Domestic large caps supplanted shares of smaller companies on the leaderboard this past quarter; the return for the thirty companies comprising the Dow Jones Industrial Average fell just shy of double digits, registering in at 9.63%, whereas the broader S&P 500 registered a respectable 7.71% for the period. While bested, shares in smaller companies still advanced 3.58% as measured by the Russell 2000 Index. Translated into US dollars, foreign markets mimicked the domestic pattern of large caps outpacing smaller company shares from July to September, albeit in more subdued fashion: the MSCI EAFE Index returned 1.42% compared to a 0.39% loss for the S&P EPAC SmallCap Index. Emerging markets also ceded ground for unhedged US investors, with a barely-positive 0.11% local-currency return for the MSCI index translating into a 0.95% decline as the US dollar strengthened slightly over the past quarter. Despite impressive returns last quarter, Real Estate Investment Trusts (REITs) were once again the domestic laggards, though they still managed to eke out a positive gain of 0.72%.
With interest rates on the rise, the short end of the government fixed income spectrum performed best: 30-day Treasury Bills marked the third quarter with a 0.48% gain; meanwhile Treasuries with durations of 1-3 years recorded a 0.20% increase over the prior three months. The broader US-denominated bond market, however, tread water, with only a 0.02% return as measured by the Bloomberg Barclays Aggregate Bond Market Index. Globally, sovereign bonds lost ground over the July-to-September period in both local currencies (-0.92%) and US dollars (-1.62%) according to the FTSE WGBI.
News outlets and the popular financial press are correctly proclaiming that the US is now in the longest bull market in history. We are in unprecedented territory. As on every other day whatever, this has led to no shortage of prognostications about where markets might next go. We at Schultz Collins are not in the prediction business. Why? Because selling predictions is selling information that does not exist. We would rather focus our efforts on making sure you are prepared for whatever the markets deliver, for well or for ill. An historic market high is, nevertheless, an apt time to revisit some of the finer points about risk.
There are three facets of the risk investors must bear: risk capacity; risk tolerance; and risk perception. Risk capacity is an objective measure of how much adverse risk your portfolio can sustain without jeopardizing attainment of your goals. Those with high risk capacity require a much lower return on their investments to meet their goals, and vice versa. Risk tolerance is a subjective measure that, research tells us, is fairly stable for an individual over time; it evaluates your behavioral response to taking on risk in exchange for the possibility of higher returns. An asset allocation customized to your risk tolerance is one that allows you to sleep at night, untroubled by the relative swings in your portfolio’s value. The third facet, risk perception, also a subjective measure, can be very unstable. It reflects our tendency to mistake the true level of risk – that is to say, of volatility – in the markets. The field of behavioral finance has cataloged many reasons we tend to misjudge risk, including tendencies to emphasize recent performance, and to notice news that is more vivid and thus easier to recall (such is the stock in trade of the financial press), as well as to follow the crowd.
Economies and markets are integrations of the acts of their participants. And because our behavior is affected by our perceptions we may conclude that economies and markets reflect investor perceptions (and those of traders and speculators). Assume, for the sake of argument, that two economic indicators, the CBOE Volatility Index and the University of Michigan Consumer Sentiment Index, are proxies for risk perception. The former is a market-based measure popularly known as the “fear index,” whereas the latter measures consumer impressions of how well consumers themselves and the economy are doing now, and are expected to do in the near future. What do we find? Since 1990, on a rolling 12-month basis, market “fear” has tended to decline and consumer sentiment (we could call it “enthusiasm”) to rise when the US stock market rises, and vice versa. Put another way: when the market is firing on all cylinders, stock market participants and US consumers expect the good times to continue; when the markets drop, fear runs rampant and the crowds see no end to the bloodletting. These perceptions then motivate trades that, all else held equal, tend to exacerbate market swings.
Why is this so? Risk perceptions are skewed by the recent direction of the markets, broadcast via the media, online brokerage portals, and monthly account statements, then to be taken up by the supposed wisdom of crowds. And crowds are rather momentous than particularly wise; sometimes, indeed, they are called mobs. They mostly discover what it seems that most people are feeling and then amplify that feeling, thereby reinforcing it. A positive feedback cycle – which is unfortunately often a vicious feedback cycle – not infrequently ensues.
To paraphrase Warren Buffett: we are wired to be greedy when others are greedy and fearful when they are fearful. We would do better to do the opposite. But, especially at times like the present, it is emotionally and viscerally difficult to breast the tide: to sell high and buy low, and to keep the longer term in mind. Nevertheless it is upon just such guts – and intellectual clarity – that long term investment success is founded.