The Best of Times, The Worst of Times

By Weston Wellington

For the twelve-month period ending May 31, 2011, equity investors around the world enjoyed the equivalent of blue skies and bright sunshine while the economic news was partly cloudy at best. Among forty-five developed and emerging-country stock markets tracked by MSCI, all but four had double-digit total returns (in US dollar terms), and twenty-six had returns of 30% or more.

If someone had told us a year ago that global markets would stage such a broad-based rally, we would have been inclined to think that trends in employment, housing, and financial distress were about to take a pronounced turn for the better. It seems hard to argue they have done anything of the sort. Somehow, despite gloomy financial page news that keeps repeating itself, equity prices marched substantially higher.

The moral of the story? Investors should be skeptical of their ability to predict future events and even more skeptical of their ability to predict how other investors will react to them.

Last Year's Headlines	This Year's Headlines
"Europe Crisis Deepens as Chaos Grips Greece" Sebastian Moffett and Alkman Granitsas. Wall Street Journal, May 6, 2010	"Greek Woes Fuel Fresh Fears" Marcus Walker and Hannah Benjamin. Wall Street Journal, May 10, 2011
"Fearful Investors Are Pulling Out" Adam Shell. USA Today, May 20, 2010	"Fear Wins: Stocks Resume Long Slide" Adam Shell. USA Today, June 16, 2011
"Housing Prices Remain Weak" Sara Murray. Wall Street Journal, May 26, 2010	"Home Market Takes a Tumble" Nick Timiraos and Dawn Wotapka. Wall Street Journal, May 9, 2011
"Fear Returns—How to Avoid a Double-Dip Recession" Cover story. Economist, May 29, 2010	"The World Economy—Sticky Patch or Meltdown?" Cover story. Economist, June 18, 2011
"Spill Tops Valdez Disaster—Deep Trouble: There Was 'Nobody in Charge'" J. Weisman, G. Chazan and S. Power. Wall Street Journal, May 28, 2010	"Japanese Nuclear Crisis Is Ranked at the Level of Chernobyl" Mitsuru Obe.Wall Street Journal, April 12, 2011
"Discouraging Job Growth Batters Stocks" Don Lee. Los Angeles Times, June 5, 2010	"Jobs Data Stoke US Recovery Fears" Robin Harding, S. Bond and M. Mackenzie. Financial Times, June 4, 2011
"Economic Outlook Darkens" Jonathan Cheng and Justin Lahart. Wall Street Journal, June 2, 2010	"Stocks Plunge Amid Fears That Global Economy is Slowing" Christina Hauser. New York Times, June 11, 2011
"Bond Fund Managers See Signs of a Bubble" Sam Mamudi. Wall Street Journal, June 8, 2010	"Why Are Investors Still Lining Up for Bonds?" Jeff Sommer. New York Times, May 29, 2011
"Rapid Declines Rattle Even Optimists" E.S. Browning. Wall Street Journal, June 14, 2010	"Investors Shaken by the Fear Factor" James Mackintosh. Financial Times, June 18, 2011

Past performance is no guarantee of future results.

How Can Retirees Determine a Sustainable Withdrawal Rate?

Ken French says the simplest answer is found in the rate offered on a long-term Treasury Inflation Protected Security (TIPS). You can go beyond the TIPS rate if you don't plan to live forever. Retirees with a shorter life expectancy might choose to consume more. Finally, you might increase your expected investment return and your expected sustainable withdrawal rate by taking more risk. But Ken warns that the expected return and the return you ultimately receive could be very different. That is the nature of risk.

Homemade Dividends

Should retirees limit their spending to the interest and dividends they receive? Ken French says investors should be indifferent to how they raise cash, whether through dividends and interest, or through the sale of shares--a method Merton Miller called "homemade dividends." Despite the economic logic, some investors focus on dividends and interest. While this approach may encourage disciplined spending, Ken explains that it also can distort one's investment approach--for example, when investors choose dividend-paying stocks over broad diversification, or chase higher yields by holding riskier bonds. In an effort to get more, they actually lose.

Stay Focused on Your Plan During the Good Times, as Well

By Larry Swedroe

Readers of my blog know that one of the keys to being a successful investor is to have the discipline to adhere to a well-developed plan through both good and bad times, rebalancing along the way. Today, I wanted to remind you to not let the bull market of the past two years cause you to become complacent about risk and lose discipline.

Disciplined investors benefited from the bull market of the 1990s, selling stocks high when their allocations exceeded the minimum and maximums for each asset class as established in their investment policy statement (IPS). Thus, they were much better prepared for the 2000-2002 bear market than if they hadn’t rebalanced.

Those investors who stayed disciplined through that bear market were buying stocks (which were now at much lower prices). The following bull market once again gave disciplined investors the opportunity to sell high, positioning themselves much better for the 2008 bear market. That bear market once again gave them the opportunity to buy low. And the past two years have once again presented you with the opportunity to sell high.

Investing is really that simple. The problem is that it isn’t easy to buy low and sell high. In fact, investors tend to do the opposite. They chase returns by buying yesterday’s winners (high) and sell yesterday’s loser’s (low). Subject to recency and the follow-the-herd mentality, they act as if they were driving forward while staring at the rearview mirror. And that leads to them underperforming the very funds in which they invest.

The winning strategy is quite simple:

• Write an IPS tailored to your unique ability, willingness and need to take risk.
• Only alter the plan if its base assumptions have changed.
• Use passively managed funds to build a globally diversified portfolio.
• Regularly rebalance and tax manage as appropriate.
• Ignore all “guru” forecasts and the noise of the market.

And that’s about it. Simple. Unfortunately, it isn’t easy because emotions get in the way. In bull markets like the current one, greed and envy take over, and investors lose discipline and take on more risk. They forget the lessons of the past and “run with the herd.” In bear markets, it’s fear and panic that take over, and the stomach overrules the head. Stomachs rarely make good decisions.

While we’ve been lucky to experience the current bull market, it’s important not to lose sight of the fact that there are only three things we don’t know about bear markets:

• When they will start
• How deep they will be
• How long they will last

I’m certainly not forecasting a bear market. However, I’m reminding you to stay disciplined. Investing in equities is always risky, no matter how long your horizon. And the risks can appear from totally unexpected and thus unforecastable sources. The recent series of revolutions in the Middle East, along with the earthquake, tsunami and nuclear disaster that hit Japan are good reminders of that. And finally, there are certainly enough issues currently making headlines to remind us of just how risky stocks are. They include:

• The continued slump in housing prices
• The potential for a default on the debt obligations of the U.S. Treasury
• The potential for default of Greece, and their possible abandonment of the Euro

Socially Responsible Investing

Question and Answer with Fama and French.

Q: Are expected returns for "socially responsible" strategies lower compared to a conventional approach?

A:Our paper, "Disagreements, Tastes, and Asset Pricing," addresses this issue. Like all prices, asset prices are determined by supply and demand. If some investors overweight the stocks of "socially responsible" firms, they push up prices and reduce expected returns. Similarly, they push down the prices and push up the expected returns of the socially irresponsible firms they underweight. Presumably that is their goal—to reduce the cost of capital of firms they like by reducing the "good" firms' expected stock returns and to increase the cost of capital of firms they don't like by increasing the "bad" firms' expected stock returns. These changes in expected returns induce other investors to underweight the "good" firms and to overweight the "bad" firms. Socially responsible investing has not been around long enough to measure the magnitude of these effects. We can be sure, however, that if socially responsible investors have any real impact, they push down the expected return on the stocks they overweight and increase the expected return on the stocks they underweight.

Home BIas

Arianna Capital

Investors tend to overweight their equity portfolios with stocks from their home country market. Ken French says that, while home bias is still the norm, investors have significantly increased their allocation to foreign markets over the last 30 years. He explains that investors might overweight their home market for economic reasons, perhaps to hedge consumption risk or to offset tax disadvantages they suffer in some foreign markets. Home bias can also be driven by behavioral factors. For example, investors may overweight their home country because of their uncertainty (the unknown unknowns) about foreign markets, or because they are overconfident about picking stocks in their home market. Ken says the best approach is to start with a global market portfolio, then make adjustments based on personal preference.