What's happening in the Market? (part one)

Investors, investment industry professionals, and even regulators have been quite anxious about the current market situation. Clearly, these are tough times-and no one can predict exactly what lies ahead in the next few days, weeks, or months.

Given this uncertainty, we thought it would be helpful to review some fundamental truths about investing that have guided our approach to designing your portfolio; they are at the heart of the advice we give our clients. As well, we want to share our outlook for the upcoming period.

Our advice is based on six principles:

1. Well-chosen stocks outperform every other asset class over the long run-by much
   The U.S. stock market provides the best data over a long period of time, with good information going back to 1925. If we go back over that time (which includes the great stock market crash and depression of the 1930s), stocks of large American companies outperformed the bonds of those same companies by a margin of roughly 1.75 to 1.
   
   That means the money made from stocks was almost twice that from bonds over five years, and with compounding, nearly three times that of bonds over a 20-year time frame.
   
   
2. The price for superior performance is volatility
   Along with superior performance comes volatility. As a general rule, stock markets make money roughly three out of four years. That means, of course, that they lose money the fourth year; the reason stocks are a good long-term investment is they do well enough in the 75% of the time they make money to offset the 25% of the time they lose it.
   
   Academics call the margin of outperformance for stocks over cash the equity risk premium. In fact, the academics state that if stocks were not risky, they would not provide a superior return-stocks have to provide higher returns over time to compensate investors for the volatility. If they weren't volatile, their return would be the same as that of GICs. We would be happy to discuss the principle of risk premium in stocks and what it means the next time we meet.
   
3. Volatility cannot be avoided in the short term
   We would all love to own stocks when they rise and be on the sidelines when they fall. Unfortunately, that's simply not possible. If you were to ask a group of investment professionals to name someone who did a consistently great job of picking stocks over a long period of time, a number of obvious candidates would emerge-John Templeton globally, Warren Buffett in the United States, and Bob Krembil who managed Trimark Funds until 2000 in Canada.
   
   Ask those same professionals to name someone who has consistently predicted when to get into and out of the stock market and you would draw a blank. Many people have made one, two, or even three good calls on when to get out of the market. However, no one has demonstrated the ability to be consistently right- and those who have tried to time getting in and out of markets have typically been wrong at least as often as they've been right.
   
   Investing always entails a combination of pain and gain-the question is when they occur. When we have weeks like the one this month, the pain of investing is immediate, the gain is in the future. If you avoid stocks, the gain in peace of mind is immediate, but the pain in lost opportunity and retirement lifestyle is to come. In times like these, sitting on the sidelines can be tempting and is certainly an option if you truly can't live with the volatility we've experienced of late. Let us remember, however, that history shows that when stocks recover from a significant drop, they tend to do it very quickly-being out of the market can mean missing a rise of 25% or more.
   
   
4. Volatility decreases the longer you invest
   The good news about volatility and risk is that the longer your time horizon, the less of an issue they are. Over periods of five or ten years, the variations in returns are reduced to a fairly modest level.
   
   For investors who need to cash in their savings in the near term, the present markets pose a real problem. Before recommending that our clients purchase investments for their portfolio, our team tries to ensure that the money will not be needed in the short term so that they are not in the position of being forced to sell.
   
   Historically, for investors with a time horizon of ten years or more, volatility decreases to the point that it is almost a non-issue.
   
   
5. Investing based on fads and emotional reactions can be devastating
   In our years in the investment industry, we have seen fads come and go and have observed how they can devastate portfolios.
   
   That is why we generally bring a conservative stance to the portfolios we construct for clients, avoiding "flavour of the day" investments that are hot one day and plunge the next.
   Similarly, emotional reactions can be deadly to a well-balanced portfolio. There is a well-known saying that most investors fluctuate between fear and greed. Excessive optimism dominated until recently; today fear and pessimism rule. Making decisions based on fear and greed can destroy value in a portfolio. We see our role in part as being an emotional anchor for our clients-preventing the emotional highs from becoming too high, the lows from becoming too low. Until recently, our struggle with some clients was avoiding an overly optimistic viewpoint, throwing caution to the winds. Today, for some of those same clients the challenge is to prevent an excessively pessimistic and negative outlook.
   
   
6. Based on history, the right managers will prove their worth over time
   Our firm spends a great deal of time conducting due diligence on the money managers whom we recommend to clients.
   
   Before we include money managers in client portfolios, we look for strong investment convictions and discipline, deep teams of investment professionals, consistent outperformance over an extended period of time, and a track record of containing losses in downturns. Once we have selected a money manager, we spend a lot of time monitoring the stocks being bought.
   
   We believe a strong team of managers is in place that will serve us well over time. Even as we write this, those managers are looking for bargains among the stocks that have been beaten down by recent events.
   
   Some clients have expressed concern that we are standing pat in the face of turbulent markets. It is important to understand that while we may not be changing the managers we work with, below the surface your portfolio is being modified as they realign the stocks they hold to capitalize on opportunities.