Here is a chart that plots out the distribution of annual returns of the US stock market as measured by the S&P Market Index*. Guess where 2008 is so far?

This chart does a great job to fix the assumption that some have that the 8% or 10% annual returns we hear about come every year. Nope, those are just historical averages. Sometimes we lose 40% or more, and sometimes we gain 40% or more – in just one year! So you can’t say today that it will take X years at 8% per year to get back to what you had before. It could take longer, or it could take a lot less.

* The source for this data is a bit vague since both the S&P company and the S&P 500 index did not exist in 1825. Most sources quote Value Square Asset Management, Yale University. I found it via Daily Kos through Bogleheads and Get Rich Slowly. Here is another similar graph. It is not clear if the chart is based on total annual return, or simply a percentage change in price each year, but it looks like the latter. This paper (also from Yale) with data from 1815 to 1925 might be related.

I knew I shouldn’t have turned on CNN in the hotel. I go away for a week and it’s 1997 again!

I don’t feel like posting any more articles from the “buy-and-holders“, although I remain one. So how about some commentary from John Hussman, whose fund HSGFX is actually even for the year down “only” 15% YTD. I don’t own this fund and am not saying he’s always right, but I think he does a good job of laying out the reasons for his conclusions.

His November 17th weekly commentary is long, but worth the read. Some excerpts:

Our activity as investors is not to try to identify tops and bottoms – it is to constantly align our exposure to risk in proportion to the return that we can expect from that risk, given prevailing evidence.

As for extreme and less likely benchmarks, the 780 level on the S&P 500 would represent a 50% loss from the market’s peak, and would put the market in the lowest 20% of all historical valuations. I would expect heavy demand from value-conscious investors about that level if the market were to decline further, and a decline below that level could be expected to reverse back toward 780 fairly quickly. Further down, but very unlikely at this point from my perspective, the 700 level on the S&P 500 would represent the lowest 10% of historical valuations, 625 would put the market in the lowest 5% of valuations, and anywhere at 600 or below would put the market in the lowest 1% of historical valuations. I don’t expect to see such a level, but there it is. Note that these estimates are unaffected by how low earnings might go next quarter or next year. Stocks are not a claim on next quarter’s or next year’s earnings – they are a claim on an indefinite stream of future cash flows.

As a side note, do your best to filter out comments like “investors are moving out of stocks and into …” or “investors are selling into this decline” or “investors are buying into this rally.” On balance, investors do not sell shares, and they don’t buy shares. Every share purchased is a share sold. The only question is what price movement is required to prompt a buyer and a seller to trade with each other. No money will come off the sidelines into stocks. No money will come out of stocks and onto the sidelines. All such talk is non-equilibrium idiocy. Keep in mind that the “market” consists of different traders with a variety of time-horizons, risk-tolerances, and analytical methods (e.g. technical, report-driven, value-conscious). It is helpful to think in terms of which group of individuals is likely to do what, and when. It is equally important to know which group of investors you belong to. As the old saying goes, if you’re at a poker table and you don’t know who the patsy is, you’re the patsy.

Here’s my attempt at a quick summary: While the present looks bleak, the potential for future returns is looking brighter and brighter for long-term investors. The opposite was true a few years ago. If you’re young and still putting money away, this is a good thing! (Although adequate emergency funds should be your first goal.)

While investigating the bond options in my wife’s 401(k), I noticed that the only “safe” option in her account was a Stable Value fund. I have noticed this label before, but never really paid them much notice. What is a stable value fund?

The pitch: “Cash with better interest”. You get the safety and stability of principal found in a money market fund, but with the higher returns of an intermediate bond fund. Here is a graph from 1990-2006 via the Stable Value Investment Association website (yellow is money market, blue is stable value, and red is bond fund):

How? In essence, stable value funds invest in intermediate-term bonds and similar investments, but the usual day-to-day fluctuations are smoothed out by the guarantee of an insurance company. For example, the insurance company guarantees that a certain amount of interest will be paid. If the actual return from investments fall short, the insurance company makes up the difference. If the actual investments outperform, then the insurance company keeps the difference.

This insurance guarantee also keeps the per-share price (NAV) at $1, much like a money market fund, even though the assets being held are riskier. Because they are limited to qualified retirement plans like a 401(k) or 403(b), they are allowed to use “book value accounting” instead of the more strict daily “market value accounting” required of most retail mutual funds.

What are the risks? In most cases, even if investments perform poorly, the insurance company will eat the loss rather than face the bad publicity. This is similar to money market funds. However, the danger is when things go so bad that the insurance company goes bankrupt. An example is the Trust Advisors Stable Value Plus fund which failed, as outlined by this NY Times article. Although technically the investors eventually recovered all their principal, it took over a year for everything to settle. There have been other isolated instances where investors have lost a portion of their principal.

To invest or not? Stable value funds are pretty popular, and found in 2/3rds of all 401(k) plans. Who wouldn’t want a fund with hardly any volatility that pays high interest? The fund in my wife’s 401(k) is “guaranteed” to earn 4.55% for all of 2008. Be careful though, because they are not all made the same. According to this study by JP Morgan Chase, returns from good/bad stable value funds can differ by up to 2% per year.

As for safety, I would treat it like a money market fund in that you should only buy if you trust the insurer and learn about the actual holdings. Otherwise, buy a bond fund somewhere else if you smell something fishy. Unfortunately, if you really want a “safe” holding place inside your 401(k), many times you don’t have much choice. Finally, I would also point out that in the end they are still bonds, and are subject to the risk of having their modest returns eaten up by inflation. If you are a young investor, stocks still provide the best long-term growth prospects.

Here are some good reads about investing from this week:

How to Survive and Succeed Through a Bear Market
This letter to shareholders is written by John Montgomery, founder of Bridgeway Funds, which are a group of actively managed mutual funds with a reputation of high ethical standard and putting shareholders first. It provides his insights into investing and reminds us that there is also a risk when we only invest in safe investments. An excerpt:

This is my fourth* bear market as an investor, three of which have happened since I founded Bridgeway Capital Management in 1993. Even before the last three bear markets, I studied stock market data in detail going back to 1926. I spent quite a bit of time focusing on the downturns and thinking about how to survive them and why stock market investing is still very attractive even when predictably it doesn’t feel that way. From this research I formed five principles of long-term investing that became part of Bridgeway’s investment philosophy and are interwoven into our investment process. […] I thought I’d share what I learned with our investors.

When should you change your asset allocation strategy?
This post on the Bogleheads forum was written by Rick Ferri, investment portfolio manager at Portfolio Solutions and author of several good books on index and passive investing (including All About Asset Allocation). As a portfolio manager, of course he’s been fielding a lot of phone calls recently. Here are his thoughts for the general investor. An excerpt:

Significant changes to your stock and bond asset allocation strategy is a major decision and can be compared to changing careers. There are several good reasons to change your asset allocation strategy along life’s journey. Below are three reasons I believe a person has a legitimate reason to make an asset allocation change:

1) Your target retirement goal is well within reach.
2) You realize that you will not need all your money during your lifetime.
3) You have realized that your tolerance for risk is not as high as you once thought.

Why stock picking is a losing game
This article on CNN Money is by William Bernstein, another well-known portfolio manager and author of investment books such as the Four Pillars of Investing. Here he tries to remind us that just because the indexes are dropping, it doesn’t mean it’s time to switch to something that sounds better.

I’m sure you’ve heard that while it’s fine to ride the market’s gains when times are good, you need an expert stock picker when the bear roars. Wrong: Active money managers do not suddenly gain an extra 20 IQ point advantage over the rest of the market just because the Dow is falling. The record shows that their funds have trouble competing with the index in the bad times too.