One of our most important jobs as financial advisors is to help our clients manage risk. This takes on many forms, but one of the most central is investment risk. We frequently hear the phrases, “I don’t want to lose money,” and “I only want safe investments.” Investing over the past several years has certainly been challenging and has driven many investors to simply give up on stocks and flock to the “safety” of cash and bonds. However, this also poses a significant risk-the risk of losing purchasing power over time.
The recent Semi-Annual letter from Davis NY Venture had the best description of this risk that I have read in some time:
…In the face of such negative articles and press reports, the desire to sell stocks 12 years into a bear market in order to buy bonds at their all-time high or hold cash with a zero percent interest rate is perfectly understandable from a psychological point of view. However, it is likely to be significantly wrong from an economic point of view. Nervousness, pessimism and uncertainty have driven down prices and the golden rule of investing is that low prices increase future returns.
… The idea that cash and low yielding government bonds are “risk free” is one of the most dangerous fictions there is. After all, a dollar hidden under a mattress 50 years ago has lost more than 80% of its purchasing power and now can only buy what 20 cents used to buy. It is hard to understand how an asset that has declined 80% in value over 50 years can be considered risk free. Yet despite an 80% decline in purchasing power over 50 years, investors continue to describe holding cash as “risk free.” A dollar invested in the late 1960s in Davis New York Venture Fund has increased its purchasing power twenty fold and now has a nominal value of more than $100.14
Our positive outlook for stock returns is not based on a rosy economic outlook. The deflationary trends from global deleveraging continue, Europe is a mess, Washington dysfunctional, and Asia slowing. But today’s low valuations discount a great deal of bad news. Furthermore, because our companies tend to pay dividends and repurchase shares, they should be able to generate satisfactory investor returns even with relatively anemic earnings growth. In short, by remembering that stocks represent actual ownership in real operating businesses, investors can focus on the quality, durability and profitability of these businesses and tune out the blaring headlines, day-to-day noise and rampant pessimism. While no one can know for sure what the future holds, we do know that our Portfolio is made up of world-class companies generating an earnings yield of close to 8%, much of which they are returning to shareholders. These facts are what make us look to the future with optimism.
We share this general viewpoint and outlook for the markets over the long term. Unfortunately, holding only investments that are “risk free” is like living a life that is “stress free,” it is simply not possible. Therefore we have to operate in the world we have and use tools to manage the risk inherent in investing.
