What a year! Both the US and offshore markets are headed toward 15-20% returns for the year. The markets are back in a big way so why wouldn’t you want to load up on equities? The answer is because of history. While historically we can’t predict market moves year to year we do know that the historical return over the last eighty years is somewhere between 10 or 12%. Sooner or later the market is likely to post much lower returns as it hews toward the mean level of return. Whether those lower returns happen this year, next year or the year after that is very hard to predict but happen they will. Don’t think so? Then you’ve clearly forgotten the lessons learned in 2000-2003. If you’d invested in the market (as defined by the S&P 500) in January of 1996, at the start of the dot-com boom, you would have enjoyed an average, annual 26% compound return for the four years through 2000. But then came the dot-com bust and the market tanked for three of the following four years. So what was your annual, compound return over the full eight years if you’d just held on? You guessed it, about 10%. If you started ten years earlier your average return would have improved slightly to approximately 11%. Go back an additional ten years and the annual return is about 13%. The fact of the matter is that the market has seldom maintained an average return of much over 14% for more than a few years. Periods of higher than average returns are almost inevitably followed by years of much lower returns.

Why do I mention this? Because part of being a successful investor is having realistic expectations. Anyone who begins to think that a 15+% market return is sustainable over a long period of time is doomed to great disappointment. The reality is that 10% returns in a 3-4% inflation environment is the stuff dreams are made of and we should be happy to accept that any day of the week. Unfortunately averages are just that, averages, and the 10% we’ll most likely get will not happen in a straight line. In a perfect world we’d be able to predict the highs and lows and invest accordingly but unfortunately we can’t accurately make those predictions. As such, we just need to accept the fact that the ride to good returns will be a bumpy one with some terrific and some horrible years. The most important thing is to stay the course and keep your nerve through the bad times and not load up on extra risk in the good times. Tempting as it is to let your profits in stocks run, it’s time to rebalance to be sure you maintain a diversified portfolio that will smooth out your portfolio values and help you resist the urge to run for cover when the markets swoon. As the last few years have demonstrated, some of the best years come on the heels of the worst and if you miss them you may pay a dear price in lost returns.

So remember, having reasonable expectations is an important component of investing. Expect that you’ll have bad years and good years but know that given enough time it will be hard for you to do poorly. Unlike life, investing is not about the journey but rather the destination.

Our best holiday wishes to clients and friends alike.

Randy Gridley

December, 2006