The Long and Winding Road

Enduring financial principles, like music, can last generations.  Benjamin Franklin gave us many examples such as, “a penny saved is a penny earned” and “early to bed, early to rise makes a man healthy, wealthy and wise.” Thomas Jefferson would tell us, “never spend your money before you have it,” and Miguel de Cervantes would warn that, “all that glitters is not gold.” 

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I have also learned firsthand that “The Beatles” are still selling millions of albums every year.  Interestingly, my ten-year old daughter is obsessed with the group.  She has the obligatory Abbey Road album cover poster, an iPod packed with every song, constantly reminds me who the greatest band of all time is and why they broke up.  Answers: The Beatles and Yoko Ono. 

In finance as in music there are timeless classics.  Drawing upon the wisdom of those who came before me and my twenty years of investment experience, this entry is my attempt to pass along eight valuable principles.  I have tied it to the Beatles to insure my daughter will read it.  I hope you enjoy and learn something new.

Yesterday

Long term investors in equities are always faced with uncertainty.  In the 1970’s, investors had to endure the ’73-’74 bear market (the worst since the Great Depression), geopolitical turmoil culminating in the Iranian hostage crisis, rampant inflation and skyrocketing energy prices.  In the 1980’s, investor were faced with Black Monday, the Iran-Contra scandal and the S&L crisis.  In the 1990’s, investors experienced a euphoric bull market, the repercussions from the collapse of Long Term Capital, the Asian currency crisis and the Russian default.  And so far in the 2000’s, investors have dealt with the bursting of the tech bubble, (likely) two economic recessions, geopolitical turmoil in the Middle East, rising energy and food prices and the sub-prime mortgage crisis and real estate deflation.

But through it all, the long-term upward progress of the stock market has continued.  In fact, since 1970, the S&P 500 Index has increased over 5,000%, which would have compounded a $10,000 initial investment into over $500,000, a fifty-fold increase.

Investing through uncertain times is the rule, not the exception…the question is not whether or when to invest, but how to invest…

Disclosure: The S&P index is comprised of 500 common stocks representing major U.S. industry sectors.

Can’t Buy Me Love

Don’t focus your research efforts on issues such as the direction of interest rates, oil and real estate prices or earnings (which are all important) but not able to be determined over the short term.  Rather, attempt to uncover important issues such as the quality of a business’ management, its competitive advantages and the quality of its long term earnings power.  Or as it relates to manager selection, focus on their investment process; current strategies employed and research capabilities.

Let It Be

Because of psychological biases and human tendencies, investors repeatedly abandon sensible investment strategies because of the short term results.  In other words, investors who impatiently switch in and out of investments, hoping to catch the next hot trend, asset class or emerging market are likely doing themselves more harm than good.  To quote Warren Buffett; “For investors as a whole, returns decrease as motion increases.”

Here Comes the Sun

When constructing a long-term financial strategy, it is important to recognize and accept that even the best managers will suffer periods of disappointment.  These times are painful and difficult…but remember, they are not only possible, they are inevitable.  Charles Munger, Warren Buffett’s partner at Berkshire Hathaway, delivered a 14 year cumulative gain of 1,156% versus only 103.3% for the S&P 500 Index.  However, in five of those 14 years, he underperformed the market.  Another example is Walter Schloss who studied under Benjamin Graham and recorded a 28 year cumulative investment gain of 23,104% versus only 887% for the S&P 500 Index.  He too had periods of underperformance in eight of those 28 years.

With A Little Help from My Friends

Maintaining a disciplined, long term investment plan is not easy; especially given the inevitable periods of poor performance.  When most investors find themselves in that situation, they tend to abandon their long term strategy and engage in “bad behavior”.  This includes chasing the “hot” sectors, trying to time the market and a number of psychological tendencies.
 
The impact of such bad behavior is devastating to long term investment performance.  A study performed by Dalbar, Inc. in 2007 showed that the average stock fund delivered an average annual return of 11.3% per year from 1987 to 2006.  However, the average stock fund investor received an average annualized return of only 4.3% per year. 

Source: Quantitative Analysis of Investor Behavior by Dalbar, Inc (July 2007) and Lipper.  Dalbar computed the “average stock fund investor” returns using industry cash flow reports from the Investment Company Institute.  The “average stock fund return” figures represent and average return for all funds listed in Lipper’s U.S. Diversified Equity fund classification model.

You don’t need to “go it alone”.   Summit (and many competent, independent firms)  find many ways to encourage “good behavior”.  In our case, we attempt to help clients find the right managers to stay invested during periods of inevitable underperformance.  In our view, the “cost” of our advice is relatively modest when compared to the cost of self-inflicted underperformance from poor portfolio construction, manager or security selection and “bad behavior”.  We seek managers who have demonstrated the ability to deliver solid performance over the long term during different market and economic environments…and are attracted to investment managers who have acted as good stewards of clients’ capital and communicate openly and honestly.

We Can Work It Out

Investing is an emotional experience.  Investors naturally feel more confident (and commit more capital) when the market has recently performed well.  They tend to sell their holdings when they experience short-term underperformance.  The key to developing a less emotional approach is to have a clear, investment strategy.  To be a successful long-term investor, have a disciplined approach including a written Investment Policy complimented by an Asset Allocation strategy.  Implement a rigorous investment manager selection and evaluation process.  Finally, consider ongoing account monitoring and rebalancing.

Come Together

Strive to find managers in the owner-operator partnership form of investment management not the conflicted, but pervasive asset-gathering model.  There is a profound conflict of interest built into the money management industry’s structure; one that grows out of the fact that the management companies are independently owned, separate from the funds themselves.  Management companies profit by maximizing the funds under management because their fees are based on assets, not performance.

Help!

Simple…read the 1934 investment classic, Security Analysis by Benjamin Graham & David Dodd,  every shareholder letter written by Warren Buffett of Berkshire Hathaway and the (difficult to find) letters from the Buffett Partnership from 1959-1969.