Most
sports enthusiasts are familiar with the great Miami Dolphins team that
went an incredible 17-0 in 1972 on their way to a Super Bowl victory. As
the only team to ever do so in the National Football League, their
accomplishment is oft referred to when a team at any level has a chance
late in their season to achieve perfection in their won-lost record. Say
“1972 Dolphins” and every true fan knows what you are talking about. It
is interesting to note that the Dolphins had few players that were well
known at the time – especially on defense. In fact, their defense was
referred to as the “No-Name Defense.” Last season, the runner up Chicago
Bears’ defense was the best in the league – hands down, and the
Indianapolis Colts won the Lombardi trophy largely due to the incredible
turnaround made by their defense during the playoffs.
The
success of teams with excellent defenses is no surprise to avid fans
because they are familiar with the mantra of team sports, “defense wins
championships.” You may have heard it in other forms as well, such as,
“the best offense is a good defense.”
In
late April, as the equities markets soared to new highs, the “offense”
was humming at maximum efficiency. So why are we bringing up defense at
a time like this? Because while you can certainly gain wealth in an up
market, you keep wealth in a down market.
Investors should be beneficiaries of both the protection and growth that
the markets freely give. Or to put it another way: individual investors
should have a good offense and, perhaps most importantly, an excellent
defense. If you are an asset class investor, you are sharing in the
benefits that this strategy brings in good and bad markets. For the rest
of you, however, we would like to illustrate just how important this
team balance is, even though we have been experiencing a roaring bull
market, not just lately, but since the beginning of 2003.
It
happens that the market time frame that serves as the perfect example in
our context of balance is the period from March 2000 through December
2006. We saw the worst bear market since the Great Depression followed
by a dramatic turnaround into positive territory. In other words, we saw
a time where good defense was really needed followed by a four-year-plus
stretch where the offense ran it up and down the field at will.
The
chart here shows the results of stock indices from March 2000 to
November 2002. Clearly a bear of a market.
|
March 1, 2000
to October 31, 2002 |
|
| |
|
Dow Jones
Industrials |
-13.09% |
|
|
S&P 500 Index |
-32.71% |
|
|
NASDAQ |
-71.48% |
|
|
Russell 2000 |
-32.84% |
|
|
EAFE
(International) |
-41.57% |
|
|
|
|
|
100% Equity
Asset Class Model |
-11.35% |
|
For
the sake of comparison, we also chart the 100% Equity Asset Class model.
As you can see, the Asset Class strategy was very effective at buffering
the ill effects that this deep bear market created. We coined a term for
this type of protection. We call it the giant portfolio stop-loss
effect. This is the result of the super-diversification found in the
asset class mutual funds. As we can see, it lost only 8.95% during this
thirty-two-month period as the major stock indices plummeted in
comparison. Imagine owning nothing but stocks during this deep bear
market and still losing only about 3.4% per year (compounded).
We
next review the time period from November 2002 through December 2006.
|
November 1,
2002 to December 31, 2006 |
|
| |
|
Dow Jones
Industrials |
63.23% |
|
|
S&P 500
Index |
72.76% |
|
|
NASDAQ |
81.64% |
|
|
Russell 2000 |
121.81% |
|
|
EAFE
(International) |
141.49% |
|
|
|
|
|
100% Equity
Asset Class Model |
156.10% |
|
This
period shows a dramatic reversal from the previous thirty-two months.
All the stock indices showed a marked improvement during these fifty
months. Note that the NASDAQ index came back over 80% during this time
period. However, the 71.48% it lost in the bear market meant that it had
to gain over 200 percent in order to reach its original level before the
bear market began. This shows the exponential damage that can occur in
difficult markets. This is why investors should be very aware of the
protection element in their portfolio allocations, which is provided by
super-diversification. In other words, you had better have a good
defense.
So
now let’s review the two time periods together covering a total of about
six and a half years: March 2000 through December 2006.
|
March 1,
2000 to December 31, 2006 |
|
| |
|
Dow Jones
Industrials |
41.69% |
|
|
S&P 500
Index |
16.07% |
|
|
NASDAQ |
-45.58% |
|
|
Russell 2000 |
48.66% |
|
|
EAFE
(International) |
41.06% |
|
|
|
|
|
100% Equity
Asset Class Model |
133.18% |
|
Note
that the NASDAQ is the only index that remains negative for this time
period. However, the other indices, ranging from 16.07% to 48.66%, have
gained less than one-third of the return of the 100% Equity Asset Class
model. Once again, the protection - or defensive - element provided by
the wide and deep diversification during the bear period allowed the
asset class portfolio to avoid playing catch-up and take full advantage
when the offense returned to the field.
Investors will not avoid periods of down markets any more than a
football team can avoid getting behind in any given game or season. In
fact, those ’72 Dolphins actually trailed their opponents about 15% of
the time in their “perfect” year (10 of 68 quarters). They also won
their three playoff games, including the Super Bowl, by a combined total
of only 17 points. So they did not exactly blow out their competition.
Yet, they are the sports world’s standard for perfection. Hopefully your
fear of losing will subside when it is understood that it is possible to
have a defense that can keep you in any game as well.
So
perhaps it is no surprise that the Chicago Bears (associated
market pun intended) had the best defense in the league last year and
made it to the Super Bowl. And yes, they did finish 2nd out of 32
teams, but that is still in the top decile (10%). Not bad in football –
and certainly not bad in investing either.
