First Quarter 2012 Letter to Clients

Just over three years ago – on March 9, 2009 specifically – the Dow Jones Industrial Average closed for the day at 6,547.

It would mark the beginning of the greatest investment opportunity in a generation.

Don’t recall it that way? Not many people do. Up to that point, stocks had been in an uninterrupted free fall. After clawing its way back to the 9,000 level at the end of 2008, the Dow began 2009 by posting declines on 29 of the first 45 trading days for a total decline of 27% in just 10 weeks. This was on top of the already 25% decline the Dow experienced in the last three months of 2008.

In just six months’ time, account values for many stock investors had been cut in half or more, and folks weren’t much thinking about putting new money to work in the stock market. To the contrary, they were in a full-on panic to pull every dollar they had out of stocks and pile them into the “safe havens” of cash and bonds, willing to lock in their losses for fear of even greater declines perceived to be ahead.

The media at that time was hardly reassuring. Every day brought an avalanche of news stories about how bad things were, how many trillions investors had “lost” in the stock market, and endless speculation as to how low stocks would go. (On the exact day of the market low, the Wall Street Journal’s lead story in its Market section was titled, “Dow 5000? There’s a Case for It.”) Anyone who tried to be the voice of calm on cable news shows was summarily laughed off the set as a Pollyanna who hadn’t come to terms with the “new reality” that stocks were done, finished, kaput.

And yet…

From that point forward through the next three years, stocks would experience the greatest bull market of the past century. A hypothetical investor who put $100,000 into the S&P 500 would have seen his investment more than double in just 36 months to $212,931 (113%). If he had put it in the Russell 2000 small stock index, his investment would have been worth $239,125 (139%). And in the Wilshire REIT index: a whopping $337,834 (238%).

It is a perverse reality about stock investing that the times of greatest turmoil in the market are also the times of greatest opportunity. This is why investor behavior is, far and away, the greatest determinant of success. Those investors who were in a well-diversified portfolio and who did not blink during the downturn of 2008-09 have seen their portfolios return to pre-bear market highs, and those who invested money during the downturn have seen tremendous growth in those investments. But this isn’t what most investors have experienced.

In an article titled “Main Street’s $100 Billion-Dollar Blunder,” (, February 28, 2012), columnist Brent Arends did some back-of-the-envelope calculations about what investors had cost themselves since the financial crisis of 2008 through bad behavior:

In October 2008, after Lehman, investors panicked and withdrew about $45 billion from their U.S. stock funds. That trade alone has cost them $25 billion in investment profits since, according to MSCI data: On average, the shares they sold for $45 billion would be worth about $70 billion (including dividends) now. In February and March of 2009, as the market slumped to its record lows, mutual fund investors sold another $29 billion worth of U.S. stock funds. That cost them another $26 billion in lost profits.

In total, by my math Main Street investors have missed out on a staggering $106 billion in investment profits over the past five years by selling stocks at the wrong time. Nearly all of that, or $96 billion, has been since Lehman imploded. It has come during a five-year period when the stock market overall has made a small, 4%, profit.

It’s not as if investors made their hasty decisions in a vacuum. Indeed, to listen to the media during the turmoil, the only logical conclusion one could have drawn was that it was folly to sit around and watch your stock portfolio continue to dwindle. (And it should be noted, with no small irony, that Mr. Arends was among the worst offenders at prodding his readers to make short-term market timing moves during the financial crisis.)

The bottom line is that it takes tremendous resolve to keep the faith when virtually all others around you are losing theirs, but that is what separates the very few successful investors from the multitudes who fail. In order to earn the long-term returns that stocks, and only stocks, have historically delivered, you have to be willing to experience the occasional bouts of volatility along the way. While it may seem that the past five years have been a long time to wait for one’s portfolio value to recover to pre-crisis levels, five years is actually a short time increment in the stock market.

Conventional wisdom today is vastly out of touch with this reality. (The next time you turn on CNBC, note that their market clock runs to the hundredths of a second.) We hear an endless chorus from investors about how much money stocks have lost them in the past five years, but when we look at the returns we don’t see it. All we see is what investors have cost themselves.

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Clearly, we view a big part of our responsibility at Capital Directions as acting as behavioral counselor for our clients. Investors historically do a great deal of damage to their portfolios during the moments of maximum emotion in the market – both fear and greed – and we believe it is crucial to help our clients navigate those moments with calm perspective.

This does not diminish, however, the importance we place on our role as investment manager for our clients. There have been many wonderful developments in the investment marketplace in recent decades. Chief among these are institutional, asset-class funds and exchange-traded funds that have allowed us to construct portfolios for our clients with a level of precision and diversification that would have been impossible thirty years ago, and do so with extremely low fees and trading costs.

Then there is the other edge of the sword – all those investment products that have been rolled out to the marketplace with great fanfare as the latest magic wand that has somehow overcome the pesky relationship between risk and reward. They all sound compelling on the front end, but they usually end up as disasters on the back end.

The litany of these products we have seen just in the past decade is long: AAA-rated, mortgage backed derivatives that somehow magically yielded 8% with a money-market level of risk (until they imploded); auction-rate securities that were “as good as a money-market fund” but with a higher yield (until they imploded); junk bond funds with double-digit yields (until they imploded); and on and on.

Just in the past few weeks, we received a sales call from a huge investment bank singing the virtues of its new “exchange traded notes”. Unlike ETFs, which actually own the securities they invest in, exchange traded notes are synthetic investments, backed by banks, which are designed to “act like” a particular index, without owning any of the actual securities. The salesman told us these sophisticated new investment vehicles would enable us to “hedge volatility” (note the emphasis on today’s greatest investor concern) by diversifying into areas that conventional mutual funds and ETFs can’t invest in, such as the VIX Volatility Index.

There is, of course, a very good reason a traditional fund can’t invest in the VIX Volatility Index. It’s because the VIX is not an index of securities (like the S&P 500); it is an index of investor emotion. It simply measures the amount of risk that investors perceive there to be in the stock market at any given time. There is no way to own it because there is no “it.” It’s like saying we are going to “diversify into happiness” or “hedge anxiety”.

If the notion of using a fund that doesn’t own anything to invest in something that doesn’t exist sounds a tad esoteric to you, it did to us as well. (Only on Wall Street could this value proposition sound attractive.) We politely told the salesman that ETNs did not meet our investment criteria. Less than a week later we were bemused to find the Massachusetts attorney general opening an investigation into one of these very funds that plunged 60% in a single day in late March, for reasons no one seemed to fully understand. Clearly, the fund accomplished its stated mission of investing in volatility, though probably not in the way its investors expected.

We live in an era of Wall Street whiz kids engineering ever more exotic investment products, always designed to solve whatever dilemma the current economic environment is presenting investors – low yields, excess volatility, etc. They march these products through the town square like the Pied Piper, drawing countless investors in with their siren song of having “fixed” the dilemma. And just like the Pied Piper, they inevitably lead these investors to disaster.

At Capital Directions, we maintain a very strict evaluation process that filters every investment we consider through a rigorous screening protocol that is designed to ensure that it not only fits our investment philosophy, but also our requirements for prudence, soundness and viability. As the investment marketplace grows increasingly crowded and exotic, it is more important than ever to have such a process in place.