The Reward For Good Behavior

Many investors have been educated on the broad investment themes to improve their investment experience and outcomes. Some of the most basic include asset allocation (this determines the vast majority of both the risk and return of your portfolio), broad asset class diversification to reduce the overall portfolio volatility, and more recently lower cost mutual funds to improve the probability of better investment results compared to higher cost funds.

One of the most common concerns that clouds an investor’s vision of a comfortable retirement with large account balances or plenty of asset class diversification with sufficient retirement income is the inevitable equity market downturn. It has been eight years since the U.S. equity markets have had a significant correction and investors should be reminded and prepared for the eventual decline that comes with equity investing.  In fact, since 1929, there have been 25 bear markets (defined by a 20% loss or more).  On average, that means a bear market occurs approximately once every 3.5 years.  If history is any guide, most of us are going to experience several bear markets over our lifetime.

The future is uncertain and investing is often influenced by unexpected events, some good and others bad. Predicting when or how bad the next correction will be is futile but you can be prepared for it. Behavioral coaching is most effective when clients are prepared for the eventual ups and downs of the markets and prepared in advance of such unexpected events.

This is exactly when advisor behavioral coaching with clients is most important. Human emotion and fear can allow clients left to their own choices to abandon their financial plan and run for cover. Advisors use their past experiences to bring logic, patience and discipline back into focus for client conversations. Clients must realize and accept these downturns as part of the investment journey.  The reward for accepting this truth is gigantic.  Over the 87 years (from 1929 to 2016) that I quoted above, an investor who kept their money in the S&P 500 would have seen $1,000 grow to over $2.7 million.  It is important to note, that to generate this return they would have experienced 25 bear markets, everyone different in their own right!

Saying you need to be prepared and actually experiencing the next downturn can be challenging. What can you do to prepare? Here are several ideas. First, recognize that market declines will happen.  The sooner that you accept that you can’t control that piece of investing, the better you will be able to handle the short-term volatility when it occurs.  Second, review your asset allocation model and be prepared to rebalance if certain asset classes are either overweight or underweight versus their target allocations. Third, think about how much money do you have saved in your “rainy day bucket”? Clients could consider these cash reserves as their “first source of funds” when markets correct so they can avoid selling assets as they are declining in value. Finally, maintain balance in your portfolios and life. Broad asset class diversification can help reduce volatility in your portfolios. As it relates to your day-to-day life, turn off the news, stop looking at the declining asset values on-line or statements and go on with your life and trust that markets will once again have better days.

Keep Your Politics Away From My Portfolio

The Presidential race is heating up and both sides are preparing for battle.  Republicans and Democrats alike will tell you that if they don't win, the country will be in for a horrific four year stretch.  The county's populace seems to be just as divided with politics as polarizing as ever.  While conventions, stump speeches, and political scandals may be great for the news media, a recent study has come out confirming our long-held view:  politics have no place in portfolios.  Researchers studied the returns of hedge fund managers that supported Republican candidates after Obama was elected.  The results weren't pretty:

Upon closer inspection using monthly regressions, we find that the Democratic managers outperformed the Republican managers from December 2008 to September 2009 by approximately 7 percentage points annualized return, which conversely is a high price paid by Republican managers and their clients to maintain a consistency of beliefs.

You may think if a certain candidate gets elected this country is going down the tubes.  Hopefully, you continue reading this article, step back from the brink, and don't make any changes to your portfolio.  None of this is meant to say that Republicans or Democrats are better for the economy (or as managers).  What we are saying is that who is in office has very little impact on stock market returns.  Studies have found this to be case, but investors still seem to entangle their political beliefs with their portfolio.  One of the reasons given in the paper for the underperformance of the Republican hedge fund managers was the idea of cognitive dissonance.  The Cognitive Dissonance Theory states that individuals tend to seek consistency among their beliefs and opinions (ask yourself what type of news you watch or articles your read).  When inconsistencies between facts and attitudes don't match, our unconscious works to either change our beliefs or silence the facts.

When it comes to investing, it is best to ignore politics.  In almost all cases, they have very little impact on financial markets.

The Smartest Person in the World Can Still Be a Terrible Investor

Have you ever felt intimidated by the markets? Thought that investing was only for really smart people?  Maybe you hear jargon like “beta”, “derivatives”, or “standard deviation” and it just goes over your head? Contrary to what you may think, you can be the smartest person in the world and still be a terrible investor.

If I told you history’s most famous physicist failed miserably at investing would you think differently? Sir Isaac Newton, the man who conceptualized three laws of motion, pioneered calculus, and discovered the color spectrum among other accomplishments, was a terrible investor.

Setting—England, early 1700s. The South Seas Company is formed in anticipation of having a monopoly on trade to the Spanish colonies in South America after the War of Spanish Succession (1701-1714). The outcome of the War did not bode favorably for the company. Even though the company had completed no voyages to the new world after 5 years, its leadership turned to advertising false claims of success and wild (but false) tales of the company’s adventures.

It was during this time that Sir Isaac Newton invested in the company, watched the stock rise, and sold making a handsome profit. Filled with greed and regret that he gotten out too early as he watched his friends make more money, he jumps back in, this time with an even bigger bet. Shortly after, the bubble bursts and the sell-off begins. Newton loses the majority of his fortune and supposedly forbids anyone to utter the words “South Seas” in his presence ever again.

molly blog 2

You might say, that’s interesting, but that was also 300 years ago. Things are different today and with the information and technology available to us now, this amusing tale of Sir Isaac Newton is no longer relevant. A lot of things about our world has changed since the days of Newton but human nature has not.

Fast forward to the year 2000. Take the people with IQ’s in the top 2% of the population and see how they do at investing. Eleanor Laise did exactly that when she looked at the investment performance of the Mensa Investment Club between 1986 and 2001. She found that Mensa had a 2.5% average annual return. Compare that to the S&P 500 which had a 15.3% return during the same period. Not much has changed after all- smart people can STILL be terrible investors.

We may have put a man on the moon, cured polio, and created the internet in the past 300 years but we are still not immune to being really bad investors. If smart people can fail at investing what does that mean for the average person? It means that you don’t have to have a top IQ or have invented the telescope (Newton pretty much did that too). It just means that you 1) need to invest for the long-term and not be swayed by the latest buzz and 2) you need to be disciplined to ride out the inevitable ups and downs of the markets.

molly blog 3

 

Stock Market Crashes And The Recency Bias

We have written before about the recency bias, and it appears this phenomenon may be reappearing.  A report by the CFA institute shows that 33% of retail investors and 29% of institutional investors are forecasting another full-blown financial crisis in the next three years.  Now, I am not exactly sure what a "full-blown financial crisis" means but lets take a look at history since 1928 when the S&P 500 has lost 40% or more (peak-to-trough), which I think most of us would define as a crisis:

  • 1929-1930:    -44.7%
  • 1930-1932:    -83.0%
  • 1932-1933:    -40.6%
  • 1937-1938:    -54.5%
  • 1973-1974:    -48.2%
  • 2000-2002:    -49.1%
  • 2007-2009:    -56.8%

So, in the 88 years we can measure, we have 7 occurrences of the stock market crashing more than 40%.  By the way, 4 of them happened during the Great Depression which saw many fits and starts, so the crashes were interspersed with gigantic rallies as well.  Since the Great Depression, we only have 3 market crashes of 40% or more, and two of them happened in the same decade.  Is it surprising that 1/3 of investors are forecasting a crash?  It seems like it should happen every few years. That's how the recency bias works…we extrapolate recent events and assume they will continue into the future.

The reality is that stock market crashes tend to happen when people aren't predicting them.  How many people were forecasting the stock market to fall in 1999.  Who was calling for real estate prices to collapse in 2006?  Stock markets crashes start when sentiment is high and the future is bright.  Fast forward to today and investors are anything but optimistic.  We are not predicting the future.  We may see massive declines in the market over the next few years, but if 1/3 of investors are already expecting this, you have to ask yourself one important question:  is the bad news everyone seems to be expecting already priced in?

 

 

Our Magic Crystal Ball

What if I told you that I knew the future.   That I could tell you the return on an investment over the next 25 years (just to be clear, I have no idea…this is hypothetical).  My magic crystal ball tells me that this investment, would generate the following return over the next 25 years:

  • If the investment performs really poorly, you'll end with about 4 times your original investment
  • If the investment performs average, you'll end with about 15 times your original investment
  • If the investment performs fantastic, you'll end with about 53 times your original investment

Most investors would look at those numbers and think this looks like a pretty good investment.  Worst case is I only quadruple my money!  The really interesting part is that the results aren't hypothetical.  These returns actually happened in the S&P 500 (rolling 25 year periods) from 1927 to 2015.  You had to put up with quite a lot to get those returns.  The really bad return (where you only get 4 times your money) took place in the late 1920s through World War II.  While things look absolutely terrible, returns still managed to average 5.62% during that period.  The fantastic return started in 1975 and went until 2000, the greatest bull market our country has ever seen, with average returns of 17.25% per year.

Could the next 25 years be the worst we have ever seen?  Could they be better than our best ever?  Yes on both fronts.  The reality is no one knows.  But looking at the past, those that have a long enough time period to invest can feel very good about what the future might bring.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.