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05/07/2009
Lessons for the Future
By
Marshall E. Blume
We have experienced one of the worst economic scenarios in memory. Investors have lost trillions of dollars in the stock markets, and unemployment rates are close to the highest they have ever been in the last sixty years. GNP has dropped significantly in the last six months. Fortunately, there are now a few signs that we are near the bottom of this recession.
Times of crises carry with them lessons for the future. What have we learned? For one thing, investors undoubtedly have a better understanding of the meaning of risk. It is one thing to talk hypothetically about risk, and another to have experienced such risk.
Most of our clients have chosen portfolios diversified over stocks and bonds. Such well-diversified portfolios have served our clients well, as the investments in bonds have cushioned the large losses on equities. This is no accident as PMAs guiding tenet is to help each client pick a level of risk that is consistent with his or objectives, being neither too high nor too low. In the past, the selection of an appropriate risk level may have seemed academic, but the recent market turmoil shows how important that decision is.
Another lesson is the deception of averages. My colleague Jeremy Siegel in his Stocks for the Long Run argues that stocks are the best investment for an investor with a long horizon. Over long periods of time, the average annual returns on stocks have exceeded those on bonds. Further, he points out that in virtually every 35-year period from 1802 through 2006, stocks have returned more than bonds.
The flaw in this line of reasoning is that it assumes a buy-and-hold strategy. Such a strategy may describe the strategy of a thirty-year old, who plans to save and invest for the next thirty-five years. The plunge in equities today may just be a blip in the video of life events.
To the retired, such plunges can have a real effect on life style. Unless spending is reduced, a retired person will eat into his or her investments, and when the market recovers, the dollar gains will be less. The diversified portfolios that most of our clients have mitigated the large losses that many other investors have experienced.
Remember that an expected return is just the average of yearly returns. Some returns will be above the average, and some will be below the average. To make an informed investment decision, an investor must understand the volatility of those returns around the average. Generally, as volatility increases, expected returns increase, but so does the probability of losses.
The most important decision facing an investor is how much volatility or risk to assume. There is no right answer, and each investor must weigh the potential long-term gains from taking on more risk against the impact of occasionally large losses. The large equity losses experienced by many investors over the last year and an half validate PMAs emphasis on selecting an appropriate level of risk.
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