A while ago, I wrote an article explaining why financial-market returns in the future are likely to be lower than many people currently expect.
Among the several reasons I cited was slow economic growth. Another was "no help from bonds." For decades, falling interest rates led to big profits in bonds and helped to fuel substantial gains in stocks. Interest rates may or may not rise significantly over the next few years. But they're unlikely to decline much, given current rock-bottom levels. And if they did, it would be because of weakening growth.
This month's stock market swoon was a long overdue pullback. Yet at one point it wiped out all of the S&P 500's gains for 2014, and most major stock-market averages around the world are in the red. A bubble? Far from it.
This year's challenges brought to mind an old investment classic, "The Battle for Investment Survival" by Gerald M. Loeb.
Its key points are worth revisiting. In the investment environment I anticipate, protecting and increasing capital indeed will be a battle, just as it was for most of the time from 1935, when Loeb first wrote the book, until he last revised it in 1965.
Most investment guides try to convince you that it's easy to get rich by day trading or some other sure-fire method. In contrast, Loeb says that investing is hard work, and that there are no such things as guarantees, "easy money" or "safe investments" in the financial markets.
But the power of compound interest is such that even 5% over a long time period can build quite a nest egg, Loeb correctly adds.
Anybody who earns more than he can spend is automatically an investor, says Loeb: "It doesn't matter in the slightest whether he wants to be or not, or even whether he realizes that he is investing. Storing present purchasing power for use in the future is investing, no matter in what form it's put away."
Loeb's biggest concern was the erosion of purchasing power that inflation and dollar depreciation wreak on one's assets. The impact was seen in the price collapse of U.S. government bonds starting after World War II.
In 1945, the yield on 10-year T-notes embarked on a long, steady climb from 1.7% to 15.8%, the highest ever in U.S. history, in 1981. No wonder Treasury bonds became known as "certificates of confiscation." The capital destruction worsened in the 1970s with soaring inflation and a collapsing dollar. In 1971, the 182-year-old gold standard was dropped. The dollar lost almost half of its purchasing power during the decade.
Loeb warned: "Those who imagine they are only interested in 'income'...run the risk that at some future date their capital will have shrunk in excess of total income received in the interim."
The subsequent collapse in yields from 1981, prolonged by the extraordinary monetary policies of recent years, continued to the all-time U.S. bottom of 1.4% in 2012. With investor anxiety fueled by the financial crisis and its aftermath, money poured into government bonds, where it largely has remained, amid low inflation but also miniscule yields on cash equivalents.
Loeb considered it necessary to measure the return from investments in purchasing power rather than dollars. "You must get back a sufficient number of additional dollars to make up for lost purchasing power if prices are rising, and a high enough percentage of your original dollars if prices are falling."
Loeb was no fan of buy-and-hold investing. It was impractical when he first wrote his book, and for many years afterwards because of choppy markets. Buy and hold became fashionable during the great bull market of 1982-2000. Results since then have been mixed, with more flexible, tactical approaches often more profitable. In my view, buy and hold is unlikely to prove successful in the years to come.
"Accepting losses is the most important single investment device to insure safety of capital," Loeb believed.
On a related note, investors often choose not to take bull-market profits because they don't want to pay capital-gains tax, even though today's tax rates on investments are relatively low.
Loeb's comment: "One of the great fallacies of investor tax policy is to reason incorrectly that one cannot afford to take a profit because of the size of the tax....The fact is that every paper gain is only the amount of the gain less the potential tax. Thus, if a stock is bought at $100 a share and advances to $140, the owner at no time has a 40-point gain. He has a 40-point gain less his tax, whatever it might be."
In Loeb's view, the single most important factor affecting security markets is public psychology."Market values are fixed only in part by balance sheets and income statements; much more by the hopes and fears of humanity; by greed, ambition, acts of God, invention, financial stress and strain, weather, discovery, fashion and numberless other causes."
Here are other Loeb quotes worth heeding:
"There is no such thing as a final answer to security values. A dozen experts will arrive at 12 different conclusions."
"Willingness and ability to hold funds uninvested while awaiting real opportunities is a key to success in the battle for investment survival."
"The distinction of being the stock most frequently listed in published institutional holdings simply means not only that the price is probably high rather than low but also that there is a large number of potential sellers should the situation take a turn for the worse."
This article originally appeared in the Mind Over Markets column. Never miss an issue. Sign up to receive Mind Over Markets by email.
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