A Q3 client letter: Mike Tyson on Sticking to Your Plan

Note to advisors: The section below could be deleted to shorten the letter

In a testament to the resilience of companies and the economy as a whole, this strong performance came in the face of headlines dominated by big picture economic and political uncertainty.

• The possibility of rising interest rates:

  The first quarter saw strong gains after agreement by U.S. Congress in early January to avoid the “fiscal cliff” that would have required dramatic reductions in spending and risked throwing our economy back into recession. Then in May stocks and bonds entered a period of uncertainty after indications from Federal Reserve Board Chair Ben Bernanke that given signs of a recovery by the economy there would be a tapering in measures to keep interest rates low.

• Challenges for Europe and emerging markets:

  While there were signs of improvement in Europe, the pace of that recovery continues to be disappointing. And as the International Monetary Fund continued to reduce forecasts for global growth, stocks in emerging markets underperformed and countries such as India saw their currency under downward pressure.

• Renewed conflict in Washington:

  In early October, we once again saw a stalemate in Washington, with uncertainty about raising the ceiling on U.S. Government debt resulting in furloughs of non-essential government workers and the risk that America will go into technical default on its debt.

The elements of an effective plan

At the start of every relationship with my clients, we create a long term plan that will look past short term issues such as we’ve seen this year. In developing that plan, my first step is to establish portfolio parameters based on each client’s return requirements and risk appetite. In doing that, I’m guided in part by a 1963 talk by Benjamin Graham, the Columbia University professor whose students included Warren Buffett and who is considered the father of value investing. Here’s what Graham had to say about portfolio construction:

“An investor should maintain at all times some division of his funds between bonds and stocks. My suggestion is that the minimum position of this portfolio held in common stocks should be 25% and the maximum should be 75%. Any variation should be clearly based on value considerations, which would lead him to own more common stocks when the market seems low in relation to value and less common stocks when the market seems high.”

That 25% to 75% range sets very broad parameters and yet today, some investors resist owning any bonds, while others are out of stocks due to concerns about them being overvalued. Let’s review the issues around bond and stock valuations.

Are bonds too risky?

Some investors have read descriptions of bonds as today’s riskiest asset class and want to eliminate them from their portfolio as a result. And certainly a significant increase in interest rates would create challenges for bond investors.

Despite that, I follow Benjamin Graham’s advice and advice my clients to keep a bond component in their portfolios:

• As we saw in 2008, bonds can provide insurance against severe volatility in stock prices.
• Given low rates on short-term government bonds, investors can find better yielding alternatives on longer maturities, in high quality corporate credits and among some foreign governments with solid finances (although I am very selective in those cases)
• The concern about the impact on bonds if interest rates rise may be exaggerated, as there is growing sentiment that weak economic growth will result in low interest rates for many years to come. One such view comes from Bill Gross of Pacific Investment Management, today’s best known bond manager, who in a recent commentary, predicted that today’s low rates will be with us until 2035.

To be clear, we should not overweight bonds in portfolios – I believe that for long-term investors stocks provide better prospects. But I do recommend that clients adhere to the minimum bond allocation that was set out in their investment plan.

Are stocks set to fall?

The flip side of anxiety about rising interest rates for bonds is fear that the run-up in stock prices makes them vulnerable to a severe correction. Some of these concerns are based on work by Yale’s Robert Shiller, a highly respected voice who looks at stocks based on a multiple of 10 year earnings. On that basis, U.S. stocks currently look expensive (although not at nearly the levels in 2000 and well below what we saw in 2007 and 2008.)

While there could certainly be a short term correction in stock prices, I continue to recommend that clients have a healthy stock allocation in their portfolios:

• Nobody has demonstrated the ability to predict short-term movements in stock prices – it is just as likely that stocks will rise by 20% as decline by 20%.
• A recent article by Wharton’s Jeremy Siegel, considered today’s leading stock market historian, suggests that accounting write-offs by American companies have distorted reported earnings and that if another measure of profits are used, Schiller’s model shows that stocks are fairly valued.
• Siegel further points out that when interest rates are low as they are today, historically multiples of earnings have been higher than average.
• Finally, for investors concerned about valuations on U.S. stocks, there are high quality companies in Europe and Asia that sell for a significant discount to their U.S. equivalents.

Sticking to your plan

Most investors might nod their heads to facts such as the ones above and can agree to a plan for their portfolio, identifying the parameters within which their investments will be managed. Of course, agreeing to your plan is the easy part - the challenge is sticking to it. As former heavyweight champion Mike Tyson pointed out, It’s easy to keep to your plan when things are going well; it’s when investors get bloodied from market setbacks that sticking to their plan becomes a challenge.

That’s why when markets become choppy, some investors look for bold advice and dramatic shifts in their portfolio, going all to cash or all to stocks. Unfortunately, the track record of those dramatic shifts is not a happy one:

• During the tech mania of the late 1990s, many investors abandoned the principles of sound diversification and over-weighted their portfolios with technology stocks.
• Ten years ago, investors began skewing their portfolios to banks and other beneficiaries of the real estate boom and in some cases extended themselves to buy bigger houses, vacation homes and investment properties.
• While most investors initially agree to geographic diversification of their equity investments, many find it difficult to stick to that commitment. After a period of strong performance such as the U.S. sees today, the instinctive response is often to heavy up what’s been doing well and to abandon what’s been underperforming – when investors should do exactly the opposite.

Recently, deviating from investment plans has taken a new form. Immediately after 2008, a search for safety led to large flows out of stocks and into bonds, meaning that some investors missed the recovery since the market bottom. And to the extent that investors were buying stocks, many only had an appetite for stocks that pay high dividends and are viewed as an alternative to the secure income from bonds.

In the words of the opening quote for this letter, each of these examples was seen as a clear and simple answer to the complex problem of where to find the best returns in an uncertain environment. In the search for that clear answer, many investors abandoned the plans that they’d agreed to in calmer times.

That’s why I see my role as an emotional anchor – keeping my clients’ highs from being too high and their lows from being too low. For many clients, helping them adhere to their plan, sometimes against their instincts, is how I provide the greatest value. There are occasions when sticking within the parameters of your plan may feel boring, but history shows that the key to successful investing is having a sensible plan and then sticking to it.

What this means for your portfolio

In my email at the end of last year, I outlined some guiding principles in my approach to building client portfolios, two of which I repeat here. I’d be pleased to discuss these guidelines at our next meeting.

1. Rebalancing your portfolio

   In light of stock valuations and the risk in bonds, early last year we recommended that clients increase equity weights to the upper end of their range. Given strong stock performance since the mid-point of last year, that has worked out well and we continue to advise that clients hold their maximum equity weight.

   But strong performance by stocks means that today some clients are above the top of their equity allocation. In those cases, we have been recommending reducing equity weighting to bring portfolios back within their guidelines. Regardless of what happens to markets in the short term, barring a significant change in your circumstances, you should stick to your investment parameters.

   On the topic of rebalancing, you might be interested in this recent article from the Wall Street Journal, pointing out how disciplined rebalancing helped one fund invested in a combination of stocks and bonds outperform both of their underlying investments.

2. Diversifying portfolios

   When building equity portfolios, I’ve always advocated strong diversification outside the U.S. This helped my clients through most of the 2000s and has hurt them in other periods such as the 1990s and the period since 2010, when the U.S. outperformed foreign markets.

   Going forward, the dollar and U.S. markets may do better or worse than global markets. However, given that we represent less than half of the investing opportunities around the world, to maximize returns we must be willing to look outside the U.S.

I recognize that today seems like a particularly uncertain time and hope you found this overview helpful. Should you have questions about this note or about any other issue, please feel free to give me or one of the members of my team a call.

And as always, thank you for the opportunity to serve as your financial advisor.

conducts programs to help advisors gain and retain clients and is an award winning faculty member in the MBA program at the University of Toronto. To see more of his written and video commentaries, go to www.clientinsights.ca. Use A555A for the rep and dealer code to register for website access.

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