If you have been holding a diversified portfolio, it's been a frustrating few years. Nothing outside of US stocks has been working. We have been counseling clients that sticking with their original plan of global diversification still makes a lot of sense since the tides will turn eventually. We may be seeing those shifts sooner than we thought. Below is a chart of showing the first month of the year:
Although a short time period, things have shifted in 2015. After a month, the US stock market (black line) is the clear loser when compared to the developed foreign markets (gold line) and the emerging markets (blue line). For the past five years, US stocks have gone up over 15% per year, while foreign developed stocks are up 5% and emerging market stocks are up 2% per year. It is not hard to understand why people might abandon diversification and just decide to stick with the US markets. The problem is that trends don't last forever. At some point the tides will change. This is not dissimilar from the 1990s. This decade was a great period for the US stock market with substantial economic growth ending with the technology boom. The US stock market had tremendous gains and outperformed almost every other asset class. Those choosing to concentrate their assets in large US companies at the end of this decade, because of that great performance, found that the next 10 years were horrific (taken from the Irrelevant Investor Blog):
Investors need to remember that if you are properly diversified, there two truths that you ALWAYS have to live with:
- You will always have something to complain about- something in your portfolio will be out of favor every year if you are properly diversified.
- You will never outperform the best asset class- in fact your portfolio will always fall somewhere in the middle of the asset classes you are invested in. In the case of 2014, if you have adopted a diversified portfolio, you should be upset you underperformed the S&P 500. It was one of the best performers
The upside of all of this is that your portfolio will never be as bad as the worst asset class in the portfolio, you don't have to try to "guess" which asset class to rotate into each year, and your returns will be much less volatile. We believe that this is a worthwhile tradeoff.
When it comes to investing, we've found that "I don't know" is one of the most powerful statements you can say to yourself to improve the performance of your investments.
"I don't know where the market is heading this year"
"I don't know what interest rates are going to do"
"I don't know if this stock is a good investment"
"I don't know what is going to happen in the global economy"
Most people have a hard time telling themselves these statements. We all want to feel like we have some control over our investments and the thought that we have no idea about the direction of the markets is a scary thing. But the simple fact is…you don't know. No one does. Once you embrace this simple truth, your whole outlook changes.
- You stop focusing on things you can't control or predict
- You start focusing on things you can control- diversification, discipline, taxes and fees
- You are more skeptical of sales pitches that rely on a manager's abilities
- You understand that when something sounds too good to be true, it is
- You discount every thing that you hear or read in the financial media (since they all claim to "know" what is going to happen)
- You look at managers who outperform as more lucky than skillful
- You demand to see real evidence to show that past performance is predictive of future results
"I don't know" is a powerful statement in many aspects of our lives, but when it comes to investing it is not only powerful, but freeing as well.
Have you ever done a post-mortem of your investment/economic thesis? Most people tend to have beliefs about the direction of our country, economy, and investment markets. Those beliefs are reinforced by reading and watching media that agree with us, which is one of the reasons for such polarization in our country today. How often do you hear someone say- "I was wrong"? More importantly, how often do you say it to yourself?
Several years ago I started going through this exercise and found I was wrong quite a bit. That is a major reason why our firm has adopted a low-cost, passive investment approach. It avoids the need of having to be right in order to create a successful investment experience for a client. Just for fun, I decided to rewind the clock and look at some of the commonly held beliefs five years ago, and how those beliefs played out:
- The US economy would continue to be in shambles due to increasing unemployment and dangerously high debt levels
- The real estate bubble had burst and it would take years for it to recover
- Commodities (particularly oil and gas) would continue to climb due to increasing global demand and a shrinking supply
- Emerging markets like China and India would be the big winners in the years to come because of lower debt levels, economic trends and favorable demographics
- Interest rates were going up because the Fed was creating a bubble and lenders would start demanding higher rates because the US would be considered not as likely to pay back their debt (due to our high debt-to-GDP ratio)
Maybe I am cherry picking here, but I would venture to guess that most of you reading this would have agreed with every statement above five years ago. And why not? These were all consensus views. The only problem is that every one of those statements turned out to be wrong. The US recovery over the past five years has been spectacular, real estate investment trusts are up over 12% per year, commodities have lost 5% a year, emerging markets have been trounced by the developed world, and interest rates have fallen even further.
You don't know the future, and I'll let you in on another secret; no one else does either. Not the hedge fund managers, economics professors, wall street strategists, or CNBC guests. Be honest with yourself about how often you are wrong with your investment decisions. It is the first step is creating a successful investment experience.
A couple weeks ago I wrote that it is now Prediction Time. As I watched CNBC this morning I was reminded of this again when the anchors asked every guest that came on the show their outlook for 2014 as it relates to the stock, bond and commodities market. I thought it would be worthwhile to point out that pretty much every strategist, economist and prognosticator predicts a stock market return of around 10% per year. And why not? The S&P 500 has generated a return 10.12% from 1926 through 2014. That seems like the safe bet. The truth is that these pundits are almost never right when they choose a return around 10% though. History tells us that returns, while averaging 10% over long periods of time, almost never actually realize that same return over 1 year periods. Here is a chart showing the frequency of annual returns of the S&P 500 since 1926:
Here are some really interesting results of this data:
- The S&P 500 has generated an annual return of between 0 to 10% slightly less than 15% of the last 88 years.
- The highest band of frequency are returns between 10 to 20% in a given year
- You have a higher probability of generating a return between 30 to 40% than to generate a return between 0 and 10%
- Losses have occurred about 27% of the last 88 years, so while not common, they will happen.
- Losses of greater than 30% are pretty rare, happening only about 3% of the time
Next time you hear a pundit talk about predictions, please remember this post. Almost all will be wrong, and because of that fact, you should avoid making any investment decisions based on these predictions.
About 7 years ago I had the privilege on 2 occasions of meeting Michael Aronstein, manager of the Marketfield Fund. Michael was launching a new mutual fund that was basically a "go-anywhere-I-think-there-is-an-opportunity" fund. Not only would he look for opportunities, but he would also hedge the portfolio by shorting investments he thought would underperform. This strategy is called long-short investing, since you buy (go long) the good investments and sell (go short) the bad ones. Back to my story. The fund was just getting off the ground and only had about $10 million under management, which is tiny for a mutual fund. His story was very compelling though. Michael had a very diverse background, a great understanding of finance and the investment markets, and a fantastic ability to communicate with his audience. Many of my colleagues at other firms were some of this first investors.
His performance from the start was spectacular. He managed to avoid most of the losses of 2008, then rode the recovery after that, outperforming nearly all of his peers from 2009 through 2012. Investors took notice and several years later the fund was sold to NY Life, fueling continued growth as their distribution network grew considerably. His assets went from essentially zero in 2007 to over $20 billion. If I am honest with myself, I have to admit that I was wondering if we had missed the boat. That if someone was smart enough and took a common sense approach to investing, there should be an ability to provide value.
Thankfully, that thought in the back of my head was in stark contrast with a deeply held belief we have as well. That markets work and those that try to add value by predicting the next move in the market will fail at some point, since most of their outperformance will be based on luck. It is easy to believe that in theory, but when you meet a manager that seems to defy those core values and you see colleagues profiting from that investment, you can see why it is hard for so many to keep the faith.
Luckily, we did. I hadn't paid much thought to the fund and that manager until I read a story last week at the Wall Street Journal about the fund:
Investors yanked more than $5 billion so far this year from the largest and most popular “liquid-alternative” mutual fund as losses mounted on bad bets tied to the global economy, according to fund-research firm Morningstar Inc. Assets in the MainStay Marketfield fund have fallen 45% from a February peak of $21.5 billion.
Here is another excerpt a little later in the story:
MainStay Marketfield, controlled by a unit of New York Life Insurance Co., was “this huge success story,” said Morningstar analyst Josh Charney, but its stumble “highlights that the strategy is a lot riskier than people think.”
The Marketfield fund made a series of bad bets that put its performance in its category nearly dead last. All of that great performance for the past several years has been nearly wiped out. Most of the advisors quoted in the article talk about now getting out of the fund because of the poor performance. While this is just another example of how hard it is to consisently outperform the market, there is another lesson to be learned. Have a belief system that is based on evidence. When making investment decisions, everthing about the new investment should align with these beliefs. This type of alignment will help you avoid hot stocks, star managers and other complicated strategies that tend to be a major cause of underperformance for investors.
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.