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Remaining Steadfast

Once in a great while, there comes a year in the economy and the markets that serves as a tutorial for the principles of successful long-term, goal-focused investing.  Two thousand twenty was just such a year.

On December 31, 2019, the S&P 500 stock index closed at 3,230.78.  This past New Year’s Eve, it closed at 3,756.07, some 16.26% higher.  With reinvested dividends, the total return of the S&P 500 was +18.4%.

From these facts, you might conclude that the equity market had a good year.  And you would be right.  What should be instructive to the long-term investor is how it got there.

From a new all-time high on February 19, the market reacted to the onset of the greatest public health crisis in a century by going down roughly a third in five weeks.  The Federal Reserve and Congress responded with massive intervention, the economy learned to work around the lockdowns, and the S&P 500 fully recovered by mid-August.

The lifetime lesson here is:  At their most dramatic turning points, the economy can’t be forecast, and the market cannot be timed.  Instead, having a long-term plan and sticking to it—acting as opposed to reacting—once again demonstrated its enduring value.   Waiting for a “pullback” once a market recovery gets under way, and/or waiting for the economic picture to clear before investing, turned out to be formulas for significant underperformance in 2020.

The American economy, and its leading companies, continued to demonstrate their fundamental resilience through the balance of the year, such that all three major stock indexes reached multiple new highs.   And despite headwinds caused by the coronavirus pandemic and subsequent lockdowns, companies in the S&P 500 paid out a dividend of $58.28 per share in 2020, surpassing the 2019 record of $58.24 and setting the ninth consecutive annual record.

Meanwhile, at least two vaccines were developed and approved in record time and were going into distribution as 2020 came to an end.  There seems to be hope that the most vulnerable population groups could receive vaccines by spring, and that everyone who wants to be vaccinated can do so by year-end, if not sooner.

The second lifetime lesson of 2020 had to do with the presidential election cycle.  To say that it was the most partisan in living memory would not adequately express it.  Supporters of both candidates were genuinely convinced that the other would, if elected/reelected, result in the end of American democracy.  For investors who exited the market in anticipation of the election, they were surprised only to realize the enduring historical lesson which is: Never get your politics mixed up with your investment policy.

As we begin 2021, there remains more than enough uncertainty to go around.  Is it possible that the economic recovery has been largely discounted in soaring stock prices, especially those of the largest growth companies? If so, perhaps the coming year could be lackluster or even a declining year for the equity market?

Yes, it’s possible.  But how do we, as long-term, goal-focused investors, make investment policy out of that possibility?   Our answer:  We don’t, because one can’t.  Our strategy, as the new year dawns, is driven by the same steadfast principles as it has always been.  It is goal-focused and planning-driven, as sharply distinguished from an approach that is market-focused and current-events-driven.

The Federal Reserve has assured that it is prepared to hold interest rates near current levels until such time as the economy is functioning at something close to full capacity, perhaps as long as two or three more years.  As investors, this makes it difficult to see how we can pursue our long-term goals with fixed income investments.  Equities, with their potential for long-term growth of capital, and especially their long-term growth of dividends, seem to be a more rational approach.  Therefore, we must tune out “volatility” and act as opposed to react.  This proved to be the most effective approach in 2020.  We believe it always will be.

May this year bring peace and joy to you and your families.  As always, we thank you for the trust and confidence you have placed in us and we look forward to serving you in 2021!

The Impact of Inflation

When the prices of goods and services increase over time, consumers can buy fewer of them with every dollar they have saved.  This erosion of the real purchasing power of wealth is called inflation. Inflation is an important element of investing. In many cases, the reason for saving today is to support future spending. Therefore, keeping pace with inflation is a crucial goal for many investors. To help understand inflation’s impact on purchasing power, consider the following illustration of the effects of inflation over time. In 1916, nine cents would buy a quart of milk. Fifty years later, nine cents would only buy a small glass of milk. And more than 100 years later, nine cents would only buy about seven tablespoons of milk. How can investors potentially prevent this loss of purchasing power from inflation over time?

Exhibit 1.    Your Money Today Will Likely Buy Less Tomorrow

monday today less tomorrow In US dollars. Source for 1916 and 1966: Historical Statistics of the United States, Colonial Times to 1970/US Department of Commerce. Source for 2017: US Department of Labor, Bureau of Labor Statistics, Economic Statistics, Consumer Price Index—US City Average Price Data.

INVESTING FOR THE LONG TERM AND OTHER “TIPS”

As the value of a dollar declines over time, investing can help grow wealth and preserve purchasing power. Investors should know that over the long haul stocks have historically outpaced inflation, but there have also been short-term stretches where this has not been the case. For example, during the 17-year period from 1966–1982, the return of the S&P 500 Index was 6.8% before inflation, but after adjusting for inflation it was 0%. Additionally, if we look at the period from 2000–2009, the so-called “lost decade,” the return of the S&P 500 Index dropped from –0.9% before inflation to –3.4% after inflation.

Despite some periods where stocks have failed to outpace inflation, one dollar invested in the S&P 500 Index in 1926, after accounting for inflation, would have grown to more than $500 of purchasing power at the end of 2017 and would have significantly outpaced inflation over the long run. The story for US Treasury bills (T-bills), however, is quite different. In many periods, T-bills were unable to keep pace with inflation, and an investor would have experienced an erosion of purchasing power. After adjusting for inflation, one dollar invested in T-bills in 1926 would have grown to only $1.51 at the end of 2017.

Exhibit 2.    Growth of $1, 1926–2017

growth of 1$ chart for investment RWS&P and Dow Jones data © 2018 Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Past performance is no guarantee of future results. Actual returns may be lower. Inflation is measured as changes in the US Consumer Price Index.

While stocks are more volatile than T-bills, they have also been more likely to outpace inflation over long periods. The lesson here is that volatility is not the only type of risk that should concern investors. Ultimately, many investors may need to have some of their allocation in growth investments that outpace inflation to maintain their standard of living and grow their wealth.

One additional tool available to investors who are concerned about both stock market volatility and inflation are Treasury Inflation-Protected Securities (TIPS). TIPS are guaranteed by the US Treasury and as such are considered by the marketplace to have low risk of default. The Treasury issues TIPS with a variety of maturities, and these securities are easily bought and sold. Unlike traditional Treasury securities such as T-bills, TIPS are indexed to inflation to protect investors from an erosion in purchasing power. As inflation (measured by the consumer price index) rises, so does the par value of TIPS, while the interest rate remains fixed. This means that if inflation unexpectedly rises, the purchasing power of any principal invested in TIPS should also increase. Although they may not offer the long-term growth opportunities that stocks do, their structure makes TIPS an effective risk management tool for investors who are concerned with managing uncertainty around future purchasing power.

CONCLUSION

Inflation is an important consideration for many long-term investors. By combining the right mix of growth and risk management assets, investors may be able to blunt the effects of inflation and grow their wealth over time. Remember, however, that inflation is only one consideration among many that investors must contend with when building a portfolio for the future. The right mix of assets for any investor will depend upon that investor’s unique goals and needs. A financial advisor can help investors weigh the impact of inflation and other important considerations when preparing and investing for the future.

E+R=O, a Formula for Success

Combining an enduring investment philosophy with a simple formula that helps maintain investment discipline can increase the odds of having a positive financial experience.

“The important thing about an investment philosophy is that you have one you can stick with.”

David Booth
Founder and Executive Chairman
Dimensional Fund Advisors

An Enduring Investment Philosophy

Investing is a long-term endeavor. Indeed, people will spend decades pursuing their financial goals. But being an investor can be complicated, challenging, frustrating, and sometimes frightening. This is exactly why, as David Booth says, it is important to have an investment philosophy you can stick with, one that can help you stay the course.

This simple idea highlights an important question: How can investors, maintain discipline through bull markets, bear markets, political strife, economic instability, or whatever crisis du jour threatens progress towards their investment goals?

Over their lifetimes, investors face many decisions, prompted by events that are both within and outside their control. Without an enduring philosophy to inform their choices, they can potentially suffer unnecessary anxiety, leading to poor decisions and outcomes that are damaging to their long-term financial well-being.

When they don’t get the results they want, many investors blame things outside their control. They might point the finger at the government, central banks, markets, or the economy. Unfortunately, the majority will not do the things that might be more beneficial—evaluating and reflecting on their own responses to events and taking responsibility for their decisions.

e+r=o

Some people suggest that among the characteristics that separate highly successful people from the rest of us is a focus on influencing outcomes by controlling one’s reactions to events, rather than the events themselves. This relationship can be described in the following formula:

e+r=o (Event + Response = Outcome)

Simply put, this means an outcome—either positive or negative—is the result of how you respond to an event, not just the result of the event itself. Of course, events are important and influence outcomes, but not exclusively. If this were the case, everyone would have the same outcome regardless of their response.

Let’s think about this concept in a hypothetical investment context. Say a major political surprise, such as Brexit, causes a market to fall (event). In a panicked response, potentially fueled by gloomy media speculation of the resulting uncertainty, an investor sells some or all of his or her investment (response). Lacking a long-term perspective and reacting to the short-term news, our investor misses out on the subsequent market recovery and suffers anxiety about when, or if, to get back in, leading to suboptimal investment returns (outcome).

To see the same hypothetical example from a different perspective, a surprise event causes markets to fall suddenly (e). Based on his or her understanding of the long-term nature of returns and the short-term nature of volatility spikes around news events, an investor is able to control his or her emotions (r) and maintain investment discipline, leading to a higher chance of a successful long‑term outcome (o).

This example reveals why having an investment philosophy is so important. By understanding how markets work and maintaining a long-term perspective on past events, investors can focus on ensuring that their responses to events are consistent with their long-term plan.

The Foundation of an Enduring Philosophy

An enduring investment philosophy is built on solid principles backed by decades of empirical academic evidence. Examples of such principles might be: trusting that prices are set to provide a fair expected return; recognizing the difference between investing and speculating; relying on the power of diversification to manage risk and increase the reliability of outcomes; and benchmarking your progress against your own realistic long-term investment goals.

Combined, these principles might help us react better to market events, even when those events are globally significant or when, as some might suggest, a paradigm shift has occurred, leading to claims that “it’s different this time.” Adhering to these principles can also help investors resist the siren calls of new investment fads or worse, outright scams.

The Guiding Hand of a Trusted Advisor

Without education and training—sometimes gained from bitter experience—it is hard for non-investment professionals to develop a cogent investment philosophy. And even the most self-aware find it hard to manage their own responses to events. This is why a financial advisor can be so valuable—by providing the foundation of an investment philosophy and acting as an experienced counselor when responding to events.

Investing will always be both alluring and scary at times, but a view of how to approach investing combined with the guidance of a professional advisor can help people stay the course through challenging times. Advisors can provide an objective view and help investors separate emotions from investment decisions. Moreover, great advisors can educate, communicate, set realistic financial goals, and help their clients deal with their responses even to the most extreme market events.

In the spirit of the e+r=o formula, good advice, driven by a sound philosophy, can help increase the probability of having a successful financial outcome.

1. Jack Canfield, The Success Principles: How to Get from Where You Are to Where You Want to Be (New York: HarperCollins Publishers, 2004).
Adapted from “E+R=O, a Formula for Success,” The Front Foot Adviser, by David Jones, Vice President and Head of Financial Adviser Services, EMEA. Dimensional Fund Advisors LP is an investment advisor registered with the Securi­ties and Exchange Commission. Past performance is no guarantee of future results. There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
R|W 2nd Quarter Market Review (2018)