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Danger & Opportunity: A Fool's Errand

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On April 9 2009, under enormous pressure from the banking community and politicians, the Financial Accounting Standards Board (FASB) issued Statement No. 157 to relax the “mark to market” asset valuation rules that have plagued financial institutions by requiring them to value residential mortgage assets at extremely low prices reflecting the worst credit crisis in history. Now after hundreds of billions of dollars in “toxic assets” have been written off, the world’s investors and financial institutions are breathing a collective sigh of relief in the hope that more banks won’t fail.

Against this improved outlook for banks, markets around the world have been rallying, but before celebrating, advisors should look carefully at the underpinnings of the market’s rally. Bull market rallies can only maintain momentum if they are supported by growth in corporate revenue and profit. But it may be a long time before renewed economic activity repairs the damage done to business capital structures and consumer confidence.

The basic tenet of successful investing is to buy low and sell high. Today, investors see the serious flaws in investment management based on the passive, buy-and-hold approach favored by traditional investment managers. For the last 30 years, investment pros have told investors that they will find a high return through investing in a diversified basket of growth stocks and to ignore short-term risk to losing money. That changed in 2000, as the second-worst bear market in history brought a prolonged time of poor returns and huge losses. The practice of buy and hold arose from a belief that an investor can’t time the market. The theory is that investors can’t avoid the down days without missing the few powerful up days that provide most of the return. Investors have accepted market volatility because stocks have been the only financial assets to provide a return that has outpaced inflation.

The problem is that investors don’t buy and hold: faced with a decline of half of their portfolio, they sell to conserve their remaining money. In theory, market returns will recover a portfolio, so investors need not worry themselves about short-term losses. The reality is that if an investor loses enough capital, she may never recover.

Diversification Doesn’t Suffice

Modern Portfolio Theory argues that a diversified portfolio will limit risk to capital. Yet in 2008, all asset classes fell hard, proving that diversification is not enough. Conventional investment “wisdom” also asserts that asset allocation determines the majority of returns, which was based on analyzing the successful investments of institutions and then applying the methodology to individual investors. However, individual investors behave differently than institutions. They react emotionally to significant declines in their account values because it’s their money. Second, unlike institutions, individuals care little about relative performance against a benchmark, only that they lost money.

Another downside to passive approaches is that secular market trends can last a long time. Our historical market research shows that positive and negative return cycles average 17 years in duration. In 1928 the Dow Jones Industrial Average Index closed the year at 300, and it took until 1952 to produce a year-end close above 300. Investors can’t afford to buy and hold for 24 years just to get back to even. During these periods, investors using buy-and-hold strategies and faced with greater losses than they can tolerate will logically move to preserve capital, which causes them to sell low rather than high. When they do sell low, they often lose so much capital that they have a hard time funding retirement sufficiently, threatening them with outliving their income stream.

Many advisors and investors know that stocks have generated about a 10% rate of return over the past 100 years, but don’t realize that only half of the return has come from price appreciation and the other half has from dividends. During secular bear market cycles, it is dividends, not price appreciation, that provide investors with positive returns. Therefore, dividend-paying stocks, not growth stocks, should be the foundation for portfolio construction.

Our experience has shown that investment success can be best achieved by focusing on buying high-yielding dividend-paying stocks when they are great values and collecting a generous dividend income stream while waiting for stock prices to appreciate. Investment capital is the engine that produces income or growth and should never be compromised. Therefore the investment process must actively manage the risk inherent in owning volatile stocks so investors can stay the course.

Now is the time for advisors to back away from conventional investment approaches they have been taught, because they don’t work. During secular bear markets, passive allocations focused on growth stocks are death for their clients’ portfolios and retirement hopes. Advisors must develop or select managers with an investment process that is active and responsive to changing market conditions, while taking the emotion out of investing by maintaining a strict buy/sell discipline. That will not only protect capital, but also help harvest gains once they have been achieved.

Don Schreiber, Jr. is CEO of WBI Investments, based in Little Silver, New Jersey, which manages $300 million for advisors and clients using a high-yield dividend-paying strategy. He can be reached through


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