As we enter the last quarter of 2013, I'm writing to summarize what went on with the markets in the 3rd quarter. Despite turbulence from economic and political events, in the 3rd quarter the US and global stock markets built on their positive returns that they have experienced throughout 2013. Bonds bounced back in the 3rd quarter from their dismal 2nd quarter which was spearheaded after indications from Federal Reserve Board chair Ben Bernanke that given signs of a recovery by the economy, there would be a tapering in measures to keep interest rates low. In the 3rd quarter Bernanke stated that those tapering measures would be put on hold.

 

The elements of an effective plan

At the start of every relationship with my clients, we create a long-term plan that will look past the kind of short-term issues we've seen this year. While developing that plan, my first step is to establish portfolio parameters based on each client's return requirements and risk appetite. There are two pertinent questions that we currently discuss related to risk and return: 1) Are bonds too risky? and 2) Are stocks set to fall?

 

Are bonds too risky?

Some investors have read descriptions of bonds as today's riskiest asset class and, as a result, want to eliminate them from their portfolio. Certainly a significant increase in interest rates would create challenges for bond investors, but there are still reasons for having bonds in your portfolio

• As we saw in 2008, bonds can provide insurance against severe volatility in stock prices.
• Given the low rates on short-term government bonds, investors can find better-yielding alternatives on longer maturities, in high-quality corporate bonds and some foreign governments with solid finances.
• The concern about the impact on bonds if interest rates rise may be exaggerated, as there is growing sentiment that weak economic growth will result in low interest rates for many years to come. One such view comes from Bill Gross of Pacific Investment Management, today's best-known bond manager who, in a recent commentary, predicted that today's low rates will be with us until 2035.

To be clear, I am not recommending being overweight bonds in portfolios. I believe that for long-term investors, stocks provide better prospects, but I do recommend that clients adhere to the minimum bond allocation that was set out in their investment plan.

 

Are stocks set to fall?

The flip side of anxiety about rising interest rates for bonds is fear that the run-up in stock prices makes them vulnerable to a severe correction. Some of these concerns are based on works by Yale's Robert Shiller, a highly respected voice who looks at stocks based on a multiple of 10-year earnings. On that basis, U.S. stocks currently look expensive although not at nearly the levels in 2000 and well below what we saw in 2007 and 2008.

 

While there could certainly be a short-term correction in stock prices, I continue to recommend that clients have a healthy stock allocation in their portfolios:

• Nobody has demonstrated the ability to predict short-term movements in stock prices. It is just as likely that stocks will rise by 20% as decline by 20%.
• A recent article by Wharton's Jeremy Siegel, considered today's leading stock market historian, suggests that accounting write-offs by American companies have distorted reported earnings and that if another measure of profits is used, Schiller's model shows that stocks are fairly valued.
• Siegel further points out that when interest rates are low, as they are today, historically multiples of earnings have been higher than average.
• Finally, for investors concerned about valuations on U.S. stocks, there are high-quality companies in Europe and Asia for a significant discount to their U.S. equivalents.
 

Sticking to your plan

Most investors might nod their heads to facts such as the ones above and can agree to a plan for their portfolio, identifying the parameters within which their investments will be managed. Of course, agreeing to your plan is the easy part - the challenge is sticking to it.

 

As former heavyweight champion Mike Tyson pointed out, it's easy to keep to your plan when things are going well. It's when investors get bloodied from market setback that sticking to their plan becomes a challenge. Tyson's actual quote was "Everyone has a plan until they get punched in the face."

 

That's why when markets become choppy, some investors look for bold advice and dramatic shifts in their portfolio, going all to cash or all to stocks. Unfortunately, the track record of those dramatic shifts is not a good one, putting it mildly:

• During the tech mania of the late 1990s, many investors abandoned the principles of sound diversification and over weighted their portfolios with technology stocks.
• Ten years ago, investors began skewing their portfolios to banks and other beneficiaries of the real estate boom and in some cases extended themselves to buy bigger houses, vacation homes, and investment properties.
• While most investors initially agree to geographic diversification of their equity investments, many find it difficult to stick to that commitment. For a period of strong performance, such as what the U.S. sees today, the instinctive response is often to heavy up what's been doing well and to abandon what's been underperforming - when savvy investors should do exactly the opposite.

Recently deviating from investment plans has taken a new form. Immediately after 2008, a search for safety led to large flows out of stocks and into bonds, meaning that some investors missed the recovery since the market bottom. And to the extent that investors were buying stocks, many only had an appetite for stocks that pay high dividends and are viewed as an alternative to the secure income from bonds.

 

That's why I see my role as an emotional anchor - keeping my clients' highs from being too high and their lows from being too low. For many clients, helping them adhere to their plan, sometimes against their instincts, is how I provide the greatest value. There are occasions when sticking within the parameters of your plan may feel boring, but history shows that the key to successful investing is having a sensible plan and then sticking to it.