In operation, the higher your capacity for risk, the more of your portfolio can be allocated to stocks which offer higher long term return potential but have greater short term volatility than cash and bonds.

The chart to the left demonstrates the historic ranges of returns for US Stocks going back to 1928.

As you can see the average one year return is 11.3%, but has been as high as 52.5% and as low as -43.8%.

Then as you look at longer time periods, losses become less likely, and over periods of at least fifteen years there has been only one loss of 0.2%.

Notice that while the difference between the best and worst returns gets narrower as you look at longer time periods, the average returns are close over all time periods.

Bond and Cash returns follow a similar pattern, with the difference between high, low and average returns being lower for bonds, and lowest for cash.

So a sound investment strategy should take into account when you are likely to need money from your portfolio, and allocate the money you won’t need for many years to stocks, while money you will need in the next few years should be in bonds and cash.

Below are some examples of how our Risk Capacity formula puts this into practice.

The more money you will need each year, the more you should allocate to bonds and cash and this results in a lower stock allocation.

If you are saving money for the next several years, you can allocate more to stocks and less to bonds and cash.

Risk capacity is also dependent on the amount of savings or withdrawals relative to the size of your portfolio as can be seen by the difference in stock allocation for examples C and F.

Example F shows that a maximum of $200,000 of the portfolio would be in stocks, thus allocating $300,000 to bonds and cash which would allow for six years of withdrawals at a $50,000 annual pace.

Example C would allocate $650,000 to stocks and $350,000 to bonds and cash, which would be seven years of withdrawals in bonds and cash.

Don't push the panic button

Probably not, even though it may feel like it.

What’s Going On

The financial markets have been hit with a steady barrage of negatives.

Europe is still struggling to address the problems inherent in the Euro — namely that they have a currency union but not a political union.

Here in the US the short term budget deficit caused by the Great Recession is being confused with the long term budget problems.

These long term problems are primarily about rising healthcare costs, tax revenues that are too low by historical standards, and to a lesser extent Social Security.

This confusion, combined with a toxic mix of politicians in this year’s Congress, caused a dysfunctional budget process. And this dysfunctional process caused Standard & Poors (S&P) to downgrade US Treasury debt (though that company’s past performance on debt ratings leaves substantial doubt about whether they should be listened to).

On top of all of this, we were already in a slowing industrial cycle directly related to China tightening their monetary policy to bring their inflation rate down.

Reactions

Fear that these issues could push the US and the world into another recession is causing falling stock prices.

Most tellingly, these issues have actually reaffirmed investors’ faith in US Treasury debt as Treasury prices have steadily risen as the negatives have piled up.

Clearly investors do not believe that S&P was correct with their downgrade, or US Treasury prices would be falling, which causes rates to rise.

In fact, since the beginning of the year, the yield on the ten year Treasury bond has fallen from 3.4% to 2.4% as fearful investors sought a safe haven. And most of this decline in rates occurred in the last two months as the debt crisis manufactured in Congress ramped up.

This Day in History

Our research tells us that it is not uncommon at this point in a recovery to have a slowdown, so the current economic slowing may not lead to a recession.

Furthermore, the current recovery is only a little over two years old, and in the last 80 years there have only been two recoveries that lasted less than 3 years. In both of those previous cases, the stock market did correct, but the decline was less than 20%.

Double Dip?

There are good reasons that this current crisis is not likely to be a repeat of 2008.

Households and corporations alike have spent the past few years rebuilding their balance sheets. Corporations have become leaner and added significantly to their cash positions.

This should enable them to weather an economic downturn without needing to make layoffs on a scale like we saw 2-3 years ago.

More Good News

We are also encouraged by attractive stock market valuations.

The current stock market’s earnings yield is around 7%, which provides a much higher return potential than high quality bonds which are only yielding about 2% to 4%.

We also believe that companies will see rising earnings over the next 5 to 10 years. Even though the decade of the 2000s was a poor one for the US economy, earnings of our big corporations still rose by about 60%.

For the decade of the 1990s, earnings rose by over 100%. So it is plausible to believe earnings will rise over the coming decade at least as much as in the 2000s.

What We’re Doing

As has been our experience with large market drops like this one (and large market rises as well), we have learned not to make investment strategy decisions based solely on short term market gyrations, though they can present opportunity.

Our research lead us to reduce stock allocations at higher stock prices in late 2007 and earlier this year. Conversely we will be increasing stock allocations at these now lower prices.

We are paying close attention to valuations as some sectors are not as reasonably priced as others.

We are continuing to emphasize large-cap, high-quality companies as they are more attractive than smaller stocks at current prices and better equipped to endure difficult conditions.

Our focus on international equities is in developed economies as they too, have better valuations when compared to emerging markets, though we are maintaining a position in emerging markets as we anticipate those countries to be the drivers of growth during economic expansions.

Many high-quality US companies are also uniquely positioned to take advantage of the emergence of a middle class in China and developing economies as they expand their operations into these markets.

Given that emerging market stocks have also declined, we may be bringing up emerging market allocations for the first time in several years.

The Bottom Line

When fear is high and confidence is low, people have a difficult time seeing how things will get better.

But they always do.

* Photo credit: jma.work

Healthcare Cost Percentage Projected through 2085

This article shows an interesting comparison with other countries.  While healthcare costs have been rising as a share of the economy across all countries, starting somewhere around the late 1970’s, our costs have been rising much faster than other countries.  And while portions of our system are better than most of the rest of the world, the entire system is not better than most developed countries.  In other words, we get very poor value for our money.

This leads us to the conclusion that our healthcare costs can be prevented from rising as quickly without sacrificing quality.  Just holding healthcare costs to the current percent of GDP would make the long term budget problem manageable.

And if our healthcare system also starts to look like other countries’ systems, we may even see our healthcare costs decline as a percent of GDP.  Looking at a few other countries, you’ll notice that  Japanese and German costs have risen the least since 1980 so they may provide the most interesting insights.

There is a school of economic theory that says that the level of taxation has a strong inverse relationship with economic growth.  In other words, some believe that low tax rates cause high growth and high tax rates cause slow growth.  This is why some believe that we should not use higher tax rates as part of a long term budget solution.

We do not share that fear.  The following chart shows average federal revenue as percent of GDP, and real GDP growth by decade.

Real GDP by Decade vs. Federal Revenue as a % of GDP

So tax rates and revenues were lowest in the 2000s, but that was also the weakest decade for economic growth.  If a strong inverse relationship exists, than the 2000’s should have instead been our highest growth rate decade of the last four.  And the 1990s should have been the slowest growth decade.

Of course we don’t believe that high tax rates cause strong economic growth and that low tax rates cause weak economic growth.  We think that the evidence indicates that tax rates simply do not have as much impact on growth as some people believe.

Closing the long term budget imbalance will be a positive for our economic future, and higher tax rates are most likely to be part of the solving the budget problem.

Where did it all go?

We all hear about how the US is going broke. Depending on the viewpoint or agenda of the source of what we hear, read or see, the cause of the federal government’s financial problems varies.

Unfortunately, there is almost always a lack of actual facts and perspective, so the public is left to try to make sense of the issues with beliefs and emotions that are often manipulated by politicians wanting votes, vested interests wanting to maintain their sources of money, media outlets whose ratings are dependent on keeping their viewers and listeners emotionally agitated, and fund raisers who’ve learned that messages of potential disaster increase contributions.

Now it is possible to get just the facts about how your own tax dollars are spent. This link http://www.thirdway.org/taxreceipt allows you to input the total federal taxes you paid, and then breaks down where that money went. Most of us will likely have some surprises when we see the actual amounts.

Sunny or Stormy?

An easily forgotten truth of investing is when prices are high, skies are sunny and when prices are low it’s stormy.  In other words, successful long term investing involves turning cautious when things look good and aggressive when things look bad.  Sunny = Sell High, Stormy = Buy Low.

Best Time to Invest

Think back to last July when there was oil in the Gulf of Mexico and the TV and radio talking heads were all convinced we were going into another recession.  Did those mid-summer days feel like the best opportunity over the last year to invest?  Since then, skies have brightened considerably and stock prices have risen about 20%.

Fear = Opportunity

We don’t know which way the Middle East turmoil will resolve.  It could be positive or negative in the short run.  In the long run we don’t think it matters, revolutions and geopolitical turmoil is the norm rather than an exception.  Short term scares provide the opportunity to pick up stocks at low prices from those who are selling out of fear.

So if market conditions get worse, how are you likely to react?

Photo Credit: rkramer62

Separate Politics and Investing

When it comes to investing, emotions are probably the single biggest obstacle to success for most investors.  Since strong emotions often accompany politics, we feel it’s important to try and minimize politics when gathering our investment research and implementing investment strategies.

Given that there are plenty of examples of the economy and markets doing well and examples of it doing poorly with every combination of party control, we believe that the business cycle is simply much more powerful than politics.  Of course in countries like Cuba and Venezuela that is not the case, since the government controls so much, but this is the United States and we are one of the most market oriented nations in the world.

As for individual investors, we have noticed that efforts of all the political actors to motivate their base around the time of elections can be a particularly dangerous time for those whose political beliefs are strong.  For this group, it is probably even more beneficial that they have us, or a trusted professional third-party in place, to implement their investment strategy.

Photo Credit: lakelandlocal

Reverse Your Emotions

Don't Panic!

Successful investing requires turning emotions on their head.  When most people are nervous is the time to see opportunity, and when most people are fearless is the time to be scared.

The stock market did worse during the 2000’s than it did in the 1930’s! Do you remember how you felt in September of 2002?  Or even last February 2009? These periods are when many people were giving up on the stock market.  Fear had brainwashed their rational decision-making skills. If they would have realized in 2002 that their investments were about to go on a multi-year bull market ride, would their fear have been as pronounced?

On the other hand, people’s attitudes of early 2000 and October 2007 were ripe with optimism and fearlessness.  This is a direct contrast to the fear and pessimism that are now dominant.  Optimism makes people overpay for opportunity, while fear makes them overpay for safety.

It’s important to recognize that we will continue to have economic scares in the future (as we always have in the past).   Economic Cycle Research Institute had a recent write-up about the lag effect in people’s perception after a recession.

Take Inventory of Your Short-Term Holdings

What percentage of your investments are in safe areas?  The basic rule of thumb is to have 3-6 months of your living expenses in a safe place with little risk.  This allows you some breathing room for the money you have invested in the markets.  Knowing that you have a cushion of cash and bonds to access for your everyday expenses gives riskier investments time to ride through the stock market dips.

*Photo Credit: pasukaru76

In the cover story “Reassessing Risk” by Olivia Mellan, Bill discusses his views on risk tolerance:

“My experience is that many people’s tolerance is directly correlated with recent market performance, so we shy away from questionnaires. I’m also wary of the way people can misjudge odds due to things like familiarity bias or the structure of questions.”

…

“We then discuss with clients how that [performed] under different market conditions, and look for their wince point to gauge whether their tolerance is lower than their capacity. If their tolerance is lower, we’ll lower the max equity exposure.”

Click here to read the entire story on InvestmentAdvisor.com.