Posted: April 09, 2013

The bear, the bull—and the 10 lessons learned, Part 2

Three more

Peter Mustian and Eric Overbey

(Editor's note: This is the second of three parts. Read Part 1.)

 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 more 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.

4. Liquidity Matters

Simply stated, market liquidity is the ability to sell an asset without causing a significant movement in its price. For markets to successfully function there needs to be a balance of enough liquidity to encourage market activity, but not too much that could lead to excessive debt and asset bubbles.  Many economists refer to liquidity as the “lifeblood of the markets,” because if liquidity stops flowing, the markets can come to a crashing halt.

Despite its importance, liquidity can often be taken for granted by investors, leading to painful results. Before 2008 many investors assumed that the ample liquidity that had been available in the past would continue to allow quick liquidation of their positions at fairly predictable prices. As the financial crisis accelerated, fear quickly took hold within the markets and liquidity began to dry up.

Many investors who had overestimated their financial strength and underestimated the damaging impact of illiquidity were obliged to sell assets at prices sharply lower than just a few months prior. Prudent investors need to constantly assess how much of their portfolios should be in highly conservative, liquid investments in order to avoid having to sell parts of their portfolio when liquidity stops flowing.   

5. Market Timing is an Unsuccessful Strategy

It is impossible to accurately and consistently predict short-term market movements in order to be invested when prices move up and on the sidelines in cash when prices fall. Market timing requires an investor to link at least two right decisions: when to get in and when to get out. Then these two successful decisions must be repeated multiple times to be effective over the long-term.

Being out of the market at inopportune times can be very costly. An investment made 25 years ago in the S&P 500 Index would have earned an average annual return of +10.4 percent before taxes and transaction costs. However, if the same investment missed out on the top performing 25 days in the market during this period of approximately 6,300 trading days, the average annual return would have shrunk to +4.3 percent. Peter Lynch, former portfolio manager for Fidelity Magellan Fund commented, “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves.”

Looking at 2008 and 2009, very few investors fully anticipated the depths of the economic recession, as well as the timing of the subsequent rebound. Sadly, many investors that were swayed by their emotions and sold their equities after the steep declines returned to the market (or are still waiting to do so) only after its dramatic rebound. The result of this poor timing is that investors locked-in meaningful losses and then missed out on the subsequent gains. In the end it is better to have a long-term strategy based on appropriate downside risk tolerance and systematically rebalancing the portfolio in both good and bad markets.

“Successful investing is about always trying to gauge the ratio of risk to reward. If you choose to ignore any form of risk, your outcome could prove to be less satisfying than you expected.” -- Ross Moscatelli, Denver Investments

6. Tail-Risk Should Not Be Ignored

In recent years, Nassim Taleb, author of the acclaimed book “The Black Swan”, has popularized the term “tail-risk”, or “fat-tails”. This expression is often used to describe systemic events that cause abnormal, asymmetrical market declines greater than three standard deviations. In other words, these events are akin to 100-year floods.

While fat tails represent statistically improbable events (0.15 percent probability in any one year), in reality they occur more often than statistics would lead us to believe. Since 1972, the S&P 500 Index has experienced four distinct periods with market stress exceeding three standard deviations. Given the frequency of abnormal market distress during the past four decades, investors have become increasingly aware of the impact of tail risk and continue to search for ways to avoid such events.

The inability to effectively quantify potential fat tail events may have been a primary factor contributing to the recent credit crisis. Many investment banks, including Lehman Brothers and Morgan Stanley, used a common metric known as Value at Risk (VaR) to identify maximum downside risk in their portfolios. VaR attempts to measure maximum downside risk on the basis of normally distributed risk/reward characteristics and asset class correlations.

However, the model’s failure to account for increasingly common abnormal events contributed to some of the largest losses ever witnessed on Wall Street, including the collapse of Bear Stearns and Lehman Brothers. While there is no proven solution to avert all systemic risks, the use of derivatives and cash floors have become somewhat more common. Nonetheless, these methods tend to have significant costs and may drag on portfolio performance. For now, the best remedy for systemic shocks is likely the benefit of maintaining a well diversified portfolio over a long time horizon.

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.

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