It’s been said that we can count on death and taxes. We should also add “market crises” to the list.

It seems like the stock market is always either in a crisis, recovering from a crisis, or anticipating the next crisis. Indeed, we’ve experienced numerous “crises” over the past four decades including the following:

• In the 1970s, we had stagflation, oil shocks, high inflation, and a stock market that dropped 44% in 2 years.
• In the 1980s, we had the collapse of Drexel Burnham Lambert and the stock market crash of October 1987, which sent the Dow Jones Industrial Average down more than 20% in one day.
• In the 1990s, we had the savings and loan crisis, the bailout of hedge fund Long Term Capital Management, and the Asian financial crisis.
• In the 2000s, we had two bear markets, the subprime mortgage meltdown, and the financial crisis of 2008-2009.

But, guess what? Despite these market crises, the Dow Jones Industrial Average rose from 800 at the beginning of 1970 to 10,198 at the end of last week. That’s nearly a 13-fold increase.

It’s easy for investors to let the events of the day or the “crisis du jour” cloud their thinking.

However, successful investors take a wider view and realize that crises happen, crises get resolved, and while they can sometime be scary, they should not lead you to panic mode.

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The US stock market has taken investors on a bumpy ride in recent years.

Market volatility has tested investor discipline and prompted some people to question their commitment to equities. While no one knows the future, looking at the past may help you gain a better view of long-term market performance and put the recent market volatility in perspective.

The above chart shows the historical distribution of US market returns since 1926. The performance years are stacked in ascending order by return range. This chart illustrates that:

• Market performance over the past two years has been severe by historical standards. In 2008, US stocks experienced their second-worst calendar return in eighty-four years. Then, in 2009, stocks rebounded strongly to deliver a return in the top quartile of the historical distribution.
• Over the long term, the market’s positive return years have outnumbered the negative return years. Since 1926, the market has experienced a positive return in almost three-quarters of the calendar years.
• Not only are the positive years more numerous, the chart shows a larger concentration of performance in the higher ranges of returns.
• The sequence of calendar returns appears random, suggesting that accurately predicting future performance is a difficult task for any investor or professional manager.

Over time, the market has rewarded investors who can bear the risk of stocks and stay committed through various periods of performance. Therefore, the best strategy is to ignore the “noise” and stick to your investment plan.

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Proponents of active investment management believe that skilled managers can outperform the financial markets through security selection, market timing, and other efforts based on prediction.

While the promise of above-market returns is alluring, investors must face the reality that as a group, US-based active investment managers do not consistently deliver on this promise, according to research provided by Standard & Poor’s .

S&P Indices publishes a semi-annual scorecard that compares the performance of actively managed mutual funds to S&P benchmarks.

The report analyzes the returns of US-based stock and fixed income managers investing in the US, international, and emerging markets.

Over the last five years:

• About 60% of actively managed large cap US stock funds did not beat the S&P 500
• 77% of mid cap funds did not beat the S&P 400
• two-thirds of the small cap manager universe did not outperform the S&P Small Cap 600 Index
• Underperformance of active strategies is particularly strong in the international and emerging markets, where trading costs and other market frictions tend to be higher.

Furthermore, across the thirteen fixed income fund categories, all but one manager experienced at least a 70% rate of underperformance over five years.

Proponents of active investment management will simply say buy managers who can outperform the market. Of course, a couple problems occur with this strategy:

• It is impossible to identify managers who will outperform the markets in the future.
• Most managers who have outperformed the markets cannot consistently do so in the future.

The message is clear: As a group, actively managed funds often struggle to add value relative to an appropriate benchmark—and the longer the time horizon, the greater the challenge for active managers to maintain a winning track record.

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Human emotion is an important factor in successful investing.

Would it surprise you to know that the worst stocks during the bear market that ran from October 9, 2007 to March 9, 2009 turned out to be–by far–the best performing stocks over the next 12 months?

Bespoke Investment Group did an interesting study where they took the S&P 500 stocks and ranked them from 1 to 500 with 1 being the worst performer and 500 being the best performer during the October 9, 2007 to March 9, 2009 bear market. Then, they sliced this ranking into deciles, with decile 1 being the 50 worst performers, decile 2 the next 50 worst performers all the way to decile 10, which were the 50 best performers.

They discovered that decile 1 (the 50 worst performing stocks during the bear market) turned around and rose, on average, 371% during the next 12 months that ended March 9, 2010. Decile 2, the next 50 worst performers, rose 184% over the ensuing 12 months. By contrast, decile 10, the 50 best performing stocks during the bear market, only rose 30% over the following 12 months. Essentially, the worst stocks during the bear market performed the best during the bull market and vice versa.

The study also showed that the average change of all stocks in the S&P 500 was 122% over the 12 months following the March 9, 2009 low.

This study points out one reason why understanding human emotion is an important factor in successful investing.

Think of it this way: on March 9, 2009, at the bear market low, would you have been enthusiastic about buying stocks that had declined 80-90% over the previous 17 months? Probably not because your emotions would have been so rattled, yet, those were the types of stocks that turned out to be the best performers over the next 12 months, according to Bespoke Investment Group.

As the last few years have shown, successful investing sometimes requires that you gather your courage and do what seems most frightening because the point of maximum “frightening” may also be the point of maximum profit potential.

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The Reuters/University of Michigan consumer sentiment preliminary index for February that was reported last week declined slightly from the late January number and it was lower than expected as consumers continued to fret over unemployment. The index is now down 24% from January 2007, according to data from the St. Louis Federal Reserve.

Ironically, when consumers are glum, that could be good news for the financial markets.

A 2002 study by Meir Statman and Kenneth Fisher found that, “Low consumer confidence is followed by high stock returns more often than it is followed by low stock returns.”

That seems a little counterintuitive because you would expect apprehensive consumers to be in no mood to buy financial securities and push their prices higher. On the contrary, though, the authors said, “When people lose confidence as consumers, they should regain it as investors.”

So, how does this make sense?

Not surprisingly, declining financial markets tend to drag down consumer confidence. However, at some point, financial markets typically revert to the mean and start heading up again. Often, financial markets start heading up before consumer confidence does.

Does this mean you should base your entire investment strategy on the level of the consumer sentiment index?

Of course not! This is just another example of why your best strategy is to have a plan in place and ignore the market “noise.”

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The financial media is pleased to report that the best performing mutual fund of the decade is Ken Heebner’s CGM Focus fund.

Through the end of January, 2010, the mutual fund annualized 18.03%, easily outpacing the S&P 500’s annualized return of -0.55%.

Did you miss these returns? Not to worry, because the typical investor in the CGM Focus mutual fund also missed out on the returns. Unfortunately, there is a big difference between investment returns and investor returns.

The financial media always focuses on investment returns. In other words, what did a specific investment return? In this case, the media focuses on the great track record the CGM Focus mutual fund had over the last decade.

Of course, the media rarely focuses on investor returns. In other words, how did the typical investor perform in the same investment? Luckily, Morningstar calculates dollar-weighted returns, which represents the returns real investors receive based on buying and selling.

Here are the 10-year annualized results through the end of January, 2010:

• CGM Focus: 18.03%
• Typical CGM Focus Investor’s return: -13.73%

How can this be? How did investors lose money in the best performing stock fund of the decade?

Simple. Poor investor behavior.

Most investors make buy and sell decisions based on past performance. As the financial media was happy to point out, CGM Focus returned 80% in 2007.

Believing this trend would continue, investors poured a whopping $2.6 billion into the fund in 2008.

Then, in horror, investors watched as the fund tanked -48.2%. Disappointed with the results, investors yanked more than $750 million out of the fund.

The typical CGM Focus investor missed all the gains in 2007 and captured all the losses of 2008.

Don’t fall victim to poor investor behavior and media hype. Understand there is a difference between investment returns and investor returns.

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With the dawn of a new decade arrives the financial media’s recommended investments.

Articles with attention grabbing titles such as “10 Stock Investments for the Next Ten Years” entice readers with promises of market beating returns.

But should you follow media’s investment recommendations? Consider the following articles published ten years ago.

In August, 2000, a Fortune magazine article presented “10 Stocks to Last The Decade.”

How would these ten stocks have performed if you spread your investments equally among each pick versus the market and a fully diversified portfolio*?

• Fortune’s 10 Stock Investments:  -44.21%
• S&P 500:  -7.26%
• Diversified Portfolio: +81.04%

Time period – August, 2000 through November, 2009.

Fortune’s stock picks drastically underperformed both the market and a fully diversified portfolio.

A second article by The New York Times asked for Buy and Hold picks from “10 very smart, very successful investment professionals…”

So how did these stock picks fair versus the market and a fully diversified portfolio?

• New York Times:  +25.17%
• S&P 500: -4.29%
• Diversified Portfolio:  +84.35%

Time period – February, 2000 through November, 2009

The New York Time’s picks beat the market but it seems a passively managed diversified portfolio drastically outperformed these “very smart, very successful investment professionals…”

Think twice before rushing out and investing your money in any of the media’s picks for the next ten years!

Having a financial plan and a fully diversified portfolio based on this plan is the best bet when investing for your goals and future.

*Fully Diversified Portfolio:
Dimensional US Adjusted Market 2 Index: 30%
DFA Equally Weighted Emerging Markets Index: 5%
Five-Year US Treasury Notes: 40%
Dimensional International Market Index: 25%
Rebalanced annually

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There is a difference between luck and skill and knowing when you are just lucky and when you are successful due to skill is of paramount importance as an investor.

For instance, let’s say you correctly called the flip of a coin five times in a row. What are the odds that you will correctly call the next flip?

Correctly calling five flips in a row might be considered a “hot streak” and lead you to believe that chances are high you can correctly call the next flip. Well, assuming it is a fair flip, there is, of course, only a 50/50 chance that you will be correct because flipping a coin is a game of known probability. The fact is the coin flip has no memory of your hot streak.

And, just like a coin flip, an investor who is on a “hot streak” may simply be lucky.

With millions of investors, odds are that some of them will make winning investments numerous times in a row.

If these winning investors were, in reality, just lucky, but they think they were actually skillful, then that is when the situation turns problematic. The lucky investor may start to think they are infallible and get stubborn when the market turns against them.

Eventually, when the lucky streak ends, it will likely mean serious losses for the investor.

The best antidote we know of to the danger of confusing luck and skill is to remain humble. When our investment strategy performs well, we are very thankful. When it doesn’t perform well, we accept this as part of the market cycle.

The investment business has an uncanny way of turning hubris into painful losses. We think humility is a safer route.

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One outcome of the financial crisis is we have to “live with messiness.”

Instead of a neat and tidy explanation for everything that happens in the markets, humans are sometimes irrational and, as emotional creatures, we occasionally let fear and greed cloud our financial decisions.

After witnessing the current financial crisis, the tech stock bubble and burst from a decade ago, and numerous other financial storms over the past 20 years, it seems that when it comes to money, humans continue to make mistakes with their money and investments.

In a very interesting September 2 New York Times Magazine article, Nobel Prize winner and liberal economist Paul Krugman discussed the development of economic thought over the past 230 years and how the current financial crisis has thrown economic theory into disarray.

Without getting into his political leanings, Krugman makes a case that almost all economists, whether they be conservative or liberal, financial or macroeconomic, missed this crisis.

Despite their impressive-looking mathematical formulas and hundreds of years of history, economists, in general, failed to predict the size and timing of our current worldwide maelstrom, and, worse yet, were generally blind to the idea that a catastrophe of this size could even happen in this (enlightened) day and age.

Krugman says economists, “Will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic ‘theory of everything’ is a long way off.”

In short, he says we have to “live with messiness.”

From a practical standpoint, it reiterates the importance of knowing that the financial markets are not perfectly rational and that they do not always behave in the way that econometric models predict. One could argue that changes in the financial markets are simply a reflection of the sentiments, fears, dreams, and hopes of us – the market participants. The markets are not separate from us – they are us!

Since we humans are, well, human, then the markets may behave in a way that reflects human behavior and that can get quite messy.

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Rarely do you see a headline in a mainstream newspaper containing the three words, “Yale,” “Harvard,” and “Losers,” but that’s exactly what happened last week in The Wall Street Journal.

The Journal certainly wasn’t talking about the Universities’ academic prowess or even their athletic exploits; rather, it was the disappointing performance of their once invincible endowment funds.

The value of their endowments each dropped by 30 % for the 12 months ending June 30, 2009. By comparison, a typical plain-vanilla endowment allocation of 60 % stocks and 40 % bonds lost only 13 % during that period, according to the Journal.

What’s newsworthy about these losses is that Yale had pioneered an unorthodox approach to endowment investing that worked spectacularly for years (and was copied by Harvard), but like many investment ideas, it eventually ran into a brick wall.

Under the leadership of David Swensen, Yale’s portfolio mix changed dramatically.

For example, the allocation to private equity rose from 3.2 to 20.2 %; real assets – timber, real estate, and the like, rose from 8.5 to 29.3 %; and hedge funds went from zero to 25.1 %. To accomplish this mix, the allocation to domestic stocks and bonds dropped from 71.9 to 14.1 %, according to a March 2009 article from Portfolio.

Essentially, Swensen argued that endowment funds should avoid traditional stocks and bonds and, instead, invest in higher yielding and less liquid assets that more closely match an endowment fund’s long-time horizon.

So keep in mind – even the best and the brightest such as Swensen eventually stumble, if only temporarily.

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