Download PDF Version - Entire Series

High Inflation and Stock Market Losses

As outlined in a recent article U.S. Debt and Entitlement Programs Point Toward More Inflation, a return to 1970s style inflation is well within the bounds of reality. CCM's multiple asset class approach includes several portfolio elements which can help clients protect their purchasing power in periods of high inflation and a weak U.S. dollar

Asset Class Correlations Can Help Protect Principal

The CCM model is built around a CCM Base Asset Allocation which produced attractive historical annual returns, relatively low volatility, and protection from inflation from 1970-2006. In order to become better prepared for the future, we collected historical data for the asset classes above going back to 1970. The actual daily historical data for specific investments was used when available. Since many of the investments we use today were not in existence in 1970, proxies were used where needed, usually in the form of annual mutual fund returns found in old Morningstar Mutual Fund Surveys. For example, the specific intermediate term bond fund used in our multiple asset class portfolios has an inception date of June 1984. In our historical asset class database, we used daily returns for this specific bond fund as far back as available. When daily data was not available, we used the historical annual returns for the specific bond fund investment. Prior to the funds inception date in 1984, we used returns from a similar intermediate term bond fund as a proxy. Therefore, the returns in the database are after all investments expenses such as annual mutual fund management fees.

The returns in Table 11 compare the CCM Base Allocation (Multiple Asset) to the returns for Large Cap U.S. stocks (S&P 500). To make the comparison more meaningful, we used the total returns from the Vanguard Index 500 Fund and the total returns of Ibbotson Large Company Stocks going back to 1970. As stated above, unlike pure index returns, total returns include both appreciation and dividends. The Multiple Asset annual returns are reduced by 0.65%, which is the current CCM management fee for the CCM Base Allocation used in this example. Actual client management fees may be higher or lower based on their specific needs and allocation.

With exposure to many asset classes which can perform well in an inflationary environment, the multiple asset class approach was able to produce favorable returns during the period of 1970-1981. Having assets which exhibited a low or negative correlation to U.S. stocks enabled a multiple asset class approach to produce positive returns during the 2000-2002 bear market.

Graph 1

Large cap stock returns used above are based on actual total returns for the Vanguard 500 Index Fund and Ibbotson Large Cap Stocks. Historical returns for specific investments typically implemented by CCM clients were used in the Multiple Asset Class calculations whenever available. When data was not available for specific investments, reasonable proxies were used. Mutual fund and ETF annual operating fees are included in the return figures quoted above. Multiple Asset Class returns are reduced by 0.65% annually, which is the approximate annual CCM management fee for the asset allocation used in this example. Actual client fees may be higher or lower based on their particular needs and allocation. Custodian trading costs, such as commissions for transactions are not included in the figures presented above.

Note: Graph 1 was produced using annual returns, which does not take into account intra-year volatility. Graphs using daily performance data would show intra-year price volatility which is more indicative of the real world. Since returns are not produced in straight lines from year to year, an investor's experience in both the S&P 500 and CCM Multiple Asset Class Approach have been more volatile than what is depicted in Graphs 1 and 2.

The CCM Base Allocation used in these examples trailed the S&P 500 in 23 of the 37 years shown. Conversely, it outperformed the S&P 500 14 of the 37 years shown. The key to successful long-term investing and the CCM approach is consistency of returns while reducing the probability of large portfolio losses, which applies to someone in their 70s as well as someone in their 20s. This is clearly illustrated in Graphs 1 and 2.

The CCM Base Allocation does not attempt to outperform the S&P 500 every year. However the CCM Current Allocation, which is the CCM Base Allocation adjusted for the current environment, does attempt to capitalize on current trends. The adjustments made when creating the CCM Current Allocation take the client's circumstances and risk tolerance into account. The CCM Current Allocation can be tailored to fit a very conservative or fairly aggressive investor. Graphs 1 and 2 assume buy-and-hold. The CCM Rebalancing Model is one of many tools used to adjust the CCM Base Allocation. Rebalancing produces an asset mix which is more in line with the current environment. Therefore, in years where the buy-and-hold CCM Base Allocation (Multiple Asset) lags the market, the CCM Rebalancing Model would attempt to improve upon those returns via allocation adjustments.

Like any investment strategy, a long-term focus is vital to success. Warren Buffet lagged the off the charts technology returns of the late 1990s. His patience and consistent approach enabled him to have the last laugh after the 2000-2002 bear market. While it is easy to look at the returns of the multiple asset class strategy and the graphs above and say, "I want to invest this way," it is quite different to stay with the strategy in years where the general stock market has produced superior returns.

Prior to discussing some asset allocation statistics, it may be helpful to compare in simple terms the historical results of the CCM Base Growth Allocation to the general stock market. Of the 23 years the multiple asset class strategy underperformed the S&P 500, the average annual return for the CCM Allocation and average lag vs. the market was 12.84% and 8.72% respectively. In the 14 years the general stock market trailed the multiple asset class strategy, the stock market's average annual return and average lag vs. the multiple asset class strategy was -2.67% and 17.01% respectively. This means when the multiple asset class approach trails the S&P 500, it still returns on average 12.84% vs. the general stock market's average of 21.56%. However, in the years the S&P 500 trails the multiple asset class strategy; it produces a loss of 2.67% vs. the multiple asset class' average gain of 14.33%. These figures also point to the importance of consistency of returns and loss minimization.

To put our 2007 calendar year returns in the context of risk/reward, it is helpful to review the concepts of average annual return and standard deviation. Standard deviation can help us understand the level of uncertainty associated with achieving a stated average annual return. The concepts are illustrated in Graphs 1-A and 1-B, compare the historical performance from 1970-2006 for large-cap U.S. stocks (similar to the S&P 500) and the CCM Base Growth Asset Allocation (Multiple Asset). In the investment world, we use historical standard deviations along with the average annual returns of specific asset allocations to help us better understand the possible range of future returns.

From 1970-2006, U.S. large-cap stocks had an average annual return of 12.39% with a standard deviation of 16.80%. From a statistical standpoint, this tells us from 1970-2006 the annual return for U.S. large-cap stocks fell between a loss of 4.41% (one standard deviation below the average) and a gain of 29.19% (one standard deviation above the average) sixty-eight percent of the time. Thirty-two percent of the time the annual return was either worse than a loss of 4.41% or better than a gain of 29.19%. Moving two standard deviations away for the average tells ninety-five percent of the time the annual return fell between a loss of 21.21% and a gain of 45.99%.

Since investment markets do not produce returns based on a symmetrical normal distribution, there are some limitations to this quick risk/reward analysis. However, it does help us understand the probabilistic range of possible future outcomes based on 37 years of historical data. If we use historical figures for U.S. large cap stocks to help us gain a better understanding of possible future returns, we can say there is a 68% probability the average annual return will fall between a loss of 4.41% and a gain of 29.19%. Similarly, we can say with a 95% probability the annual return will fall between a loss of 21.21% and a gain of 45.99%.

The average annual historical return from 1970-2006 for the CCM Base Growth Allocation used in these examples was 13.40% and the standard deviation was 9.53%. If we use these historical figures to help gain a better understanding of possible future returns, we can say there is a 68% probability the average annual return will fall between a gain of 3.87% and a gain of 22.93%. Similarly, we can say with a 95% probability the annual return will fall between a loss of 5.66% and a gain of 36.33%.

Understanding the limitations of assuming returns are based on a normal distribution, it is helpful to look at the risk of each strategy from an actual historical perspective as well. We use a historical measure termed "maximum historical draw down" (Max Draw Down) to describe an asset allocation's worst historical performance from a market peak (top) to a market trough (bottom). Since we only have daily data going back to 1995 for the wide variety of asset classes, the Max Draw Down /Loss figures below are for the period 1995-2006. The total return investor in the S&P 500 from March of 2000 to October of 2002 lost roughly 47%. 47% is said to be the maximum portfolio draw down for the S&P 500 during the period from 1995-2006. Over the same period, the CCM Base Growth Allocation's maximum portfolio drawdown was 12.50%, which occurred from April 1998 to August 1998.

Asset Allocation and Portfolio Management Statement of Purpose

What it all comes down to is risk adjusted returns. When S&P 500 makes 8.0% in a given year you must take the return in the context of how much risk you exposed yourself to in order to get the 8.0%. In the worst case scenario from 1995-2006, the risk historically for the S&P 500 is you would have lost 47.74% of your capital from the S&P 500's high in March of 2000 to the low in October of 2002. When earning 8.0% in the Multiple Asset Class Strategy, your worst high to low loss would have been 12.50% over the same period.

Risks and Limitations to the CCM Approach

The next segment will discuss how we use investment simulations to provide more realistic retirement and investment projections.

• Using Investment Simulations To Assist In Risk Management

Chris Ciovacco
Ciovacco Capital Management