One year from the bottom of the worst recession in our lifetime, it is important to reflect on the recovery and the lessons learned about financial risk taking. Through March 19, 2010, the S&P 500 stock market index has risen over 71% from the low set on March 6, 2009.
The most recent twelve month market performance is the best twelve month post-recession performance in U.S. market history. Despite this impressive return, a 132% improvement is required to raise the market back to the peak level attained in October of 2007 from the lows set in March of 2009. Thus, we are still in need of a few more years to fully recover the losses in the stock market. In fact, we will need to average 17.6% annually to complete the recovery in the next two years. If the stock market advances at around six to seven percent annually, it will take five more years to complete the recovery.
For Oak Wealth Advisors clients, the loss in portfolio value from the recession was painful but nothing close to the 57% decline for the market. In most client portfolios, new high water marks will be set in 2010 as the recovery from the March 2009 lows continues. The biggest reason for the faster recovery has to do with staying invested in the market with well diversified portfolios. Rebalancing and tax loss harvesting also add value to the portfolio management process as does the implementation of low cost, tax efficient investments.
We can all take comfort that the average bull market lasts for fifty-six months. While our most recent bear market plunge needed only seventeen months to completely erase the sixty- month bull market run that preceded it, we are now starting the thirteenth month of a new bull market. We should probably not expect a ten-year bull market run like the one we had that began back in October of 1990 that drove the S&P 500 up over 400%. The market fundamentals do not portend such significant growth in the stock market in the near future. Hopefully, we can achieve moderate growth as the economy continues to recover and consumer confidence continues to build.
As the market recovery allows us to safely peek out from the shells that many had been hiding under during the recession, we can look back and find four truths that we should never forget regarding investment risk.
First is the importance of liquidity. It may feel great to have wealth on paper, but what really matters is wealth that can be monetized. In times of trouble, cash is king. If your wealth is illiquid, recessions can be especially painful. During the recent recession, investors who were forced to sell their illiquid assets in some cases received pennies on the dollar for what the carrying value had been for their investments.
Oak Wealth Advisors has always favored and only recommends liquid investments. Many firms attempt to differentiate themselves with access to illiquid investments that can give an investor a feeling of being special. While the diversification benefits of owning an illiquid investment can statistically benefit a portfolio, after factoring in expenses, taxes, the lack of access to information, and the inability to cash out on demand, they are much less attractive for individual investors.
In fact, the incremental diversification benefits of illiquid investments like hedge funds, private real estate deals, and venture capital opportunities are minimal for an investor who already holds a well diversified portfolio. In summary, if the investment requires you to sign a legal agreement, you probably should not be investing any money that you consider essential for your well being.
The second truth is that you should never own anything that you do not understand. Surprises are great for kids’ birthdays. They are much less enjoyable when they hit your investment portfolio. The swings in the prices of stocks and bonds, known as the volatility of their prices, have gotten more extreme over the past decade. Sometimes the prices rebound; sometimes they do not. Understanding an investment’s inherent risks, cost, tax characteristics and purpose in a portfolio are key elements in avoiding negative surprises.
The third lesson is that over-reliance on models can be dangerous and potentially catastrophic. Whether the model forecasts your annual living expenses for the rest of your life, your net worth at various ages, or the growth of a particular investment, no financial model can deliver foolproof results. The financial services industry is filled with sales people armed with financial models developed by impressive staffs. They provide beautiful, compelling illustrations that often provide comfort in numbers. The sad fact is that the numbers are stale and unreliable shortly after they are created. The variables used in the models are constantly changing and often in unpredictable ways. The best solution to evaluating your needs and resources is to periodically update the numbers that you are reviewing and reflect on whether or not you are progressing toward your goals.
In the investment world, there are numerous examples of investment firms who developed sophisticated models that they believed would provide better than market returns. While many may work well in the short term, most will fail over longer periods of time. We have seen and read stories about overconfidence in models leading to the destruction of firms and it is a leading reason for the collapse of the derivatives markets in 2008.
Finally, the fourth point to remember is that that the types and sources of risks are continually changing. This is the most challenging of the lessons because it requires us to remain diligent and circumspect. Even if you could develop a bulletproof solution for your portfolio incorporating all knowable information today, tomorrow brings new developments and potential challenges to our future success. Asking questions, staying informed, and never becoming complacent are our best defenses against risks to our financial well being.
Oak Wealth Advisors appreciates the confidence that you have placed in us and we look forward to riding the current bull market with you. We promise to keep the most recent recession’s lessons in mind and will endeavor to keep you apprised of new potential risks as they arise.