October 8, 2003
Why is long term investing more prudent than short term investing? Long term investing is appropriate for both safety minded fixed income investors, as well as for investors looking for an aggressive portfolio. Should a safety minded portfolio contain investments other than pure fixed income and safety investments? Should an aggressive portfolio only own Common Stocks? These are some issues that I will approach in this letter.
First, please let me describe a little bit of what our firm does in the area of investing.
1. We specialize in developing long-term portfolios. These portfolios are custom designed for each client. The portfolios are based on future needs, investment time frame and risk tolerance.
2. We are thorough in our research. Our research includes the ripping apart of financial statements, the attempt to predict future business trends and the understanding of peaks and valleys in business cycles.
3. The key ingredient in our recipe for portfolio management is the ability to tolerate and investigate “doubt”. Doubt is central to understanding. By exercising doubt we get the opportunity to poke holes in either our research or in the research that we undertake to study.
4. We are often concerned about certain areas of investing. During the late 90’s we were concerned with the bubble valuations of the NASDAQ. During this year we were (and remain) concerned with the possibility of rising interest rates. We are also concerned with the state of the economy. We are concerned with a potential bubble in the real estate market (that includes areas such as New Jersey and Southern California). We are confused as to whether we are in a recovery or are we in the next phase of a recession. Obviously these are not necessarily happy and pleasant items, but they are legitimate concerns, which we continually try to monitor. One question we have been searching for is “why is consumer spending rocketing, while unemployment remains at rising levels? We are trying to determine if this is residual from lower interest rates and refinances, or perhaps the tapping of Home Equity via ATM like ease, or is the data we are being presented being distorted, or is the economy just plain old healthy and strong?”
There are two major factors in designing and maintaining a portfolio.
1. Time frame allotted for investment. How long are you planning on keeping this money invested? Will you need all or a portion of the money in say 6 months or 2 years? Perhaps you don’t plan on touching the money for 15 years? It is important that you differentiate and identify the difference between wanting and not wanting the money tied up for a specific short term period, versus the need for the use of the money in a specific period. For example, an investor might have $130,000 to invest; yet $30,000 of that total might be needed for a car to be purchased in 9 months. Hence, we would look for a short-term investment for the $30,000 and consider various long-term investments for the remaining $100,000. The owner of the money in this example might say the following: “ I have no tolerance for risk of principal in my portfolio. I want only high quality fixed income investments such as, Certificates of Deposit or US Treasuries. I won’t need the $100,000 for at least 10 years, but nevertheless, I want all of my money to be liquid and not tied up for more than 2 years.” This is an interesting example. We would attempt to educate the investor as to why they may want to invest a portion of their money in terms greater than 2 years. We might suggest, “laddering” the portfolio. Laddering is a term used for investing a portfolio in different time periods (like steps on a ladder). The purpose of laddering is that money is always coming due and could be reinvested at current interest rates. It is important that an investor invests with their head and knowledge, and at the same time trying to limit their own emotions in investing.
2. Risk tolerance of the investor. We have seen that what investors think their risk tolerance is, versus what their risk tolerance really is, are often two different things. Here is an example. During 1999 we had clients that felt our balanced portfolios were too conservative. They saw that their friends were making 30 % investing in various mutual funds and tech stocks, while at the same time, they saw that their risk balanced portfolios they had with us, were “only making 17%”. They would claim, that they could tolerate the loss of principal if the market were to give back some of its gains. We often asked our clients the following: “Can you afford to lose 50 % of your portfolio?” Very often a client thought they could psychologically tolerate such a loss, but in reality they could not financially afford such a loss. We also noticed that investors who thought they could psychologically tolerate such a loss, in reality could not at all tolerate such a loss. Keep in mind that the NASDAQ lost in excess of 75 % of its value from its March 2000 highs of 5048.62 on March 10, 2000. The NASDAQ closed at 1907.85 on October 7 2003. The year to date gain of the NASDAQ through October 8, 2003 is 42.86%. Let’s put this into perspective, using the following example.
Person invests $100,000 into the NASDAQ on March 10, 2000. Person claims to be a long-term investor. On October 9, 2002, over 2 years after the original investment was made, with the NASDAQ at 1114.11 the original investment is worth $22,067. Yet, the markets have bounced back strong so far in 2003 and the original $100,000 investment is now worth $37,746, with the NASDAQ being at 1907.85. The investor is no longer losing 78 % of their original investment; the losses are down to only a 62.25 % loss. This has happened during a period of 3 ½ years. One really has to explore whether this investor was truly an investor who was psychologically able to tolerate massive losses. Diversification, balance and an understanding of intrinsic value, enabled us to prosper during the same period.
What is an investor supposed to do? How does an investor manage to determine if they should be in pure safety, or if they should have an emphasis on a more aggressive portfolio?
1. An investor should consider hiring a competent investment advisor. The investor in making this decision, should understand the fee structure of that investment professional. The investor should understand the difference between an advisor that is fee only versus one that collects commissions (either directly or indirectly) from selling an investor a specific investment. We wrote an article on “Questions to ask a financial adviser”. This article can be found at features/questions.htm. There is also a book titled “ Winning the Losers Game”, written by Charles Ellis. This is an excellent book that emphasized the need for a teamwork approach between the investor and the investment advisor.
2. Investors who are risk adverse need to understand the risks of fixed income investing. We discussed this at FixedIncomeInvestingtoday.html. Here are some of the risks of fixed income investing:
a. Credit quality
b. Rising interest rates
c. Duration of fixed income vehicle
e. Rare but possible, currency devaluations.
3. Generally a portfolio should always be balanced. This means that there should be an investment allocation that contains both common stocks and high credit quality bonds. The allocation will differ based on the investors risk tolerance and the investment environment. Yet, an aggressive investor should generally have a bond allocation. Similarly, a conservative investor should consider alternatives to pure fixed income (be it only small allocations) investments.
4. Always try to think about “long-term investing”. Patience is vital to investing. Very often we are buying investments that are out of favor and being tossed aside by most investors. An example of this was our accumulation of high quality bonds in the late 90’s. We were accumulating bonds, quite inexpensively as Wall Street was dumping bonds to generate investment funds to put into the high flying NASDAQ stocks. We also had been accumulating technology shares near the bottom of the 2000 Crash. Nevertheless, we based our decisions on our perspective of future revenues and cash flows of the companies we invested in.
5. Exercise doubt in all aspects of investing. Professional skepticism is not popular, yet we find it incredibly necessary in helping us research an investment. Ultimately we trust the markets and our financial system, but questioning that system until it makes sense is a vital step in investing. Peter Lynch wrote an excellent book called “Beating The Street”. You can read some notes on that book at this link features/beatstreet.htm. Peter suggests that you should never invest in any idea you can’t illustrate with a crayon. He feels that you should be able to explain any investment to a 10 year old. If you can’t explain it to a 10 year old, then you should consider passing on the investment.
6. Always look forward, never look back. Whatever has happened in the past is over. Use your knowledge of the past in your investment philosophy going forward. We refer to using the costly lessons of the past as “sunk costs”.
In summary, remember that investing requires patience, research, understanding, and a teamwork approach with your advisor, an open mind, doubt, balance and the ability to recognize mistakes and implement action to correct those mistakes.
We invite you to stop by our office for a free book on our investment philosophy. We have a great deal of information at our website, http://www.rbcpa.com. We also can supply a sample portfolio based on your risk tolerance levels. Feel free to call me at (908) 276-7226 or to email me at email@example.com
Ronald R. Redfield CPA,PFS