By now, you have probably worked up the courage to peek at your October statements. For most investment positions (with the exception of some bond funds) returns were “double-digit” negative. The October decline accounts for approximately half of portfolio year-to-date losses across a broad spectrum of asset allocations. In terms of SCLC’s reporting metrics, October results are at the end of the left-tail of the historical distribution of post 1972 returns—declines of this magnitude have happened before; but nevertheless it comes as a shock.

Here are some observations for your consideration:

BONDS

• The Lehman Brothers Index of the aggregate U.S. Bond market (-2.36% in October) has a ten year average annual return of 5.00% for the period ending October 31, 2008.
• A proxy for the nominal risk free asset (CitiGroup 3-Month Treasury Bill Index) earned 0.12% in October; and, over the comparative ten-year period, earned an average annual return of 3.36%.
• A proxy for the inflation-adjusted risk free asset (Lehman Brothers U.S. Treasury Inflation Protected Bond Index) declined 8.69% in October; however, it has a positive annual average return of 6.12% over the last ten years.
• Many investors sought to capture yield as the inflation rate and nominal interest rates declined. This was not a good move. The Merrill Lynch High Yield Master Index lost 16.30% in October and produced an average annual ten-year return of only 2.70%.
• During periods of low interest rates, investors sometimes seek returns in longer-term bond maturities. However, the Lehman Brothers Index of Long-Term Treasury Bonds lost 3.26% in October and generated a 10 year return of 5.97%.

Reaching for returns in the Bond market appears to have been counter-productive during the October market shock. The effects of the failure of large institutions (Wachovia, Washington Mutual, Lehman, Fannie and Freddie, and so forth) are still working their way through the credit markets, so that the “counterparty risk” perceived by surviving players is much higher than normal. Increases in perceived risk drive interest rates higher, which in turn drives bond values lower. It is hardly surprising, therefore, that riskier bonds saw further declines in October. Lower risk bonds appear to have fared better.

STOCKS

Virtually the entire global equity market suffered in October. The magnitude of the year-to-date declines rivals that seen in the 1970s during the OPEC energy crisis, Watergate political crisis, U.S. Dollar inflation crisis (another “perfect storm” of bad news).

• Large Cap International Stocks (proxied by the MSCI EAFE Index) declined by 20.18 in October. For the ten year period, it returned only 1.90. [Yes—you are reading this right. Investors over the last decade have taken the risks of foreign stock investing and have earned less than the three month U.S. T-Bill Index!]
• The MSCI World Index (includes the United States) fell 18.94% in October. This dragged its ten year average annual return down to only 1.03%. [Yes—you are reading this right as well—over the past decade, the U.S. was a drag on equity returns!]
• The S&P 500 (a traditional cornerstone of portfolio asset allocation) fell 16.79% in October. Amazingly, the 10 year average annual return on the S&P 500 stock index is a microscopic 0.40%—so much for the “pick quality stocks” crowd.
• By contrast, the Russell 2000 Value Stock Index (stocks with smaller market capitalization and with higher book-to-market accounting fundamentals) lost 19.98 in October, but generated a ten-year return of 7.40%.

In general, many equity benchmark returns for the ten year period were lower than fixed income benchmark returns, suggesting that the realized equity risk premium provided to investors was negative.

BEST SECTORS IN WHICH TO INVEST

Often, during times of financial distress, investors hear the following argument: “There are economic sectors that offer the opportunity to generate positive equity returns. The job of the investment manager is to analyze macroeconomic and industry trends to identify these sectors. The best asset management approach in turbulent times is, therefore, Sector Rotation, because it keeps the investor out of the ‘deep waters’ of the troubled sectors.” In order to test this hypothesis, we examine the year-to-date returns (through October 31, 2008) from the 45 Fidelity “Specialty” funds, each of which focuses on a specific sector of the U.S. or global equity markets. Here is a summary of the results:

• Every equity sector fund lost money.
• The returns span a range from the best year-to-date result (-10.68% for the Fidelity Select Biotechnology Portfolio) to the worst year-to-date result (-56.70% for the Fidelity Select Automotive Portfolio).
• Of the 45 sector funds, an amazing 36 (80%) had year-to-date negative returns greater than 30%.
• The Fidelity Select Gold Portfolio generated a -49.50% year-to-date loss.
• What about the health care sector which supposedly exhibits inelastic demand? The Fidelity Select Heath Care Portfolio returned -31.88%.
• How about safe Utilities? The Fidelity Utilities fund returned -37.45%.

Given the fact that it requires extreme asset concentration risk, the Sector Rotation strategy preferred by many market timers does not appear to offer reasonable prospects of success.

THE EQUITY RISK PREMIUM: DECIDING WHAT TO DO NOW

The fundamental law of finance states that investors will not take risk unless they have a reasonable expectation of receiving a reward greater than the risk-free rate. We grant of course that the return figures listed above are quite time sensitive: the past decade has perhaps seen more than its fair share of economic shocks, including the bursting of the internet bubble, 9/11, and the current credit crisis. Other ten year sample periods present a much different picture. Nevertheless, despite the frequency and magnitude of shocks over any ten-year period, the fundamental law of finance still applies. Sometimes investors are not aware of their expectation of receiving a risk premium—but the expectation had to have been there nonetheless, or they would never have moved out of cash.

Here is the important thing to ponder: when investors feel that they cannot earn the required risk premium by purchasing a financial asset at its current price, there is only one possible outcome. The price of the risky asset must drop so that, at the newer and lower purchase price, investors’ reward expectations seem justified. A corollary of the fundamental law of finance is that the lower the average current price of assets (as compared with sales, equity, or any other “objective” factor), the more likely it is that investors will realize their return expectations. [It does not hold for individual firms considered in isolation, but only for broad swathes of the capital markets; statistics such as averages are characteristics of populations, rather than of individuals.] This corollary motivates Warren Buffett’s recent decision to buy stock.

How should investors decide to respond to the current crisis? It’s no good to look back at the declines suffered since a year ago; they are water under the bridge. The question is what to do now, given the situation that now obtains. At one extreme lies moving entirely to cash, and at the other, lies Buffett’s decision to buy lots of stock at the cheapest prices in decades. Each investor must evaluate where on this spectrum his personal risk tolerance lies. There is no “universally true rule of thumb,” no “guaranteed best outcome,” no “foolproof asset management decision.” However, as you reflect on the question, you should bear in mind the fundamental law of finance. It will keep you from making many of the common investment mistakes that arise out of greed or fear.

Put another way, there was a reason why you settled on your original investment policy.

Patrick J. Collins PhD, CLU, CFA