The Importance of Investment Discipline

logo_bTo borrow from Jim Rohn, “discipline is the bridge between goals and accomplishment.” This statement rings especially true in investing. As Balentine Chief Investment Officer Adrian Cronje told the Atlanta Business Chronicle, when markets experience volatility, such as during the third quarter of 2014, it brings both opportunity and risk. The opportunity lies in the ability to rebalance strategies proactively to capture mispricings as they occur. The biggest risk though is that volatility plays to investors’ emotions, causing them to be reactionary and lose the discipline that is necessary for a long-term investment program to work. This is especially true if volatility occurs after a long period of tranquility in markets when investors have forgotten that it is quite “normal” for volatility to occur.

In investing, discipline comes from understanding three key points:

  • Thoughtful diversification is better than trying to time the markets. For all but the most aggressive investors, it is usually better to construct portfolios beyond just stocks, into bonds and other asset classes to maximize the probability of reaching goals over time.
  • Portfolios should always be proactively rebalanced through time.
  • Historical context matters. Consider these facts:
    • There has not been in a 10% correction in 780 trading days, or since 10/3/11, the fifth longest such streak since 1927.1
    • Fourth largest rally in the S&P 500 since the Great Depression, in terms of length (trading days) and magnitude2

chart 1a for investment discipline

Source: FactSet, Balentine

 chart 1 for investment discipline final

Source: FactSet, Balentine

Another important historical factor to consider is that volatility has been muted and valuations are at extremely high levels. Consider the below:

  • Warren Buffett’s most preferred valuation indicator, market cap/GDP, is currently 131%.  This compares with 154% at the height of the Internet bubble, 62% in March 2009.  Buffett believes 100% represents the level at which caution regarding stocks is potentially in order.3
  • Tobin’s Q of 1.12 is much higher than in 2007 (~0.90) and compares with 0.57 in March 2009 and 1.64 at the height of the internet bubble.4
  • 10-year CAPE of 25.1, which is well above the historical average of 16.5.  Bottomed at 13.3 in March, 2009 and topped at 44.2 during the internet bubble.  The market’s current CAPE is in the 91th percentile, though still trailing the 2007 peak (95th percentile), the 1929 peak (97th percentile), and the internet bubble (99th percentile).5
  • Dividend yield on the S&P 500 is currently ~2%, which would be the 73rd lowest yield in the 88 years since 1926. 6

Even though these valuation measures do not imply that a crash is imminent, they do illustrate that it is realistic to plan for more muted returns from US stocks from today’s starting point. Investors could become even more tested as the Federal Reserve begins tapping the brakes on its bond-buying program in 2014.

Sources

  1. Ned Davis Research
  2. FactSet and Balentine
  3. Doug Short – Advisor Perspectives “Market Cap to GDP: The Buffett Valuation Indicator Is Now in Levitation Mode
  4. Doug Short – Advisor Perspectives “The Q Ratio and Market Valuation: Monthly Update”
  5. Doug Short – Advisor Perspectives Is the Stock Market Cheap?
  6. Aswath Damodaran – Stern School of Business at New York University

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