The 5 Iron Rules of Investing
As of the end of April, 62% of the companies in the S&P 500 have now reported Q1 earnings. And the headline is: “Earnings Skid Worst Since Financial Crisis.”
According to Thomson Reuters, the estimated year-over-year earnings decline for Q1 2016 is -6.1% (based on the combination of companies that have reported results thus far and an estimate of the companies yet to report).
Assuming there is a decline in Q1 earnings, this will mark four consecutive quarters of year-over-year declines in earnings. The last time this happened: Q4 2008 to Q3 2009.
The revenue outlook for Q1 is similarly gloomy, with revenue expected to drop for the fifth quarter in a row.
The chart below identifies energy as the wet blanket sector weighing down earnings. But according to Thomson Reuters, “Even excluding energy companies, which are expected to have their worst quarter since oil prices began to plunge in 2014, profits are on pace to fall by 0.5%. Revenues are expected to fall 1.4% overall, or rise 1.7% excluding energy.”
And while the pro forma adjustment to exclude energy is an interesting intellectual exercise to understand what’s happening to corporate profits in the rest of the economy, energy companies still account for about a 7% weighting of the S&P 500.
When earnings take a dive, other things being equal, valuations based on future estimates of earnings tend to rise. Case in point: According to FactSet, the P/E ratio based on the current 12-month forward estimate of earnings is now 16.8 (compared to a 5-year average of 14.4 and a 10-year average of 14.2).
This combination of a string of earnings declines with corresponding valuation increases brings out the catastrophists in force.
At times like this, it is especially helpful to step back and add some perspective to think about what really matters for the typical investor with a multi-decade time horizon.
In fact, a sound investment plan has nothing to do with current events but is instead grounded in a handful of timeless, bedrock principles, which we think of as the five iron laws of investing.
- Diversification. Since large company stocks have historically generated an average return (before inflation) of 10% annually, the goal of every equity investor should be to earn as close to the market return as possible. And the equity market return can be achieved, simply, by owning broadly diversified equity index funds, which lets an investor own a little bit of every one of the leading companies in the world. This is also a bet on the humility of not trying to outperform the market, which history has shown to be a valuable trait.
- Costs. Over the past 10 years, over 80% of actively managed U.S. stock funds have underperformed a low-cost equity index fund. One way to look at this is that investors in actively managed funds get excess fees instead of excess performance. But investors can tilt their odds of getting better returns in their favor by simply lowering costs.
- Volatility. The stock market has historically offered stellar long-term returns—two to three times higher than those of bonds (after adjusting for inflation). And the reason why stocks offer superior long-term returns is precisely because it is impossible to forecast what they will do in the short run. The price of admission to earn these high long-term returns is volatility—the market’s often times gut-wrenching gyrations in reaction to whatever happens to be the apocalypse of the day along with a ceaseless torrent of unpredictable outcomes. An investor who is able to ride out the rough spots doesn’t actually pay this bill, though it is a very real mental tax. And not everyone is willing to pay this price, which is why there is an opportunity for those who are. The bumpy ride is the reason for the return.
- Time. The average annual gains associated with longer time horizons overshadow the average annual losses in one-year holding periods. This is why strategies that invest over a market cycle, such as dollar cost averaging and dividend reinvestment, are powerful An investor’s sensitivity to market volatility is largely determined by his investment time horizon; and the equity markets have rewarded those who have stayed invested over longer periods of time. Time, patience and endurance pay off.
- Behavior. The biggest risk investors face isn’t a recession, a bear market, the actions of the Federal Reserve, the results of an election or geopolitical events. Instead, it is their own emotions, their reactions to these emotions, and the destructive behaviors they can cause. One of the iron rules of investing is to avoid behavioral errors. But investors are humans, and they’re going to make predictable mistakes like selling out at the bottom. That’s where a wise investment counselor can help most investors avoid emotionally-driven behavior that can have adverse consequences for their long-term goals.