Compass January 2016

In this issue:

Compass is the quarterly newsletter of Creekside Partners. All information is obtained from sources deemed to be reliable, but is not guaranteed as to accuracy. Nothing in this newsletter should be construed as financial or investment advice to any reader. All material herein is the copyright of Creekside Partners.

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Volatility is a Drag — Literally

A couple of years ago, with the 2008 crash fresh in our short-term memory, I recall a sense of astonishment when I read that the typical stock investor continued to expect double-digit returns from stocks. In the past year, I have been encouraged by signs that investors are finally beginning to understand that such results are not sustainable or realistic.

I conducted an informal poll the past few weeks as I ran into people around town. I heard the consistent view that, yes, perhaps we had best get used to the single digits again. Figures in the seven to ten percent range seemed to make sense to my buttonhole poll group.

No, I’m not writing yet another column imploring you to lower your expectations. I am turning my attention this week to the topic of risk. Not just any risk, but specifically the form of risk that is most widely reported by securities analysts and research firms like Morningstar.

This risk measure is called standard deviation. Standard deviation is a mathematical calculation that tells us how far from the average return we can expect year-to-year returns to be. For example, let’s say the average stock return over some period of time is 10%. We all understand that stocks did not really pay exactly 10% each year; the actual numbers were all over the place and they averaged 10%.

Let’s now say that stocks had a standard deviation of 16%. That means that we would expect that the returns in most years to be in a range of 16 percentage points above or below the 10% average. Technically speaking, we would expect about two-thirds of the years to fall in the range minus 6% to positive 26%. One-third of the years would be expected to be beyond those highs and lows.

Now that investors seem to have the rational view that long-term stock returns are likely to be about, say, 5%, I wondered whether they had considered what happened to the standard deviation. In poring over the historical databanks, we find that, while stocks go through varying periods of high and low returns (see article on page 3), the amount by which those returns vary from year-to-year does not change much. The 16% number holds reasonably steady over extended market cycles.

Stick with me for one more technical bit. As time goes by, we do not really earn the average return on our stocks. How is that? The standard deviation serves to drag our returns downward. The more volatile our year-to-year returns, the less money we actually have at the end of a reasonable holding period. We call this the “volatility drag.” I also like to call it the volatility tax. Volatility drag can be calculated through another bit of math. A standard deviation of 16% results in a volatility drag of about 1.3 percentage points.

The effect of volatility drag is to reduce the expected return. An expected average return of 10% is lowered by 1.3%, to result in an actual expected return on cash of 8.7%. This is the price we pay for seeking higher returns. We are familiar with the canard that you have to take risk to get reward. Well, my friends, that reward is not free. It comes with a cost.

If you achieve those 10% average returns, a 1.3% volatility tax is the price you have to pay. Still, 8.7% compounded return, after paying that price, isn’t so bad. The 1.3% drag eats up about one-eighth of your monetary gain.

However, let’s see what happens if your expected average falls from 10% to a more rational 5%. The volatility tax is still the same – 1.3% – and lowers the actual expected return to 3.7%. The 1.3% volatility drag now eats up about one-quarter of your money.

The drag on returns due to the inherent volatility of stocks will eat up twice the amount of returns as it did during an era of high returns.

If average returns fall, and volatility remains at its historic levels – and we have no reason to suspect that it won’t – then investors are in for another round of disappointment. A cure for this ill – a tax dodge, if you will – is to position your portfolio so that it experiences less volatility. Even investors with a high tolerance for risk should consider taking less of it if they share our view that returns going forward will not be as high as in the past 30 years. A larger proportion of bonds might do the trick, as would carefully selected asset classes that, while volatile, do not follow the same pattern as the standard stock indexes.

All categories of stocks demonstrate this high level of volatility. And, in a market crisis, they all tend to behave similarly. But over the course of the business cycle, a portfolio that includes disparate stocks from various sectors can exhibit lower volatility than any single sector. It is important to include foreign stocks, stocks of varying size and even bonds of different types.

This diversification of holdings can help to reduce the portfolio-wide volatility…and reduce the volatility tax.

Our key message for friends and clients:

» Personal financial planning and the execution of that plan are more important now than ever;
» While return expectations in the near-term are low, so is inflation;
» This is not the environment to attempt to increase returns by taking more risk;
» Remain patient…the business cycle rolls on and it will, as always, present opportunities.

Risk is like a bed of nails.

When there is a thick mattress of high returns sitting over the nails, we can blithely ignore the risks. When that mattress shrinks to a thin little camping pad, those very same nails will keep us awake at night.

Expected Returns

The article to the left makes a quick and, admittedly, unsupported suggestion that stock returns going forward will be sharply lower than some historic averages. Briefly…here is why that is likely to be true:

When computing an average return on stocks, one must choose a starting point. If I choose a starting point when stocks were unusually cheap — and at the start of an extended rally — I will naturally compute a high average return. If I choose a starting point when stocks were irrationally exuberant — and at the start of a bear market — I will compute a low average return. Average after-inflation annualized returns on the S&P500, at various starting points:

Last 16 years: 2.0%
Last 33 years: 8.4%
Last 50 years: 5.5%

So…what is the average return? A cynic might say, “It depends on what you’re selling.” Since we don’t sell anything other than fiduciary advice, we can remain neutral and answer with candor. We can ask: What is different about those starting points? The answer — the price-earnings multiple. When stocks start a period of time already expensive, they tend to deliver lower returns going forward. When they start out cheap, they do better. Here’s those same starting periods, with the cyclically adjusted P/E ratio (“CAPE”) at the starting point:

Last 16 years: 44.2 at Jan.2000; 2.0% return since then
Last 33 years: 8.5 at Jan.1983; 8.4% return since then
Last 50 years: 23.7 at Jan.1966; 5.5% return since then

It is quickly apparent that a high CAPE leads to lower returns. A low CAPE leads to higher returns. The S&P500 index is currently priced at a CAPE of 25.0, a level only exceeded three times in the past 100 years.

The average real return on stocks in the 10 years following a CAPE higher than 24 is 2.4%. With inflation running under 2% (and widely expected to stay there for some time), that brings gross returns to 4% or so.

For example, the “last 50 years” starting point above was January 1966. In the ten years following that date, annualized real returns were minus 2.5%. Gross returns were just 3.5%. You might note that, given 50 years, the returns actually ended up pretty good — 5.5%. We agree!

Except we (and our clients) don’t have 50 years to wait for things to work out.

The market has few genuine “rules.” But one of them is this…high valuations lead to low returns. And vice versa. With todays high valuations, we encourage investors to reduce their total return expectations. However, the volatility — risk — is the same as it ever was, and will drag down your total results more than usual.

Note that the above analysis is limited to the S&P500…one of many available stock indexes in which to invest. Other stocks sectors (foreign, emerging…) are more attractively priced.

What the Fed did — and didn’t — do.

On December 16, 2015, the Federal Reserve announced that it was raising interest rates. More specifically,
it raised its target for the so-called federal funds rate. Before talking about just what is the federal funds
rate, we’d like to point out what it is not:
» It is not mortgage rates
» It is not CD rates
» It is not bond interest rates
» It is not credit card rates
» It is not muni bond rates
» It is not the prime rate
» It is not T-bill rates
» It is not the index on a variable rate mortgage

Most of these interest rates have actually fallen since December 16.

From our good friends at Wikipedia: The federal funds rate is the interest rate at which banks and credit unions lend reserve balances to other banks and credit unions, overnight. A “reserve balance” is a bank’s own bank account at the Federal Reserve. It’s the portion of customer deposits they must keep in reserve, to protect against risk of a bank panic. Customer deposits $100; bank puts $10 of that in the Fed for safekeeping. If a bank gets a new deposit via a customer walking in the door and depositing a check, this $10 set-aside for reserves works normally.

But sometimes banks create deposits out of thin air (if that’s a surprise to you, you’re not alone). When a bank lends a business $100, it does so by making a ledger entry of $100 into the business’ deposit account. Any $100 deposit triggers a requirement for $10 to go into the Fed. Since the business needs the full $100 (not just $90), the bank is missing the $10 reserve amount it owes the Fed. So it borrows the $10 in reserves from another bank. Another bank might have extra reserves due to one of its customers paying off a loan (among other reasons). So a $10 reserve loan is made, at a particular interest rate…

The Federal Funds Rate

In theory, if these reserve loans between banks get more expensive, borrowing banks will be reluctant to make as many new loans — and the associated “out of thin air” deposits. This will, in theory, dampen the business cycle and reduce inflationary pressures. The method by which the Fed coaxes this rate higher is not important to us here.

What is important is to realize that the Fed is not controlling any other interest rates. In fact, if its federal funds rate-raising actions work, the economy could slow down and other interest rates might fall. This happened in 2005. Then-Fed President Greenspan termed it a “conundrum” — that while the Fed was pushing up the federal funds rate, most other interest rates were falling.

2015 Index Returns (ending 12/31/15)

Total Market U.S. Stocks

Foreign Stocks

Emerging Market Stocks

Muni Bonds

Taxable Bonds









Wherever possible, we use the returns on Vanguard Index Funds as the benchmark figures for various asset classes.

Readers wishing to review the actual performance record of a composite of our client portfolios should call or email us at