“We have met the enemy and he is us.” - Walt Kelly, Pogo. “With financial markets, you never know what they are going to do.” - A.A. Milne, Winnie-the-Pooh.
These quotes sum up why mutual fund investors generally do much worse than the funds themselves. Indeed, in its 22nd Annual Quantitative Analysis Of Investor Behavior 2016, DALBAR states that investors consistently fare worse than do the funds themselves. In 2015, the 20 -year annualized S&P return was 8.19% while the 20-year annualized return for the average equity mutual fund investor was only 4.67%, a gap of 3.52%. There is no reason to believe that the underperformance DALBAR notes will cease any time soon as the behavioral traits responsible for underperformance are wired into our emotions. How might we help you to overcome behavioral biases that harm returns even though you never know what your investments will do? Fortunately, time is on your side.
Over a period of time in which most will invest, at least 30 years, common stock investments follow the earnings of their parent companies. Furthermore, company earnings track very closely to economic performance in the country in which the company is domiciled. It only takes faith that our economy will not collapse to realize that by holding on to common stocks of quality companies that pay growing cash dividends, we will leap over the pot holes caused by short-term uncertainty and the occasional overshoot and undershoot of the growth trend caused by greed and fear on the part of investors. Point no. 1, then, is that we can obtain the long-term growth rate of portfolio companies if we but hold on to them while letting their cash dividends compound over long periods of time. But is 100% stock investing for everyone?
Just as where we live has influence over our well-being, where we invest constitutes a significant influence over investment results. Though we don’t know what investments will do over the short term, we do know how stocks, bonds, commodities, and real estate correlate with each other over the long term. In general, stocks have a growth rate about twice that of bonds (stocks represent ownership, bonds represent debtor-creditor relationships) while commodities and real estate diversify stocks and bonds because they don’t correlate well with them. Furthermore, stocks are volatile in their short term price movement, bonds are not. By combining stocks and bonds, then, we can target a growth rate and volatility level that fits an economic need and emotional capacity for uncertainty.
Why Quality Stocks?
According to Professor Jeremy J. Siegel in his 5th edition (2014) of Stocks For The Long Run: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies, dividends account for nearly half of the growth rate (total return) of common stocks when the cash from dividends is reinvested in more shares. Furthermore, the common stock investor’s greatest nightmare is waking up one morning to find her/his account drop precipitously due to the market’s sudden re-rating of company earnings prospects. Quality company earnings are more certain and have fewer serious disappointments, resulting in greater peace of mind for shareholders. Quality company dividends also grow so that over time, in a retirement account for example, the cash income from dividends and interest alone will approach income needs. We can be free of concern that account movement caused by market pricing ups and downs will affect economic well-being. Why? Interest from bonds is protected by covenant and dividends from quality companies are highly resistant to cutting. This means that though stocks prices may go up and down somewhat peripatetically, cash income is steady as a rock.
Putting It All Together
By holding quality stocks in a portfolio balanced with bonds and other diversifiers that befits needs and tolerances, we can avoid the temptation to buy in speculative fervor and to sell in panic. Following a disciplined process, then, we can avoid behavioral pitfalls that torpedo the account growth rate, thereby arriving emotionally whole at a financial destination.
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