Factors That Determine Your Investment Success

There are three fundamental factors that will determine evertone's investment success:  Deposits & Withdrawals, Investment Strategy, and the Sequence of Returns.

1.  Deposits & Withdrawals.

The first factor is the amount, the frequency, and the timing of your Deposits & Withdrawals. 

Accumulating for retirement.  If you are accumulating assets for retirement, you may be making periodic contributions, i.e., automatic monthly investments, to an IRA or 401(k) plan, or adding to an existing investment account.  Each deposit will influence your overall portfolio’s return depending on whether the market is rising or declining at the time of contribution and what level the market is just before retirement. 

You can think of each deposit as having its own mini rate of return which collectively contributes to the portfolio’s overall return.  Some deposits will generate positive returns, others will generate negative returns, and some will break even. 

On the other hand, if you are making a one-time (the frequency) lump sum investment (the amount) such as an IRA rollover, or from an inheritance, then the market environment at the start of the investment (the timing) can be crucial in determining your success.  It will make a huge difference in your accumulation whether you buy near the market peak, close to the bottom or somewhere inbetween, especially if you are nearing retirement.

Retired.  If you are retired and withdrawing from your investment accounts, the amount and the frequency and the timing of each withdrawal will also affect the portfolio. 

As discussed in the section on Defensive Investing™, if the financial markets are generally rising, withdrawals may have little impact on portfolio values as portfolio growth may offset income withdrawals to some degree.  However, if the markets are generally declining, withdrawals may diminish a portfolio’s value and shorten its longevity as income is withdrawn from a declining asset base. 

The size of the withdrawal in terms of percentage of the portfolio also has an impact.  Studies show that for most retirees a withdrawal rate greater than 4-5% may put your portfolio in jeopardy, especially in markets that post frequent or steep losses.

So, the bottom line is that the amount, the frequency, and the timing of your deposits and withdrawals, and how the markets are performing at the time are one of the three critical factors in determining your investment success.

2.  Investment Strategy.

The second fundamental factor is the Investment Strategy you use.  There is a wide spectrum of investment strategies: from the buy-and-hold approach using individual stocks or mutual funds, to various forms of asset allocation and privately managed accounts.

It is essential for you to understand the differences in the underlying investment philosophy and stratgies, and understand what the dirvers are for performance and risk management .

Each strategy along the spectrum emphasizes one of two factors, or relies on some combination, to generate performance and reduce risk:

1. General Market Trend
2. Manager’s Skill

General Market Trend.  Investment strategies that employ a buy-and-hold and "formula" asset allocation approaches rely primarily on the overall market trend to generate returns and less on the manager’s skill.

“Time in the market” and long holding periods are seen as a ways to generate returns, since the market generally rises over the long run.  Theoretically, the risk of losing money diminishes the longer you hold the investment, so investors are encouraged to hold through the tough times and “stay the course” for the eventual rewards.  

In reality, staying the course may actually increase your risk in later years when you have the most at stake.  A major market decline can wipe out years of accumulation.

I refer to this approach as “relative return" investing in which portfolio returns, and by default the investment strategy, are judged "relative" to the performance of a benchmark, such as the S&P 500 Index, or combination of indexes. 

While it may be academically interesting to compare portfolio performance to a benchmark, there is little comfort in beating a benchmark that has produced a major loss by losing a little less.  "Relative" negative returns can still ruin a retirement portfolio. 

Strategies that rely on the general market trend for results have largely been discredited in recent years due to the prolonged period of poor market performance.   As discussed in the section on Three Enduring Lessons, the S&P 500 Index has made no progress in 11 ½ years through March 2009.

Furthermore, portfolio diversification, which is the foundation of asset allocation theory as a way to reduce risk, has proven to be totally ineffective in 2008 as investments of all kinds fell sharply.

Moreover, there is a practical limit to investors’ time horizons and their ability to “hold for the long-term”.  As investors approach or enter retirement, their need for greater investment certainty compresses their long-term orientation and reduces the ability of a portfolio to tolerate negative returns.   

Gary D. Halbert of Halbert Wealth Management states succinctly , "At the end of the day, what really matters to most investsors is the value of their accounts when they need their money. [my emphasis]  A double-digit historical return over a 75-year time horizon doesn't do you much good if the value of your investment dives 50% just at the time you need your money for retirement."     

Manager’s Skill.  Conversely, investment strategies that employ an active management approach to asset allocation and portfolio management tend to rely more on the manager’s skill, and less on the market trend, to navigate market uncertainties and opportunities. 

Active managers have greater flexibility to respond to changing market conditions in order to control risk and generate returns.  Many managers will raise cash when market risks are high or when profitable investment opportunities are scarce.  Active managers typically make greater use of non-traditional investments and can take more concentrated investment positions as opportunities present themselves.   Others will incorporate sophisticated hedging techniques to preserve investor's capital.

Often the goal of active managers is to produce “absolute returns” for investors, that is, to generate positive returns every year, regardless of market conditions. 

There has been a scramble recently by mutual fund companies and money management firms away from reliance on “market-based” strategies towards more active portfolio management.  In my opinion, this is a welcomed development for investors.

Riding the market trends with a buy-and-hold strategy in these volatile markets, in my opinion, will lead to disappointing results.  Managing those trends, on the other hand, with a more flexible approach, in my opinion, gives your the best chance of having your money last throughout your lifetime.

The bottom line is that it is very important to understand the underlying philosophy and strategy of the investment approach you are using, and how returns are produced and losses minimized.  You have to determine if it makes sense to you, and how comfortable and confident you feel about putting your life savings at risk in this manner.
 

3.  Sequence of Returns.

The third factor, and most important factor, that determines your investment success is the sequence of market returns. 

It is the frequency and size of the negative returns that make allthe difference.  It matters a great deal whether the negative returns are few and shallow, or more frequent and larger.  It also matters a great deal when during your investment lifecycle you experience them.

Positive and negative returns do not happen randomly.  There are periods of time when there is a pronounced pattern.   It is especially crucial as you approach or enter retirement because the impact of negative returns can be devastating, raising the likelihood of running out of money.

Historically, the stock market moves in long-term trends, called “secular” trends, that typically last 10 to 20 years, producing long periods of high returns, followed by lengthy periods of low returns.

If the long-term market trend is up over time and continues to establish new highs, it is called a “secular bull market”.  If the long-term market trend is down or sideways over time, it is called a “secular bear market”. 

Since 1896, there have been four secular bull market trends and four secular bear market trends.  Click here to view the Dow Jones Historical Trends, an excellent chart of secular market trends for the Dow Jones Industrial Average over the past 112 years. 

It is absolutely essential to your financial security for you to understand the reality of secular trends and know which trend you’re in because the sequence of market returns differs enormously depending on the trend. 

Secular bear markets, which we are in, generate more frequent and larger losses compared to secular bull markets, and as a result, the sequence of returns will have a much greater impact on the performance and longevity of your portfolio.  I discuss this in much more detail in Three Enduring Lessons. 

In Summary.

The interaction among the three fundamental factors of Deposits & Withdrawals, Investment Strategy and the Sequence of Returns will determine your investment results. 

While the Sequence of Returns is the dominate factor of the three, you are not at the mercy of the market.  It comes down to what you can and cannot control.

You can control your Deposits by delaying or cutting back, or by making additional contributions to take advantage of investment opportunities or to make up for portfolio losses. 

You can also control your retirement income by changing the Withdrawal percentage.  If your portfolio performs well, you can give yourself a raise.  Or conversely, if your portfolio performs poorly, you can cut back on withdrawals and adjust your expenses accordingly. 

And you can control your Investment Strategy by changing to one that is better suited for the market environment, or to one showing better performance, or to one more in line with your tolerance for risk. 

These changes can be done easily.

However, what you cannot control is the Sequence of Market Returns. 

Nor can you cannot control the length of secular market trends, or the frequency or magnitude of stock market rallies or declines. 

What you can control is how you invest in the market, by controlling which investment strategies you use. 

You can decide whether you want to ride the general market trend or try to manage it.

I have found that in secular bear markets where volatility is the norm and where the Sequence of Returns can work against you; active portfolio management works best in helping prevent large losses or a series of losses from permanently damaging your portfolio, and is the key to surviving, prospering and preserving your capital. 

  
The opinions expressed in this commentary are mine alone and do not represent the views or opinions of ASC or APIA.

Copyright © 2009 Jeffrey M. Stark, CFP®

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