If our household checking and savings and investment reserves equal the amount we owe for living expenses and loans, our budgets balance. If our reserves exceed our deficits, we feel good that we have money to spare. If our personal and business deficits exceed our reserves beyond any hope of achieving balance, we are bankrupt. That’s the way things work for us at home and for businesses. That’s not the way things work for governments that print their currencies… as ours does. At the national level, reserves held by the private sector (our households and businesses, and maybe foreign lenders) are matched by an equal level of deficits assumed by the government… because the actual value of the currency and credit that resides in the private sector relies upon the full faith and credit of the Treasury to redeem its currency and meet its credit obligations. Shrinking the government deficit serves to shrink private sector cash flows… and vice versa: expanding government deficits tend to increase private sector cash flows. There is an upper limit when government deficits outstrip Gross Domestic Product at full national production capacity in the private sector. And there is a lower limit when shrinking government deficits reach zero, drying up cash flow and production in the private sector. We have been there, done that, at each of the two limits; history marks them “hyperinflation,” “Great Depression,” and “Great Recession.” Balancing our personal household and private business accounts is a virtuous goal. As the graph above shows us, balancing our government’s budget by shrinking its deficits to zero choked our national economy several times in the last 50-plus years… nothing virtuous about it. That’s because our government was designed to enhance the health, safety, commerce, and general well-being of its citizens: it is not a business.
Down markets are bad, but recovery is worse. It is hard to grasp the fact that a 50% drop in value requires a 100% market improvement for complete recovery. Look at the red curve reflecting performance of an all-stocks portfolio that lost 59% of its value in the 2008-2009 Great Recession; it had to improve by 144% for full recovery and a year later only reached the 90% mark. For contrast, look at the orange curve for a half stocks/half bonds and cash portfolio: within a year it had recovered to values 5% beyond its 2007 peak. Portfolio assets are identical from curve to curve, but equities and fixed-income allocations vary. On the illustration, fixed-income assets (bonds and cash) increase from 0% to 100% from the top down; portfolio curves flatten as fixed- income allocations increase and performance volatility decreases. Conversely, allocations for equities (stocks) increase from the bottom up. The red curve (all-equities) portfolio recovered fully in about 5 years, but the orange curve (50% equities/50% fixed income) portfolio recovered within a year… and the lower blue curve (all fixed-income) portfolio did not lose value at the 2009 market bottom. Which curve would you choose for your portfolio?
What to do, what to do.. Should I liquidate my portfolio before election day? What will be the impact on the world’s markets of some pretty wild anticipated and actual outcomes? Can the markets behave as badly as some of the candidates? I don’t think so… especially long term. Will the markets survive? Of course they will. We’ve felt these concerns to a greater or lesser extent before every election. We’ll hear once again just how badly the economy will be damaged if the other guy wins, and there may even be noise about taking dramatic steps to protect our investments… but not from me. I’ve been hurt in the market only once, for any length of time: my advisor convinced me that it was unnecessary to diversify my portfolio during the Dot-Com boom. The resultant bust was painful. By the time the 2008-2009 meltdown came along, my portfolio had recovered and was properly diversified at an acceptable level of risk. I learned my lesson, and I pass it along to you now. You stay calm, make sure your investments are balanced and diversified among stocks, bonds, and cash, consider the candidates’ promises, and vote your heart.
One of England’s grand houses that served as a hospice for wounded troops in the Great War has an oak-paneled library where one of the panels is speckled with small holes drilled by stray darts hurled wide of a dartboard. The statistical chance of hitting the bullseye on that wall was greatly reduced by whatever caused so many stray throws… like the distance, the light, and the condition of the players. A statistical bell curve can be built that represents variance from the averaged throws. Within the central one-third of the bell curve, where most of the “hits” are concentrated, the formula quantifies the deviation from the performance mean for 67% of total hits below the curve… the Standard Deviation. It is common practice to base our judgements upon the central third of all the scores, and treat the rest (in this case, the holes in the wall) as less-informative, or even insignificant, outliers. The formula for determining Standard Deviation can also be applied to describe the range of performance volatility arising from your particular mix of stocks, bonds, and cash; it can provide insight concerning the extent of your market risk. From another perspective, if you can pinpoint your tolerance for market risk, you can use Standard Deviation as a guide for assembling assets in your portfolio. An experienced advisor can help you do that without leaving any tiny holes in your wall.
How many times do you glance at the scoreboard during a game? We do rely on it to assure ourselves our team is really winning… or losing. We do the same with our investments. There are several ways to score investment performance, from simple to sophisticated. Here’s a simple one.
|Start Value (-)||End Value (+)||Gain / Loss||Contributions (-)||Withdrawls (+)||Net Gain / Loss||%|
Start with total value at the beginning of the year and subtract that number from total value at the end of the year; the result is overall gain or loss for the year. If you added money to your accounts during the year it would affect overall gain or loss but would say nothing about investment performance… so you would subtract any contributions from overall gain or loss. Withdrawals from your accounts during the year count as part of investment performance… so you would include any withdrawals by adding them to overall gain or loss. The final result is a simple net (of contributions and withdrawals) gain or loss. Dividing net gain or loss by total value at the beginning of the year gives a percentage for that year’s gain or loss. This percentage gain or loss is only a ballpark indication of actual investment performance, but it does say you are gaining or losing and it does provide a number to compare with results of other years, to show a general trend.
The procedure used by a marriageable Etruscan young woman of 2300 years ago to identify her prospective husband may have lacked precision compared to today’s computer dating services, but it was more fun. The first step was to draw a circle on the ground, then divide the circle into twenty-four sections and scrawl a letter of the alphabet in each section. The next steps involved dropping a kernel of corn beside each of the 24 letters and releasing the family hen to forage among the kernels. The hopeful bride then worked out two names one might make from the kernel-free letters. The hen had to be sacrificed and its cleaned collar bone was left to grow brittle in the sun… to become a wishbone. At the appropriate time two people each grasped an end of the wishbone, making a wish for one of the two names, and they pulled until it broke. The larger side was the “lucky break” and the rest is human nature.
One can wonder whether the Etruscans had a stock market from which to select lucky breaks among investments of the time. Whatever the application, the wishbone procedure continues to reflect human nature to this day.