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This is Why

Sigma Investment Counselors

November 30, 2012

I recently received a call from a client expressing concern about the outcome of the recent United States presidential election. And the fiscal cliff. And the problems in Europe. Etc. He feared that the outlook may have dimmed for investors in common stocks. As is often the case during emotionally charged periods, his suggestion was a sale of his stocks with an expectation that reinvestment might take place at a later date when “things looked more promising.” As a practical matter, when one feels emotionally secure in investing, that is usually the worst time to commit to investing in common stocks, and vice-versa. Emotional buying and selling of stocks generally assures losses of capital.

I reminded him that our efforts on his behalf were largely aimed at ensuring his standard of living for as long as he lived. I told him that, if it was possible, we would simply prepay all of his future expenses and in that way we would “ensure his standard of living.” Of course, this is implausible because there is no way to accurately forecast what his future purchases would be. The challenge for investment advisors, therefore, is to determine how to best accommodate what might be needed in the way of each client’s future purchases. In a simplistic world, this can best be done by purchasing shares in companies that provide most of the goods and services that the average person would consume, to the extent possible.

Consider this example. Assume that your only future purchases were for gasoline. If you bought shares in an integrated oil producer such as Exxon Mobil, you would be relatively assured of your ability to continue to purchase gasoline because, should the price of gasoline rise, so too would Exxon Mobil’s earnings and dividends and those higher dividends that you received as a shareholder would cover the increased cost of gasoline. If the price of gasoline declined so too would the revenues of Exxon Mobil and likely the dividends. The share price would undoubtedly fall. Notwithstanding this decline in the dividends and share price, the ability to purchase gasoline would be preserved. That simple “standard of living” – buying gasoline, would be preserved.

Now, expand this simple example to the panoply of goods and services purchased by average consumers – or, the pool of providers. This pool might actually represent an entire, diversified portfolio of common stocks that would occupy an integral role in an investment portfolio.

Using a similar simple example consider also the following. An investor elects to maintain all of his $ 3 million in savings in currency in a vault in his own home, seeking maximum security. This posture is taken because the investor fears the volatility of common stock investing which has shown at any given time that one’s portfolio value can shrink by as much as 30 to 50% within a very short period of time (recall 2008-2009). If that investor needed $100,000 per year to maintain his standard of living (not an unrealistic scenario), in 10 years he would have dissipated one third of this principal, and in 15 years, half of his principle – permanently. Gone. Is this not a greater risk, notwithstanding that the position was taken to facilitate safety?

These are simplistic examples indeed, but they demonstrate the problems of emotion guided investing. We end up creating more damage than what we are trying to control.

This is the reason that we advise clients with a long-term investment horizon who do not expect to deplete their capital in the short run (such as college funds), to allow equities to form the bulk of their portfolios, and recognize that there is a great risk in adopting any extreme or unusual investment posture.

All comments or questions are welcomed.

Bob Bilkie, CFA

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