2014 investment resolutions

Every market brings an opportunity to apply time-tested investment disciplines to a brand new fact set. Today, facts are substantially different than they were just a year ago — when U.S. stocks, as represented by the S&P 500, were at 1,426, almost 30% below today's 1,850 level — and dramatically different than they were five years ago, when the financial crisis had ravaged equity prices worldwide. Over the past five years, disciplined, valuation-driven investors have captured double-digit compound returns in an unusually low-inflation environment. So five-year, real, compound returns are far ahead of expectations. But, as price increases, investment risk often increases. Price defines risk, and managing risk defines serious investing.

As 2014 begins, our work on price (P) to normalized earnings (E) reveals a multiple of a little over 21 times, compared to that same P/E ratio of a little over 10 times in the spring of 2009. Both multiple and earnings have increased to create those double-digit compound returns that we have enjoyed.

So, where do we go from here? Is the U.S. stock market now overpriced? The answer is yes and no; portions are overpriced and portions are not. If we think of positive stock markets as having three phases, we are now in the second phase. Prices are higher; therefore, risks are higher and the next five years are likely to be more challenging than the last five.

1. The quiet phase starts when everything is cheap, sentiment is negative and investor participation is thin — active management may be unnecessary — disciplined investors can capture tremendous returns.
2. The stock picking phase where selection is key — active management is often better than indexing — careful selection can still produce solid returns
3. The blow-off phase where speculators take overpriced stocks higher and higher until an inevitable and generally ugly repricing — and it all starts again.

As phase two moves into phase three, wise investors will certainly taper exposure to U.S. stocks. That will mean underperforming in the blow-off phase to avoid real capital loss (not just underperformance) at repricing.

These are the facts that greet us this New Year and it is in that context that I emphasize these investment resolutions for 2014.

1. I will never forget that investing is first and always about managing risk. We achieve superior returns by making superior judgments regarding risk, and risk is always a function of price. There is no asset that is a good investment at any price.
2. I will remember that price draws the bright line between investing and speculating. Buying an asset that is overpriced and hoping that it will become more overpriced is speculating, not investing. Not knowing what a fair price is but buying anyway is foolish.
3. I will remember that the risk of losing money is far more important than the risk of not “keeping up with the Joneses.” I will not jeopardize the future financial security of the institution that I love to keep pace with peers who have begun to act irresponsibly by disregarding downside. A foolish decision is foolish whether or not it delivers pain in this particular episode.
4. I will carefully consider any legitimate investment that broadens my opportunity set. As the U.S. stock market becomes more overpriced, I will carefully consider out-of-favor investments that I may not have considered in the past.
5. I will evaluate each investment opportunity in terms of risk and return — net of all costs. All costs count. Consequently, remembering that some opportunities can only be captured with active management, I will not use an active manager when an index fund will suffice.
6. I will remember that even the most talented money managers in the world have a style that can be priced. I will assign more assets to managers whose styles are underpriced and, consequently, have a lower risk of losing money.
7. I will extend my investment horizon. A sound investment process with a genuine multiyear horizon can systematically exploit short-term randomness created by speculators who emphasize sentiment and momentum over valuation. I will modify investment policy and reporting structure to maximize my horizon advantage.
8. I will work to achieve investment success as I define it, not as my neighbor does. I will avoid letting peer pressure from Wall Street, my board members or the media impact my decisions. Peer pressure can be just as hazardous to adult investors as it is to teenagers.

These are the resolutions that strike me as most relevant for 2014. It's all about price. As chief investment officers, we allocate capital among various “return sources” (more granular than asset classes) via indexes, factor sleeves and active managers. The normalized earnings of these return sources change only gradually, but price levels can change dramatically almost overnight and price changes everything. That's what keeps it fascinating.

Jonathan J. Hirtle is the CEO of Hirtle, Callaghan & Co.