“No amount of sophistication is going to allay the fact that all your knowledge is about the past and all your decisions are about the future.”
Ian H. Wilson, 1923 – 2014, former GE executive
BACK TO INVESTING BASICS
Each spring, tens of thousands of investors descend upon the small Midwestern town of Omaha, Nebraska to attend an annual shareholder meeting that has become legendary. The atmosphere feels closer to a carnival than a buttoned-up investors’ conference, and for many, it’s a required annual pilgrimage. In the sprawling CenturyLink arena, shareholders sip Coca Colas, eat See’s Candies, and indulge in Dairy Queen Dilly Bars. It’s the largest gathering in corporate America and one of the city’s biggest draws.
Often referred to as ‘Woodstock for Capitalists’ where people camp out to be early for prime seats, Berkshire Hathaway’s annual shareholder weekend has easily become the most popular formal corporate gathering in the investment world. While the formal meeting is a dry 30-minute corporate event, it is essentially an add-on to the real show. What everyone is really there for is to gain sage investment advice from the ‘Oracle of Omaha’, U.S. billionaire Warren Buffett, Berkshire Hathaway’s chief executive and one of the world’s most successful investors.
Every year, Buffett (91) and his long-time business partner Charlie Munger (97) spend several hours fielding questions from shareholders on a range of topics, including Berkshire, the financial markets, the economy, and life lessons. They have been friends for over 60 years and business partners since 1978. During that time, they’ve built Berkshire Hathaway into what is arguably the most successful investment holding company in the world, creating billions of dollars in shareholder value and amassing a multi-billion dollar fortune along the way.
While Buffett is the more public and recognizable face of Berkshire, the thousands of shareholders who attend the annual meeting in Omaha are also fascinated by the man who sits beside him on the stage and helps the ‘Oracle’ answer questions. They call it the ‘Warren and Charlie Show.’ What most of them don’t know, however, is that they had a third partner in the early days of Berkshire Hathaway - his name was Rick Guerin.
The three partnered on several notable business deals during the 1960s and 1970s, but their paths diverged following the See’s Candy acquisition in 1972. When asked recently about Guerin, Buffett said: “Charlie and I always knew that we would become incredibly wealthy. We were not in a hurry to get wealthy; we knew it would happen. Rick was just as smart as us, but he was in a hurry.”
Apparently, Guerin wanted to get rich quick and leveraged his investments using margin loans. When the stock market crashed almost 70% in the 1973-74 downturn, he suffered painful losses and was hit with margin calls. As a result, he was forced to sell thousands of shares of Berkshire Hathaway to Buffett at under $40 a piece. To put this in perspective, each of those shares would be worth $421,000 at the time of writing. In Buffett’s words, “the stock market is a device for transferring money from the impatient to the patient.”
Guerin was one of the select few who were named ‘super investors’ by Buffett in his famous 1984 essay ‘The Superinvestors of Graham and Doddsville’, a classic rebuttal of the efficient market hypothesis. The essay provides the performance track record of an elite group of investors who follow the value investing philosophy of Benjamin Graham, the father of value investing, all of whom delivered results that exceeded the market index over long periods of time. Rick had the best track record out of all these Superinvestors. He could have been legendary, but his ‘impatience’ cost him not only a chance at greatness, but also the faith and trust of Buffett and Munger.
This unfortunate story reminds us that there are really no shortcuts in investing as a means of building personal wealth. Just as in Aesop’s fable of the tortoise and the hare, the tortoise ultimately triumphed because it focused on its ultimate goal and ignored distractions. Quite simply, a patient, disciplined long-term investing approach is still the most effective wealth creation strategy. Investing is a marathon, not a sprint!
Although most investors understand the importance of patience, it is one of the most difficult skills to learn. As the late singer-songwriter Tom Petty used to sing: “The waiting is the hardest part.” We can’t help it. The human brain is not wired for consistently disciplined investing. We are just not born patient.
Nobel laureate and renowned psychologist Daniel Kahneman long ago recognized that people are hardly ‘rational actors’ when managing their money. Cognitive biases and behavioral tendencies greatly influence the decisions of investors in the stock market. Overconfident investors, for example, tend to underestimate risk and feel that they are better than others at picking the best securities or strategies and when to enter or exit a position - a behavior that oftentimes leads to the wrong investments and excessive trading.
We don’t have to search far and wide to find examples of such overconfidence. Despite a couple of minor pullbacks, the benchmark S&P 500 index has gone up almost in a straight line since November last year and notched 54 new all-time highs along the way, turbocharged by an overriding investor confidence in ample liquidity injections by the Federal Reserve to keep interest rates low and markets propped up. Driving a significant part of the market’s upward trajectory were individual investors and amateur traders who piled into the market in droves to trade stocks at a pace not seen in over a decade, which resulted in daily stock options volume reaching unprecedented heights.
Fueling this unprecedented speculative fervor are the so-called mottos TINA (‘There Is No Alternative’) to stocks with bond yields so low, FOMO (‘Fear Of Missing Out’) and BTD (‘Buy The Dip’), as a firm belief has taken hold that the torrent of monetary and fiscal deluge inundating the financial markets will continue unabated. Those three acronyms have become simplistic abbreviations for rationales that a new generation of younger, risk-loving traders and investors use to justify their investment strategies and have encouraged them to embrace the liquidity paradigm irrespective of the underlying fundamentals and, in some cases, spurred irresponsible risk-taking. And the less certain they feel about what an asset is worth, the more hesitant they will be about selling.
As a result, Wall Street has been incredibly resilient to a series of lingering challenges as investors looked past potential economic headwinds that could challenge the market’s underpinnings. These include fading monetary and fiscal stimulus, the Federal Reserve’s shift toward tapering bond purchases, rising inflationary pressures, a litany of proposed tax increases, peak growth in both the economy and corporate earnings, the slim-but-growing possibility of a fiscal crisis if Congress doesn’t act on the debt ceiling, intensifying geopolitical risks, and the spread of the Delta variant.
When such emotionally charged herd behavior drives the market, it’s usually wise to proceed with caution. That’s even more true with equity markets hovering near all-time highs, common valuation ratios close to their highest levels since 2000, and no correction greater than 10% since the start of the pandemic in March 2020.
Valuations in particular matter for the market’s long-term return expectations. History has shown that the price paid for an investment has a significant impact on the future return that an investor may earn. For example, when share prices are relatively high compared to earnings, subsequent returns tend to be lower, and vice versa (see graph above). Years of gains have left overall U.S. equity market valuations stretched, with the forward price-to-earnings (P/E) valuation of the S&P 500 of nearly 21, compared with the five-year average near 18 and the 10-year average near 16, according to FactSet (see graph below). As a result, more muted return expectations are sensible at this stage. Having said that, valuation metrics can help in investment decision making, but they are poor market-timing indicators.
Now, we are certainly not advocating market-timing - trying to pick tops and bottoms - but we also don’t believe that investing should be a spectator sport either. Taking a dynamic approach allows investors to be more mindful of opportunities among asset classes, sectors, or individual securities and can offer downside protection and reduced volatility.
A simple mathematical calculation shows the crucial role that downside protection plays in determining long-term outcomes. Let’s assume your $10,000 investment declines 25% to $7,500. It subsequently takes a 33% positive return to recover your lost capital. Because of this fact, it is our strong belief that downside protection should be a key focus of any investment strategy.
IMPLICATIONS FOR INVESTORS:
Charlie Munger noted that “the desire to get rich fast is pretty dangerous” because it causes investors to gamble on the short-term direction of the market or some stock. The trouble is that the short-term price direction of any security is subject to all kinds of price swings due to events that have nothing to do with the actual long-term value of the underlying business.
Such emotional biases can be difficult to manage as they derive from impulse rather than interpretation of information. They tend to cloud our judgment and lead us to act in ways that are counterproductive to our financial success. Thankfully, there are ways to avoid the pitfalls of emotional investing – here’s a collection of a few that can help you on the road to financial success:
Establish your financial goals.
Before you can set out to achieve financial success, you need to create a framework with a set of specific and realistic financial goals to steer your investments in the right direction. The stage of your life usually determines what type of goals you wish to achieve. They typically include savings, investment and spending targets you hope to achieve over a set period of time. And no, ‘beating the market’ is not a financial goal! More important than your rate of return is to avoid major investing pitfalls, such as trading too much, trying to time the market, taking too much risk, and panic selling during market dips. A real and more achievable expectation should be to build enough wealth to meet your specific, relevant financial goals.
Create a long-term investment plan based on your goals and needs.
Once you have established your financial goals, you can start to determine your time horizon for achieving them and gauge your level of risk tolerance. A detailed long-term investment plan focuses on strategies that will enable you to meet those goals and desires and to sit tight through market volatility and economic cycles.
Devise a proper asset allocation and rebalance your portfolio periodically.
Achieving your long-term goals requires balancing risk and reward. Proper asset allocation refers to the way you weight the investments in your portfolio (stocks, bonds, and other investments) to try to meet your specific objectives. Setting and maintaining your strategic asset allocation are among the most important determinants of your long-term investment success. As changing market conditions shift the balance of securities over time, check your portfolio on a periodic basis (such as annually or when your circumstances change significantly) to determine if you need to rebalance your asset mix.
Diversification is the practice of building a portfolio with a variety of investments that have different expected risks and returns. By including a variety of investment types, you reduce your dependence on the performance of any single investment. Think of the adage, ‘Don’t put all your eggs in one basket.’ When it comes to your bond investments for example, consider varying maturities, credit qualities, and durations, which measure sensitivity to interest-rate changes.
Keep tabs on your progress.
Take the time to periodically review your investments and other financial matters – not just when the markets are down and you are nervous. An annual financial checkup can help you better understand the ‘big picture’ of your overall investment and financial situation.
Create a Professional Buffer.
If the steps outlined above seem daunting to you, you might want to consider working with an established financial advisor, such as Telos, that can simplify the process. We can help you create a financial plan tailored to your financial needs and goals and make sure you adhere to it over the long run. We can not only help you manage your portfolio, but above all, we can help you manage your emotions. To quote Benjamin Graham: “In the end, how your investments behave is much less important than how you behave.”
Underlying these investing basics is the simplest principle of all: having clearly defined, goal-oriented priorities and a plan for sticking to them. Value is ultimately created in the long run. That’s where scale takes off and compounding works its magic – over years and decades, not months and weeks. Investors need to be prepared to play the long game!
QUARTERLY MARKET UPDATE:
Seasonal headwinds arrived on cue in September. After a seven-month winning streak, the major equity market indices declined last month. Going all the way back to 1950, September is the market’s worst month of the year, according to the ‘Stock Trader’s Almanac.’ Living up to its reputation, the S&P 500 fell 4.8% last month but managed to eke out a slim 0.2% gain for the quarter to notch its sixth consecutive quarterly gain. The Dow Jones Industrial Average slid 4.3% for September, while the Nasdaq fell 5.3%, marking their first quarterly loss since the first three months of 2020. Strong fundamentals have been a big catalyst for the stock market, with huge upside earnings surprises boosting the Dow 10.6%, the Nasdaq 12.1%, and the S&P 500 14.7% year-to-date.
Weighing on investors’ minds were concerns of higher inflation - driven in part by supply-chain disruptions -, economic data that have been falling short of expectations, and the continuing budget wrangling in Washington DC. Also dogging markets recently were fears of contagion from debt-laden property developer China Evergrande Group and the tail risk from the Delta variant.
The U.S. economy, as measured by GDP, grew at a 6.7% annual pace in the second quarter and is likely to sustain above-trend growth into 2022. However, the easiest gains appear in the rear-view mirror as the recovery phase of the business cycle matures.
Overseas, the pan-continental Stoxx Europe 600 ended September with a 3.4% decline, but finished higher for the quarter.
Worries that the bout of inflation will last longer than many had expected and could result in tighter monetary policy caused long-term Treasury yields to surge at their fastest pace in months. For the first time since June, the yield on the benchmark 10-year U.S. Treasury note, which helps set borrowing costs on everything from corporate debt to mortgages, topped 1.5% and closed out the quarter at 1.528%, its largest quarterly gain since March. Inflation hurts bonds the most of all asset classes because it erodes their fixed value, prompting investors to sell off and yields to rise.
The Bloomberg Commodity Index gained 5% in September and is up 29.1% year-to-date, which represents its largest annual gain in 42 years. The U.S. Dollar Index rose four straight weeks in September for a monthly gain of 1.7%.
As we enter the final quarter of what has been a good year for stocks, we should enjoy the gains we have experienced so far without trying to project them out into the unknown future. Strong GDP and corporate earnings growth should continue to be a tailwind for equities, but inflation fears and the Fed’s pivot toward winding down its asset purchases raise the potential for an uptick in volatility and could even trigger a meaningful market pullback.
Keep in mind that significant intra-year market pullbacks are common. The chart on this page (courtesy of Calamos) shows how frequently at least one double digit decline occurred within any given calendar year since 1980. In contrast, the deepest pullback in 2021 so far was last month’s 4.8% decline in the S&P 500.
In the meantime, we encourage investors to keep their emotions in check and to focus on their strategic plans for achieving their goals. In the words of Warren Buffett: “Sound investing can make you very wealthy if you’re not in too big a hurry.” OCTOBER 2021