upward in the long-run, investors need to consider their staying power during periods of significant wealth destruction before determining their return target.

Every investment has risks. For instance, many investors believed real estate property values could not decline, which we soon discovered to be far from the truth. As stated by legendary investor John Bogle, “When reward is at its pinnacle, risk is near at hand.”

3. Correlations Increase in Times of Market Stress

Investment professionals have widely accepted the portfolio construction process of Modern Portfolio Theory (MPT). MPT suggests that by combining a series of uncorrelated asset classes with favorable risk/reward characteristics, an investor can reduce overall portfolio volatility. While the theory holds true over the long-run, during periods of extreme market stress the correlations of riskier asset classes tend to converge.

Even effective long-term portfolio diversifiers such as commodities and REITs fell when stocks tumbled in 2008. The correlation of the DJ UBS Commodity Index to the S&P 500 increased exponentially from 0.05 before Lehman Brothers’ collapse to 0.84 afterwards. In addition, the DJ Wilshire REIT Index went from a correlation of 0.37 to 0.85 over the same time period. Many market observers contend that the integration of capital markets and free trade have decreased the diversification benefits between asset classes. Should market integration continue to increase, investors may have difficulty identifying asset classes with long-term diversification benefits.

Despite recent challenges, several asset classes held their diversification benefits from 2008 to early 2009. Most notably government and municipal bonds maintained fairly low correlations to equities during the market downturn. Additionally, hedge fund of funds had moderately low correlations to domestic equities, despite experiencing declines as leverage unwound in late 2008. Investors should remember that history has repeatedly proven the benefits of remaining broadly diversified over full market cycles. While maintaining diversification may not prevent portfolio losses in down markets, it should continue to mitigate portfolio volatility over the long-term.

Peter Mustian, MBA, is a principal and director at Innovest Portfolio Solutions LLC. He is also a member of the Capital Markets Research Group, responsible for asset allocation studies and portfolio construction and Innovest’s Investment Committee, which makes decisions on investment related research and due diligence.  He has more than nine years experience in the investment industry.

Eric Overbey is a consultant and vice president at Innovest and is a member Innovest’s Investment Committee, which makes decisions on investment related research and due diligence.  He is also a member of the firm’s Capital Markets Research Group and the Due Diligence Group, responsible for both qualitative and quantitative manager due diligence.

Enjoy this article? Sign up to get ColoradoBiz Exclusives. The opinions expressed in this article are solely that of the author and do not represent ColoradoBiz magazine. Comments on articles will be removed if they include personal attacks.

Readers Respond

Commenting is not available in this channel entry.

ColoradoBiz TV

Loading the player ...

Featured Video