Investment takeaways worth applying in the new year.
Every year the markets provide investors with lessons on the prudent investment strategy. This year's bear market provided a sufficient number of lessons that it should be considered a "doctoral seminar."
Neither investment banks nor other active managers (including hedge funds) can protect investors from bear markets. All crystal balls are cloudy, which is why Warren Buffett concluded: "The only value of stock forecasters is to make fortune-tellers look good."1 If their money managers could protect you, why did firms like Lehman Brothers and Bear Stearns go belly up, and Merrill Lynch have to be rescued by Bank of America? It is in the best interest of these firms to manage their risks well. Yet, they have clearly demonstrated that they cannot.
As evidence of their lack of ability to forecast events, consider that in 2008, Lehman spent $751 million buying back its own stock at an average price of $49.60, and Merrill Lynch spent $5.27 billion buying back its stock in 2007 at an average price of $84.88.2 We can only conclude that with all the conflicts of interest that exist between these firms and their clients, there is no reason to think that they would manage their clients' risks any better. Investors don't need to pay Wall Street big fees to have their money managed. Large fees are only likely to make managers rich, not investors. Wall Street's best skill is designing products that separate capital from owners.
Never take more risk than you have the ability, willingness or need to take. Violating this rule is what led to the failure of Lehman, Bear Stearns, AIG and others. They all took on so much leverage—especially considering the risky nature of the assets—that they had to be right all the time, not just in the long run.
Diversify broadly across many asset classes. However, remember that even low-correlating risky assets have a nasty tendency to have correlations rise at the worst time. Thus, make sure your portfolio has sufficient fixed-income assets of the highest quality so that overall portfolio risk is reduced to the appropriate level.
For fixed-income assets, stick only with Treasuries, bonds of government agencies and the highest-rated municipal bonds (AAA/AA). With municipal bonds, make sure the underlying rating (not the rating with credit insurance) meets that test. Anything else (such as high-yield [junk] bonds, convertible bonds, emerging market bonds and preferred stocks) can have the risks show up at the wrong time and, thus, should be avoided. Their risks do not mix well with equity risks.
Thus, although such instruments are touted for their additional return, what little additional expected return they actually offer is more than offset by their greater risks when considered in the context of the overall portfolio. If one is willing to take incremental risk, they should do so by increasing their equity allocation. The incremental expected returns can then be earned more tax efficiently and the risks can be more effectively diversified.
Don't confuse the familiar with the safe and concentrate labor capital and financial assets in the same basket. Many employees of once-great companies lost not only their jobs, but also much of their financial assets because they made this mistake.
One of the more persistent myths is that active managers can protect you from bear markets. In 2008, the hardest-hit sector was Financial stocks. Financials comprise a significant portion of the asset class of value stocks. As benchmarks for the active managers, we can use the Vanguard Small Value Index Fund that lost 32.1 percent and the Vanguard (Large) Value Fund that lost 36.0 percent.
The following is a list of the returns of some of the actively managed mutual funds with superstar value managers, four of whom were named by Morningstar in June 2008 as their recommendations to run value superstars (noted with *):
- Legg Mason Value Trust lost 55.1 percent
- Dodge & Cox lost 44.3 percent*
- Dreman Concentrated Value lost 49.5 percent
- Weitz Value lost 40.7 percent*
- Schneider Value lost 55.0 percent*
- Columbia Value and Restructuring lost 47.6 percent*
Of course, some actively managed value funds beat those benchmarks. However, how would you have known ahead of time which ones they would be? As the Security and Exchange Commission's required disclaimer states: Past performance is not a predictor of future performance. Thus, the prudent strategy is to use only passively managed funds.