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Market Perspective
Good Strategies vs. Perfect Outcomes
 By Ernie Ankrim, Chief Investment Strategist
Russell Investment Group
Global Leaders in Multi-Manager Investing
August 1, 2003
This article has been provided by our parent company, and primarily deals with the US market. All figures are in US dollars unless otherwise noted.
During the 1990s, it was not difficult to convince investors of the benefits to retaining a disciplined allocation to equities. During those years, it was easy to demonstrate the wisdom of staying committed to the market, even when it was temporarily painful. As the decade ended there was little concern about investors "bailing" out of stocks. If anything, they were jumping in with both feet.
Times sure have changed, haven't they? Mutual fund cash flows from earlier this year and late last year reveal that investors were not just leaving the stock market — they were fleeing from it.
The Long-Term View
Regular readers of this column know I'm a firm believer in sticking to a consistent investment plan. And for the most part, the evidence has proven me right.
Back in 1995, I wrote an article illustrating the costs of deviating from a disciplined investment strategy. In this article I compared the results of two hypothetical investors. I assumed that both investors started off by allocating 60% of their portfolio to stocks (measuring this asset using Ibbotson Associates' US Equity total returns series) and 40% to bonds (following Ibbotson's Intermediate Government Bond returns series). However if, once a month, when looking back over the previous 24 months, the investors saw bonds outperforming stocks by 2% a year or more, one investor would "bail" to a portfolio of 20% equities and 80% bonds, while the other ("disciplined") investor would stick to his existing plan.
I found that no matter what time period I looked at — from 1928 through 1994, from 1946 through 1994, even from 1960 through 1994 — the bailer lost to his more disciplined counterpart by slightly over 1% per year just by getting out of stocks on those rare occasions when bonds had outperformed by 2% or more.
But that was then. Would these results still hold up nearly 10 years and a stock decline later?
Does it Ever Make Sense to Bail?
When I updated my results through June 2003, I found that this advantage to the disciplined investor had shrunk by about half. Rather than outperforming somewhere over 1% on the bailer, the disciplined investor was now leading by only an average of .59% per year:
What happened? Was my long-term theory flawed or was something else at work? It became obvious to me that the equity markets of 2001 and 2002 were so consistently poor that bailing had actually worked. During that two-year period, returns were so strongly in favor of bonds that our hypothetical investor would have barely been in the market at all, having bailed out for 22 of those 24 months. Only during the first two months of 2001 would he have stuck with a 60/40 portfolio.
In my earlier analysis, I had found that bailing as a strategy had been advantageous between 37% and 42% of the time (much worse than a coin flip). However, the updated study showed that from 2001 to 2002, the bailer now outperformed more than 63% of the time. In other words, this two-year period generated a result that was in great contrast to the results we had seen for the previous 75 years.
Nothing is Guaranteed
Do I suddenly believe that timing the markets now works, that bailing out of equities when they have been out of favor is a good long-term strategy? No — and I hope that doesn't surprise you. After an anomalous few years, we're already seeing evidence that this year's market appears to be returning to historical patterns. In fact, even though the trailing 24-month performance of bonds was still dramatically greater than stocks, four of the past six months saw better equity than fixed income returns. I don't know if the market will continue to perform at that rate, but it does seem to be behaving more in line with the longer-term experiences we saw before 2001-2002.
What the past two years have reminded me is that, like most things in investing, nothing is guaranteed. A good strategy is one that has a probability of enough positive performance to justify implementing it. But even with successful performance, there will still be periods in which even the best strategy disappoints. Unfortunately, there is no plan out there that can avoid the possibility of underperforming for some period of time. Clearly, 2001 through 2002 was a period when the disciplined approach produced outcomes that were poorer than simply running for the hills (something that, over many observations, has shown to be a poor strategy).
What to do Now?
At this point, I understand it's going to be difficult to convince any investor who did bail out — and was rewarded for avoiding a horrible market — that a disciplined investment strategy has better odds of paying off in the long term. Yet I still believe that bailing out poses substantially greater risk and a higher probability of loss than it does of being a source of value.
Personally, I draw more comfort from experiences that are longer than 24 months; I like experiences that are longer than 24 years. And I've learned that the prudent way to have a reasonable chance of securing a positive return after taxes and inflation is to have some portion of a portfolio in equities. To me, the probability of success of this kind of disciplined investment strategy is greater than one that chases what is hot and flees from what hasn't recently worked. As the next few years roll out, I imagine we'll look back on this time as confirming the wisdom of this disciplined strategy and exposing the "bailing" success of 2001-2002 for what it really was: a lucky roll of the dice.
Copyright© Frank Russell Company 2003. All rights reserved. See Legal Information. Date of first use: August 18, 2003.
This is a publication of our parent, Frank Russell Company. It should not be construed as investment, legal, or tax advice. The contents are intended for general information purposes only, and you are urged to consult your own investment, legal, or tax advisor concerning your own situation and any specific investment questions you may have. For further information about these contents, please contact Russell Investments Canada Limited.
1 "Don't Bail Out: The Value of a Disciplined Investment Philosophy". This was published as a Russell Research Commentary in July 1995 and subsequently published in the Journal of Pension Plan Investing. Summer 1996. pp: 8-18.
Ibbotson return series performance taken from Ibbotson Yearbook, which provides a comprehensive, historical view of the performance of capital markets dating back to 1926. Containing total returns and index values for large and small company stocks, long-term corporate bonds, long- and intermediate-term government bonds, Treasury bills and inflation.
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