Three Steps to Investing Peace

Investors entered a dark tunnel last September. As with most market dips, the sentiment was that this one was different, and that the world would never be the same again. For many, you either turned off the news at some point last year because you couldn’t stand it any longer, or you have worried yourself into casting the seeds of some form of ill health.

We now have some benefit of time perspective, with this crash one year behind us. As a young man observing the past before my time (e.g. the Great Depression), I ignorantly concluded that each generational cohort on this planet needed to experience one major cataclysm, and that this experience would steel us from future such events. I was wrong on two counts. First, the markets throw more than one such event in a lifetime (the Tech Bubble, the ABCP-induced Crash, the Mexican crisis, “Long Term Capital” etc). Second, we typically don’t successfully learn from these incidents. In fact, experiential memory in the investing world is quite short!

As we come out the other end of yet another cycle, it is worth another try at learning some lessons and engraving them somewhere prominently. Let me offer this….

Simplistically, there are Three Steps to remember and embrace in the long term stewardship of wealth accumulation. These three draw from a hippy author, a bean counter and a financial planner.

Tom Robbins wrote a book in the Seventies called “Another Roadside Attraction” which was largely set in his home state of Washington (you may remember his other book more readily, as it became a movie and had the catchy title “Even Cowgirls Get the Blues”). Throughout the storyline of the book, he frequently re-quoted the following simple phrase:

“And the world situation was desperate… as usual”

Little did he realize he was saying something prophetic to the investing world! The well-known investment writer Nick Murray has his own similar term which he calls the “apocalypse du jour”. I think both of these statements are the first step to learn and embrace. The world, and the Financial Press, will always provide some thing to worry about. I don’t need to list examples – you can do that yourself. Some of these things are real, and have some temporal impact on the planet; others never happen or have a meteoric fall from the front page. My advice is not to get caught up in this trap of being lead around by the Financial Press. Investing is a long term project, whether you are 30 or 60, or even older but building inter-generational wealth. What is important is not to panic and sell at or near the bottom, and also to make sure that your over-all investment strategy (we call it “asset allocation”) is sound. This leads to Step #2.

Nick Murray uses the term “planning-based investment management”, which is, simply to say, that investment management ought to be “planning-based” and not “market-based”. Which leads us to the financial planner’s role in this three step process. A formal financial plan will have included in it an asset allocation strategy which will derive a proforma long-term rate of return required from your investments, which will a) deliver the lifestyle that you seek and b) deliver an ending estate value that you wish for your heirs. Based upon the numerous financial plans that we
have done over the years, this proforma nominal long term rate of return on a balanced portfolio is typically 5-6%. Hold that number and move on to Step #3.

Now we need the bean counter to help you or your investment manager to calculate the actual historical rate of return on your portfolio. In fact, two numbers are required here, and one derives the other. The first is the series of annual simple rates of return earned year-by-year. This isn’t the data to work with, because they likely will jump all over the place and not give you a clear picture of how you are doing long term. But these numbers can be used to derive a running, single long term compound return, and this is the one to compare to Step #2.

If your long term compound return in Step Three is at, near or above your financial planning proforma return in Step #2, you know you will be on track to meeting your goals as dictated by the plan (as long as you also adhere to your budgeted spending plan!). So, there, you’re done! We recently have been calculating the returns for certain portfolios for the twelve months ending August 31, 2009. This period included a temporal high last August 31st, followed with the deep crash in September/October and then followed with the steep recovery from March to this August. The three accounts we have analyzed had simple returns for that period of -2.5%, -4% and -5%. The impact of these negative returns on each of the long term compound returns was between 3/4ths of 1% and 1 ¼%, and in all cases the long term compound returns retreated to approximately 6%. These were all portfolios with a balanced strategy involving between 40% and 60% in equities. You’ll note above that a long term proforma rate of 5-6% is sufficient for most people to achieve their life goals.

The Three Steps

  1. Avoid the siren-call of the financial Press
  2. Have a formal financial plan which includes a long-term target rate of return that delivers your goals
  3. Calculate your actual long-term compound return and compare it to the target rate

In a keynote address that I recently gave at a 2020 Accountants Conference in Niagara Falls, entitled “Ten Commandments of a True Professional”, some of the commandments are actually universally applicable. The first one historically is known as “Nilson’s First Rule”. It says:

“Don’t worry about the problems you don’t have”

That rule is directly applicable to the 2008 apocalypse du jour in the markets and to the Three Steps. If you have been applying the Three Steps prior to the latest Crash, then Nilson’s First Rule has been easy, and you have not incurred significant angst since last September.