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Investors are told over and over that stocks are risky investments.  How true is that though?  If you watch the financial news each day, it seems like there is no reason why stocks go up, down, or remain unchanged at times.  For every financial pundit that gets the direction of the market correct, there are many others that predicted things incorrectly or have been saying that the “sky will fall” for the past five years.  I will admit that stocks are very risky on a daily basis.  However, if you are not running a hedge fund or are a trader on a Wall Street firm’s proprietary desk, the “vicissitudes and vagaries” of the daily moves in the stock market are of no concern to you.  In fact, being too concerned about daily/weekly/monthly/quarterly movements in stock prices will actually hurt your long-term performance.  Investing is not a sprint.  It is a marathon!  If it seems as though the professionals on Wall Street do better than you, please keep in mind that the financial media rarely interviews people that were totally wrong on the market.

I do not like to pick on anyone; however, I will provide one example just to make a point.  Mark Faber, a long-time fixture on Wall Street, predicted that the S&P 500 index would drop to the 1266 level back in November 2012.  Refer to http://moneymorning.com/2012/11/08/stock-market-today-why-marc-faber-predicts-a-20-slide/.   He was recently on CNBC in August 2013 and predicted that the S&P 500 index would by 20% this year.  So is he actually more bullish on his bearish prediction about one year later?  Who knows how to characterize that one?  It is important to learn about stock price movements which are termed volatility in the jargon of Wall Street.  Your Financial Advisor will refer to it over and over when he/she advises you on how to construct your portfolio.

Why does volatility matter to you?  Well, in the very short run, stocks are one of the riskiest investments.  I recently read that over the last 50 years stocks were up 53% of the time and down 47% of the time.  So your odds of being right about one day is essentially a bit better than calling a coin flip.  Now hopefully you are not a speculator.  If you are trying to double your money this year or in even a shorter period of time, you need not read any further.  However, if you would like to learn how volatility affects portfolio construction and portfolio performance over the long term, please read on.

I pulled down some annual returns from the S&P 500 for the period 1926-2012.  Note that the S&P 500 was preceded by a number of other indexes of smaller components, so it is unwise to use this data in full.  Whenever anyone uses statistics to make an argument (myself included), you always need to be very skeptical.  So do NOT make me an exception.  If you look at the S&P 500 index’s performance over the 50 year period from 1961-2010, the annualized performance is a bit less than 9.7%.  Wow, that sounds really good!  However, it seems counterintuitive because the S&P 500 was down over 36% in 2008.  Plus, you may have heard that the 2001-2010 period is often referred to as the “Lost Decade”.  Stocks earned basically nothing over that timeframe.  You need to remember that the 9.7% figure is composed of five decades with different characteristics.  For a primer on how compounding of returns works, you can refer to one of my earlier posts:  https://latticeworkwealth.com/2013/07/08/double-edged-sword-of-the-power-of-compounding/.  The aforementioned annualized return of the S&P 500 index over the last 50 years is composed of the following returns for each decade:  8.1% (1961-1970), 8.5% (1971-1980), 13.8% (1981-1990), 17.3% (1991-2000), and 1.4% (2001-2010).  You will most certainly remember the financial crisis of 2008 and the Internet Bubble of 2001.  These major events in the stock market took a huge toll on performance returns over the last decade in this series.  With that being said, Time magazine had a cover story in 1982 where they declared the de facto death of equities.  Oddly enough, it turned out to be the beginning of the strongest bull market in history.  Why is it important to decompose this data?

The importance lies in human nature.  An annualized return of 9.7% means that an investment in stocks should essentially double every five years.  Well, if your Financial Advisor invokes market history when building your portfolio, he/she may set your expectation that you can expect to double your money in stocks every 5 years.  What if it takes longer or you do not double your money after even a ten-year period like 2001-2010?  Humans tend to seek patterns and be risk averse.  Many of the great bubbles over time have come because financial professionals extrapolate from the past, be it with stock prices, corporate earnings, or housing prices more recently.  We look at the immediate past for a guide to the future.  This analysis is called ex post facto, and, as you can see above, it can get you into a lot of trouble.

Many investors used the 1980s and 1990s as a guide to what would happen in the 21st century.  In fact, there were books written and predictions of why the Dow Jones Industrial Average (Dow Jones) would reach 36,000 which is more than twice its current level as of September 2013.  I have met many investors that are still shying away from buying stocks because of the Internet Bubble of 2001 and the financial crisis of 2008.  Now I am not making a prediction about the future direction of the stock market, my only observation is that people tend to wait too long to get back into the market if they attempt to time the market properly.  Everyone wants to buy low and sell high.  Furthermore, they want to sell all their holding right when the market reaches its highs.  Buying stocks and holding them for the long term is not really all that much fun.  When I was 13 years old and buying stocks in the late 1980s, I know I wanted to double my money each year.  I got frustrated really quickly; however, I kept plugging away and investing more every month.

After the experience many had in the stock market from 1966-1982, they felt it was unwise to invest in stocks at all.  The Dow Jones was essentially unchanged during that period.  Very few Financial Advisors were recommending the purchase of stocks in the early 1980s.  Conversely, most every Financial Advisor was recommending the purchase of stocks throughout the late 1990s.  As humans, we tend to seek out patterns in history and, even subconsciously, think that the past will repeat itself.  You may think that you do not fall into that category, but I urge you to think about your experience with the stock market in 2001, 2002, and 2008.  Did you sell all your stocks, hold them, or buy more stocks during those years?  I can remember 2003 where it was very unfashionable to still invest in stocks.  It is easy to say that you will not succumb to the pressure to sell stocks, but, after the stock market fell over 35% in 2008, many investors just had enough.  Imagine you had $1,000,000 on January 1, 2008 and opened your brokerage statement on December 31, 2008 only to see the balance was $640,000.  Hard dollar figures are much more impactful than testing your risk tolerance by wondering if you would sell your stocks if the market went down 10%, 20%, or 30%.

Your Financial Advisor will talk to you about diversification and the benefit of holding securities in many different asset classes.  Moreover, you will be told over and over again that stock price volatility is bad and hurts your returns.  I will agree that stocks are volatile, but the assertion that Modern Portfolio Theory (MPT) makes about risk/return can lead to odd answers.  Here is a homework assignment.  Ask your Financial Advisor if he/she remembers how stocks performed during 1987.  Of course, everyone remember the huge crash in October, but very few remember that the stock market was actually up a bit over 2% that year (S&P 500 index).  Why does that even matter?

Well, stock price volatility is measured by statistics.  Think of the bell curve in your days in school.  The bell curve has been used in education which basically states that most of the students will be average and get a grade of C.  There will be other students that get B’s and D’s as well.  Of course, there will be a small group of students that fail a class or exam or do extremely well and get an A.  MPT tells investors that volatility is bad.  It is bad in terms of the decisions you might make, but there are many odd answers given by the theory.  For example, the average daily return of stocks in was roughly 0.03%.  The main measure of volatility is standard deviation, and you do not need to worry how to calculate it.  Standard deviation simply measures how far from the average a series of numbers in a population is like daily stock returns.  The standard deviation for daily returns was about 2.0%.  The annualized standard deviation was 31.8% (just so you know standard deviation is not additive in nature, so it takes some mathematical manipulation to get to that answer).  Why did I present these numbers?  I presented them to make another observation.  In 1973 and 1974, the S&P 500 index was down 14% and 26%, respectively.  However, the annualized standard deviation for each of those years was 15.6% in 1973 and 21.6% in 1974.  Thus, those years were less volatile than 1987, but an investor would have lost a large amount of money in each year.  Would you rather make money during the course of a year or lose money over the course of the year with less volatility?  If you are a long-term investor, daily fluctuations in the stock market should not guide your decisions.  Otherwise, you will end up selling all your stocks just because prices are going up and down a lot.  The most important thing is the terminal value.  The terminal value just means what the return will be at the end of the period without regard to the volatility over the course of the year.

The validity or, more aptly usefulness, of MPT becomes more apparent when we look at daily returns.  MPT makes a lot of assumptions, one of which is that stock prices will follow the normal distribution.  That is just a fancy way of saying the bell curve.  Now if you know about statistics, you can make predictions about a set of data based upon the historical experience of that data.  I downloaded the daily returns of the S&P 500 from 1957-2012 because I had some extra time on my hands and was bored.  The average daily return of the index was 0.03% with a standard deviation of 0.98%.  If you assume the normal distribution holds, you can make the assertion that 99% of all observations should be within a low daily return of -2.25% and a high daily return of 2.31% (Formula is average – standard deviation * 2.33 and average + standard deviation * 2.33).  You might ask if that is really true.  This way to express the data means that the daily return for the stock market should be equal to or between those two figures 99 out of every 100 trading days.  In statistical terms, it is referred to as a 99% confidence interval.  What about the market crash in 1987?  The S&P 500 index dropped 20.5% on October 19, 1987.  How would you express that statistically?  In order to have a daily return that far away from the average, it equates to approximately 21 standard deviations from the average.  How likely is that?  It is pretty much the same odds of flipping a coin 20 times and having it come up heads each time.  Keep in mind that this date was not the only big drop over this period.  For example, there were over 20 times when the S&P 500 index dropped by 5% or more in a day during that period.  The likelihood of that happening over the course of 55 years (1957-2012) is infinitesimal.  If you would like to learn more about this type of odd result, I would encourage you to read the book, The (Mis)Behavior of Markets, http://www.amazon.com/The-Misbehavior-of-Markets/dp/B008A0LNBM/ref=sr_1_2?ie=UTF8&qid=1378664066&sr=8-2&keywords=The+Misbehavior+of+markets.

Suffice it to say that the path of stock prices does not follow the normal distribution.  Now academics will admit that is the case and have made modifications to MPT.  Additionally, most academics will use the lognormal distribution or other distributions to explain the volatility of stock prices.  However, the mathematics becomes exponentially more difficult and challenging.  With that being said, the financial advice given to you from your Financial Advisor is likely to be taken from the first iteration of MPT.  If you have heard your financial professional talk about beta, alpha, sigma, mean, r-squared, and the like, he/she is constructing your portfolio by making reference to the ideas laid out by MPT.  Now I will not go so far as to say MPT is incorrect.  Much smarter folks than me developed it.; believe me!  However, the great Warren Buffett gave a speech back in 1984 that encapsulated why MPT he does not subscribe its tenants.  To see a transcription of the speech, refer to:  http://www.bestinver.es/pdf/articulos_value/The%20Superinvestors%20of%20Graham%20and%20Doddsville%20by%20Warren%20Buffett.pdf.

In the next part of this discussion, I will attempt to show you how to look at the volatility of stock prices in the context of your portfolio.  If you do not need to withdraw money from your portfolio on a short-term basis, MPT has less and less applicability for you.  MPT assumes that all investors have a one-year time horizon.  Therefore, if you do not plan on needed to withdraw money over the course of a 12-month period, this discussion definitely will apply to you.  You should be looking at your portfolio in terms of one-year and five-year increments.