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July 18, 2005 Dear Client: "A whole lot of nothing going on" sums up the U.S. stock market this year. U.S. markets recovered a bit in the second quarter. These small gains left the S&P 500 index down about 1% since January 1, 2005. Small-cap stocks are down 2% year-to-date, and foreign stocks are down 3%. Bonds also recovered in the second quarter, putting the Lehman bond index up 2.5% year-to-date. Pain of our losses, pleasure of our gains. Three clients called during the last two months concerned about the performance of their investments. This was unusual; we rarely get this type of call, and the portfolios were not declining. One client referred to the "barrage of bad news", another to "the market’s really poor results this year." Together we looked at their portfolios. Each of the clients was surprised to see that the value of their portfolio was essentially unchanged over the quarter, or even up a bit. Each client received a daily email from Schwab, listing each investment with its daily change. Losses were shown in red, gains in green. I found the clients' comments puzzling: why did they have the perception of losses, when the markets have been so unremarkable this year? Daniel Kahneman, Professor of Pyschology at Princeton University, and the 2002 recipient of the Nobel Prize in Economics, first demonstrated one of the primary tenets of risk-aversion behavior: investors feel the pain of their losses more deeply than the pleasure of their gains. Further studies have quantified "more deeply" to be more than twice as much. Our advice: discontinue the daily email reports, stop looking at online quotes. Quarterly statements will provide the same information while filtering the short-term noise of daily volatility. There is no daily movement that should affect the investment plan of a properly diversified portfolio. If you cannot tolerate a loss of a certain amount or percentage, please share that information with us and we will reduce the expected volatility of the portfolio to reflect your risk capacity. It isn't a bad thing for the markets to take a rest. The S&P 500 gained 29% in 2003 and 11% in 2004. Small-cap stocks gained 45% in 2003 and 17% in 2004. The valuation of the U.S. stock market is high by historical standards. There are two ways for the stock market valuation to decrease: the price of stocks in the market can decline and/or corporate earnings can increase. Earnings of the S&P 500 companies increased twelve percent (annualized) in the first half of 2005, while stock prices were flat. Although investment returns have been flat this year, higher corporate earnings mean lower stock market valuation, which in turn reduces investment risk. To balance the short-term view of performance above, we offer a perspective on long-term objectives. The daily or monthly fluctuations of a portfolio can be a distraction from the larger question: what is the proper allocation of your investment assets to meet your long-term objectives? The difference between a portfolio designed to return 8% and one expected to return 7% annualized is substantial:
The chart below illustrates a very simplistic financial scenario: A couple has IRAs totaling $1,000,000 and a taxable account also worth $1,000,000. The couple will begin retirement this year. They plan to withdraw $127,000: $100,000 for living expenses and $27,000 to pay taxes. Each year their living expenses will increase at the rate of inflation, so their withdrawals would need to increase accordingly. A small difference in investment returns has a large impact on the ability to fund their objectives. With an 8% annualized rate of return the accounts would last 32 years. Though a one percent difference might not sound like a lot, a 7% return would cause the portfolio to run out six years sooner.
If you have any questions, please do not hesitate to contact us. Regards, Audrey Grubman
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