Some Perspective on Last Week’s Tumult

With media outlets clamoring to write ever more alarmist headlines, there are precious few voices of reason to be heard in the press. Let’s pull up a few thousand feet and answer some questions:

• How did last week’s downturns actually look compared to other big drops since 1950?
• What global investment performed best in the last 10 years, when the S&P 500 was doing terribly?
• What was best in the 10 years before that? (you guessed it – the answer is completely different)

First let’s take a look at the 15 biggest drops in the S&P 500 since 1950, in chronological order:

This week’s two drops, coincidentally at 4.7% each, look scary when combined. But after Friday’s rally, the actual S&P 500 was up for the week by 0.33%! It’s true – Monday morning we were at 1251, and Friday’s close was 1255.

Keep in mind that during this tumult, hundreds of billions of dollars left the stock market for money markets and bank accounts, missing Friday’s 4% rally. Truly, reacting to headlines can be hazardous to your financial health.

Capitalism has proven to be the equal of every challenge it has faced in the last century, and the failure of Fannie Mae, Freddie Mac, Lehman Brothers, and possibly AIG will be no exception. The world will survive without the advice of Lehman Brothers. Mortgage-backed securities don’t exist because of Fannie and Freddie – they exist because they make sense as financial instruments. Including AIG, these 4 firms represented less than 1% of a diversified US equity portfolio on June 1, 2008, and an even smaller proportion of a global strategy.

What is not in doubt is that the S&P 500 was a poor investment over the last 10 years. This points to the importance of global diversification. Over the last decade, emerging markets the world over have been tremendous growth engines.

Let’s take a look at how 4 major indices compared. If only we’d known in advance to put all of our money in Emerging Markets.

 
Here are some definitions, for those of you less familiar with this index stuff

• MSCI Emerging Markets Index – this is a good benchmark put out by Morgan Stanley Capital International (MSCI). Emerging markets are places like Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela
• MSCI EAFE Index – This is the Europe Australasia Far East (EAFE) Index. Kind of like the S&P 500 for the Developed World outside of the US. Developed Markets are places like Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom
• Lehman Brothers Aggregate Bond Index – an index comprised of all US bonds, including government, mortgage, and corporate.
• S&P 500 – These 500 companies comprise approximately 75% of the total US market capitalization. Roughly another 6,200 mid- and small-cap companies comprise the rest of the US public equities market.

Now let’s look at these same four indices, but for the 10 years from 1988 to 1998. This is the period directly prior to the graph above.

Hmmmm. Looks like the S&P 500 was the big winner. The other developed countries (EAFE) lagged even the US Bond Index.

The obvious lesson here is that if you can predict the future, you win!

The other lessons are:

• If you don’t own the stocks of individual companies, you won’t get killed when an individual company blows up. Buy indices to avoid the “uncompensated risk” of owning individual stocks. The rule here is: if you’re not going to own 100 stocks in a given asset class, then the Index provides higher returns with less risk than owning individual stocks.
• In the long run, investing in the S&P 500 alone is probably fine…but the “long run” can mean 30 years or longer.
• If you want to do well in the less-than-long-run, your portfolio needs to mirror the global economy, with a tilt towards those places where tremendous growth is happening.
• Bonds are very safe. You want some bonds or you will likely freak out when your overly-risky portfolio loses 50% of its value and doesn’t recover for 3 years

Posted on September 21st, 2008