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| Newsletter | October 2008 | |||||
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In This Issue |
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I wanted to share with you some of my thoughts regarding the current economic environment and to leave you with some positive actions for moving forward. |
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| Mark Sladkus | ||||||
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| Harvest Those Losses | ||||||
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One of the benefits of having risky assets in your taxable account is that you get to harvest those losses and share them with the government in the form of a deduction from |
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your taxes. For example, if you do have losses and are in |
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a 50% tax bracket, you are essentially reducing your losses by half. Even if you haven’t made any purchases in the last few years, you may have losses that you don’t realize. For instance, do you have any mutual funds that you have owned for a long time? If your capital gains or dividends are being reinvested, you probably have losses you may not even be aware of. Be mindful of distribution dates for capital gains, remembering that even a fund that is down may have gains based on prior year’s positions. Consult a tax attorney if you have any questions |
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It is tempting to believe that you can bail out of the market and get back in when things tend to look more promising. The reality is that by the time macroeconomic factors are more settling, the market has usually already factored that in. As Burton Malkiel said in an op-ed in yesterday’s (Oct 13, 2008) Wall St. Journal (“Keep Your Money in the Market”) being in a “fetal position and 100% in cash” is likely to be the wrong decision. Stocks are a discounting mechanism. They are a leading, not a lagging, indicator. Stocks reflect the future not the past. |
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The expected returns on bonds and stocks are lower when the economy is strong and higher when the economy is bad. This is the market’s mechanism for rewarding those willing to take on risks. In other words, the reward you receive for taking on risk is countercyclical. An intuitive explanation is that the risk taking behavior of investors changes with the current conditions. When the economy is at the bottom, people don’t want to take risk. In this situation to attract investors, the risk premium (compensation) has to be higher. Furthermore, the risk of value stocks becomes greater than the risk of growth stocks when the economy is bad. And because risk premiums are countercyclical the value stocks’ expected returns are higher than the growth stocks’ expected returns. The same applies to small cap stocks. Size and value are closely related to future market cycles. Size and value premium represent compensation for these risks. |
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After a crisis, it is natural to think that markets will take a long time to recover. You may be tempted to rush into cash, expecting it to be a long time before stocks recover. The following example, based on a balanced 60/40 strategy illustrates how market’s respond to such events. |
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During the tech bubble, market participants had witnessed an extraordinary decade of returns. By the end of 1999 the S&P 500 had a 10 year annual return of 18.21% and a 5 year return of 28.56%. It was human nature to assume that such returns would continue into the indefinite future. Making such an assumption, however, was very costly. Similarly in the current environment it is not surprising that you may see ‘gloom and doom.’ This phenomenon is known to psychologists as recency. Humans tend to put a disproportionate emphasis on things that happen in the recent past. Try to avoid this natural human tendency. For instance at the end of 2002, the US had just witnessed three terrible years. From an equity perspective the S&P 500 had fallen 37.61%, international developed markets, as measured by EAFE, had fallen 43.32%. And yet for those investors who had the fortitude to stay invested, relief came quickly. In 2003 the S&P 500 climbed 28.69% and by the end of 2005 the S&P 500 was up 49.70%. During those same three years, EAFE was up 89.2%, and emerging markets and US small cap and value were up well over 100%. I don’t pretend to know if a bottom has been reached. I do believe that patience in your asset allocation will be rewarded. |
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Red Lighthouse Investment Management - 212.799.3532 - www.redlighthouseinvestment.com
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Copyright 2008 Red Lighthouse Investment Management, LLC
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