Notes, Views, and the Occasional Provocation August / September 2013 

Though disasters strike during all seasons, some of the most poignant – a shark attack on a snorkeler in Hawaii; a rogue wave pulling California tourists into the sea – happen during the summer, when the sun is out and our guard is down.

I dropped my own guard this summer on a family trip to Costa Rica and am grateful none of us became a morbid statistic. It's a sober memory that I'm keeping in mind more generally as tempting higher returns surround us in the capital markets.

Best Regards,

Milo Benningfield

Vacation, Vacation Disaster (Who Knows How Narrowly Missed?)
On vacations, as in the markets, we expose ourselves to unusual places and circumstances on purpose, for reward; accordingly, we should keep our wits about us. more

Vacation, Vacation Disaster (Who Knows How Narrowly Missed?)
Our family trip to Carrara National Park in Costa Rica this past summer was as fun and rewarding as we hoped it would be. We got to the park early and were led by our guide Franklin, an expert birder, to a less frequented area of the rain forest, away from other tourists. Yes, it was hot; yes, it was humid; and, yes, we had to brave swarms of mosquitoes. But, wow, the birds.

Our boys, ages ten and eight, were thrilled to see the rufus-tailed jacamar and the turquoise-browed mot mot and, later, the scarlet macaws. At one point, we even followed Franklin off the main trail past the "Do No Enter" signs designed to stop less adventurous souls in their tracks. Walking through a dense underbrush of palms, ferns and vines, past the skeleton of a howler monkey splayed in the mud, we came upon a special sight: a common pauraque resting on the ground. Despite its name, finding the bird in its native habitat was anything but ordinary, since, even with Franklin pointing directly at it a few yards away, it was almost impossible to see, blending in so well with the leaves and shadows on the forest floor.

That, anyway, is the "upside" version of the story. The downside version is this: knowing nothing firsthand of Franklin, we nevertheless followed him into vegetation so thick we couldn't see where our feet were landing. My wife got wrapped in a prickly hanging vine that felt like a cross between Himalayan blackberry and poison oak and left welts that lasted for days. Throughout it all, we later realized, we dared fate to arrange a collision with one of the deadliest snakes on the planet, the feared "fer-de-lance" that biologists call "the ultimate pit viper."

The snake grows over six feet long and often raises its body off the ground before it strikes, hitting humans above the knee. Its potent venom sends fire through one's veins and leads quickly to tissue necrosis and death. Even a fast trip to the hospital may not ward off major muscle and skin degeneration, requiring reconstructive surgery. Juvenile vipers hang in trees to drop on their prey; older vipers are adept at camouflage, hiding their dark-brown scales on the forest floor. The vipers have slithered into people's homes and bitten them as they slept, and one of our guides saw a fer-de-lance chase a man twenty yards down the trail.

Would we do it again? The answer seems a resounding no, right? I'd like to think so, and I do feel fairly certain I'd choose to stay on the main path next time. But I also know that there are so many other times in life when memories fade, the bad moments soften, and people slide right back into the things they swore they'd never do again.

It's happening right now, as we speak, with investors and the markets. This past weekend, on the fifth anniversary of Lehman Brother's bankruptcy and the midst of the greatest market crash since the Great Depression, Barron's reported that investors are once again seeking risk:

After years of playing defense in cash, bonds, and large U.S. dividend-paying stocks, the nation's 40 largest wealth-management firms are recommending investments that, until lately, have been considered far too volatile, too illiquid, or simply too susceptible to economic setbacks. . . [W]ealthy clients themselves . . . are helping to drive this more robust appetite for risk.

"Seeking Higher Returns," Barron's, September 14, 2013.

In fairly short order, the risk of falling asset prices has turned into the risk of missing out, as U.S. stocks, in particular, and other equity asset classes as well continue their multi-year rally. It's tempting to say that "risk off" has turned back into "risk on," as they say in the business, but the truth is, investors aren't thinking any more about risk than I was about snakes in the forest. They're thinking about the high returns, or, as Warren Buffett put it a few years ago during the dark days of the financial crisis, the robins that have come out to sing.

U.S. stocks, in particular, are causing agitation for some investors who have stayed true to their global diversification. As they compare the gains on large U.S companies and with their well-tempered portfolios invested in assets around the globe, they see their overall returns muted by international stocks which, while positive year to date, are much lower than the S&P 500 Index. They see bonds, former asset champions in their portfolios, now holding them back, and say, "Tell me again why bonds are such a good idea, particularly when rates may be rising?"

To me, this is an amazing question. From peak to trough, 2007 through 2009, U.S. stocks fell a stunning 55%. In early 2010, financial headlines trumpeted how it had been a "lost decade" for stocks, noting the negative 1% return on the S&P 500 Index over the previous ten years. Two ferocious bear markets in one decade caused a multitude of investors to cash in their portfolios and swear off stocks and other "funny money" forever. Yet I suspect it's many of these people who may once again be taking an interest in the riskier assets now.

The challenge, as always, is to remind people of the middle path. My family's choice on the vacation was not between plunging recklessly into the forest or sitting at home with nature videos narrated by David Attenborough. Rather, we could still go to Costa Rica but choose to stay on the well-maintained trails, where a fer-de-lance could more easily be spotted. It was on the main path, after all, on another hike with a more prudent guide that we saw one of the rarest birds on our trip, the resplendent quetzal, sitting in a tree next to the parking lot as we returned to our van.

The middle path in investing, as elsewhere, does not equate with low returns or "boring." While the S&P 500 Index was delivering a negative 1% return for the decade ending in 2009, a globally diversified portfolio of stocks delivered well over a positive 6% return – a fact that was conveniently ignored by all the headlines.

More than anything, the middle path means striking the proper balance between risk and rewards, with an emphasis on avoiding the low-probability, high-impact events like snake bites or market crashes. This is why we hold bonds, as volatility buffers, while stocks are soaring.

When investors seek out additional risk in hopes of higher returns, they almost always justify it by pointing to signs that economies and markets have strengthened. Being an optimist, I generally agree with this sentiment. Today we're no longer facing, to the same degree as before, an unemployment crisis, fiscal cliff, or financial meltdown.

On the other hand, there are and always will be concerns about the perils that might strike next. Despite improvement over the past five years with bank balance sheets, there are still many structural concerns with the larger financial system. See "After a Financial Flood, Pipes Are Still Broken," The New York Times, September 14, 2013 (The so-called "plumbing" of the financial markets, the system of short-term funding known as the "repo market," is still fragile.)

Remember, too, the sunny skies that preceded the 2008 crash. In the markets, as during vacations, when the sun shines, we typically drop our guard. It's typically then that a rogue wave carries off the tourist in California, or a snake strikes in Costa Rica, turning a vacation into vacation disaster faster than we can blink. Investors would have been a lot better off if the largest wealth management firms had recommended higher stock allocations four years ago in 2009 as the rally was starting. Raising them now feels a little like daring that snake in the forest.

Thank you for reading. Please look for our next newsletter in November.

Best regards,

Milo Benningfield
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