IFA Radio's Episode 35

IFA RADIO
Thursday, September 02, 2010

 

With the fall season fast approaching, we are entering a time of the year where the market gets really volatile. It is in these times that being tied to the mast so you do not succumb to the siren songs of active investing becomes so important. Because with volatility comes downs AND ups. Pulling out of the market because the market is dropping and getting back in while it’s rising takes a crystal ball…well, a crystal ball that actually DOES tell the future.
There are no future tense verbs in the market. Prices have a way of washing out all known and projected market changes, thereby resetting the price so it has an equal chance of going up or going down based on a positive expected return. Every price comes with an expected positive return commensurate with the risk they take. This is the basic fundamental principle guiding the market each and every day. The market has to clear everyday, which means contrary to the notion that no one wants to buy any equities, people are constantly buying them.
As advisors, we like to let send out a little article that we call The Resilience of Capitalism.
Warren Buffett gives us his opinion on our capitalistic market.
"The American economy is going to do fine. But it won't do fine every year and every week and every month. I mean, if you don't believe that, forget about buying stocks anyway... It's a positive-sum game, long term. And the only way an investor can get killed is by high fees or by trying to outsmart the market."
                                                                                    -Warren Buffett
Capitalism will rebirth itself. Companies on average make a profit. Even in turbulent, down economies, stock prices will correct themselves to a point where people are interested in buying them. On average over a long period of time, capitalism works.
So how does a person’s portfolio become a representation of the capitalism system? Diversification. If you diversify your portfolio over thousands of stocks, you stand to capture the ups and downs in the different sections of the economy. If it helps, you can view the economy as a cube. This over time this cube is slowly moving upward. Inside this cube all hell is breaking loose with things bouncing around up and down. Screaming voices, things appearing, things disappearing. Nothing is standing still. There are times the cube will stall; sometimes it will drift down. But by owning a well diversified portfolio, you own that cube and therefore capitalism, which over extended periods of time has been moving upward since it came into being. If you have a select group of stocks that are not diversified, you own parts of the chaos that takes place inside the cube.
Below is a chart comparing the average equity investor with a Global Equity Index Portfolio. By owning capitalism (essentially the Global Equity Index Portfolio) you capture capitalism where the average investor, who likely owns select portions of capitalism, falls well short.
 

Nobel Prize winning economists and academics have revealed that broad-based diversification among low-cost indexes has shown to be the most prudent investing strategy over time. Harry Markowitz, the 1990 Nobel Prize in Economics winner and Academic Consultant to Index Funds Advisors, recently stated, “In choosing a portfolio, investors should seek broad diversification. They should understand that equities and corporate bonds involve risk and that markets inevitably fluctuate. Their portfolio should be such that they are willing to ride out the bad as well as the good times. “

 

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