…or… How I Learned to Stop Worrying and Love Volatility (with credit to Dr. Strangelove)
Why are we so diversified? Why so many different asset classes? Aren’t US stocks the best place to be? Shouldn’t we be more aggressive? These are a few of the questions I’ve fielded recently with ever greater frequency as the bull market in US stocks enters its ninth year----an unusually long period for any asset class to rise without a serious correction.
The frequency of the questions reflects a degree of complacency in investor psychology that is typical of the final years of a bull market. It may also reflect wavering conviction in the wisdom of broad diversification after a period when US stocks have performed much better than other asset classes as they have in recent years.
We all have short memories.
The more time that passes between market crashes, the less we remember the pain. Continually rising markets and double digit increases begin to feel normal. That sets the stage for greater risk taking and unhappy endings. Ultimately the paradigm will shift and reality will hit hard. The timing and the triggers are rarely guessed accurately in advance, but the likelihood that serious corrections will occur is nearly guaranteed. Sh*t happens---roughly every 6 to 12 years throughout history. In recent years we had drops averaging more than 40% in 1973, 1981, 1987, 2000, 2008. The longer the period between serious corrections, the harder the fall. We’re now entering year 9.
It’s not “different this time”.
This slogan was popularized in 1999 to justify extraordinarily high stock valuations. It turned out not to be correct. It’s never different this time. High valuations reduce future returns, it’s as simple as that. They also increase the risk of a major crash. That is why we diversify. Diversification acts as a shock absorber. Most of the asset classes we own have long term “average expected returns” of 5% to 10% per year, each with its own degree of volatility. Individually, they can provide a very rough ride. Collectively the ride is much smoother.
Diversification is a free lunch
Diversification allows you to decrease the risks you face in investing without decreasing your expected returns. To see why, imagine you are considering two investments, both of which are expected to appreciate at 10% on average, but which have a 1 in 5 chance of going down in value by as much as 50%. If you buy just one of these investments, there is a 20% chance that you will lose half of your money. But if you buy them both (assuming they are perfectly uncorrelated), the chance of losing half of your money falls to only 4%, while your expected return is still 10%. Keep adding asset classes? The more uncorrelated asset classes you add, the lower your chance of losing half your money. Why? Because only rarely do they all have bad years in the same year.
Learn to love volatility
Volatility can add to long term returns when it is used to our advantage. We follow a disciplined asset allocation and rebalancing strategy that forces us to consistently sell high and buy low, always returning to our original target percentages. Volatility creates the opportunity to do just that. Multitudes of studies demonstrate that this discipline adds between 1% and 3% annually to long term returns over long periods of time. The more the volatility, the greater the excess return. Most of these studies use rolling ten year periods as their definition of long term.
Trust Data, Not "Predictions."
Many people approach investing as a series of "predictions”… like "I just have this feeling that the stock market is going to go up in the next six months." The problem with this is that even the so-called "experts" have a horrendous record at making these kinds of predictions about the direction of the market. To put it charitably, they are wrong more often than they are right.
Suffice it to say that none of the evidence suggest that it is wise to pay too much attention to the average commentator's "feelings" about the stock market.
Invest for 2017, not 1999.
An alternative approach is to try to avoid making predictions and to invest based on what the data tells us and what we know to be true about the markets. For instance, we know the kinds of portfolios that have performed the best in the past, we know that the returns we get from buying an asset in the future will be inversely related to the price we are paying to get it, and we know something about the way that markets work. We can compile all of these "truths" and data into a framework that will let us make rational decisions about what to invest in without the need to make any hand-waving predictions.
Consider the Math.
The magic of compound interest is pretty impressive. If you can generate a 7% average return for 10 years, you will double your money. In 20 years your money will quadruple. In 30 years it will increase in value by a factor of 8. In 40 years it will increase in value by a factor of 16.
But compound interest has a downside as well. If you sit through a bear market and your portfolio takes a 50% decline, then you need a 100% increase to make up for this. If your portfolio falls by 75%, then you need a 300% increase just to break even. This could take decades. But it could be worse. If you invest 100% of your portfolio in the next Enron and lose everything, you will never break even. You will never recover from a 100% loss.
Manage Risk Above All Else.
It is tempting to say then, that the first rule of investing is don't lose money. But of course, you have to be willing to accept the possibility of a short-term loss in exchange for a long-term gain. But it is essential to understand the size of the risks that you are taking and to actively manage your portfolio to avoid "falling off a cliff" at the wrong time.
Your portfolios accomplish this in two ways. First, it remains diversified at all times, since this increases the chance that something in a portfolio will do well no matter the external environment. Second, we actively control the volatility (size of the swings from a day to day, week-to-week, and month-to-month basis) and make adjustments if this goes outside our expected range. Managing risks prudently comes first; if we can do that right, the returns will follow.
Thoughts are Fragile, Systems Last.
Many people, objectively speaking, "know" how to invest. The basics of the subject are not that difficult to understand, and anyone can buy good mutual funds or ETFs from a discount broker like Vanguard, E*Trade, or Charles Schwab. Yet despite this, many of these same people achieve returns that fall far short of their potential. Research from Dalbar shows the average investor in the stock market struggles to keep pace with inflation --- this in a market that has gone up an average of 7% a year over the last century.
The reason most investors fail is simple: inability to execute.
Two things tend to fall in the way of even the best-laid investment plans. The first thing that trips up even well-informed investors is inattention. Many people have great intentions when it comes to investing. And then life happens. Kids come along, work heats up, other side-projects or hobbies come along that seem more interesting for a Saturday afternoon than re-balancing a portfolio. The result is that too often people end up in undiversified portfolios that are in dire need of a rebalancing, or --- worse yet --- not even knowing what they are invested in or where to go to do anything about it.
The second is psychological mistakes. The human brain came into its present form millennia ago in a hostile environment of lions, tigers, and warring tribes. The "impulses" that we get through our intuitions may have worked very well in this kind of environment, but they frequently do us harm in the modern-day financial markets. So in the time they do spend on their investments, individuals too often end up making decisions that cause them active harm, like pulling money out of the markets at a low in 2002 and putting it back in at a high in 2007.
Luckily, there is a clear solution that makes it easy to execute: use a system.
Taking a systematic approach to investing takes the emotions and impulses out of investing. Our "thinking" is mostly at the time of creating the system, rather than in the heat of the moment when we are more likely to make a mistake.
Our approach systematizes most of the key aspects of investing. We have a clear plan, defined buy and sell criteria, and routine monitoring for rebalancing opportunities. That takes emotions out of the process as much as possible. Best of all, having a system allows you to relax and spend your Saturday afternoons doing things that are more interesting, knowing that someone else is monitoring the system and taking action for you when it is most needed and most effective.
The challenge to adhering to any system is maintaining discipline and conviction.
If you abandon a system based on short term disappointment, you don’t have a system at all. Maintaining discipline and conviction is hard. Helping you do that is an important part of my job. Given the strength of the US stock market in recent years as compared to virtually every other asset class, the challenge of maintaining discipline and conviction in a system that requires broad diversification has been especially tough.
Commonly asked Questions
Many of us have a heightened sense of risk as we head into 2017. For better or worse, rapid political change is producing major uncertainty for the US and abroad. This is a good time to review your investment strategy and ensure that your confidence and convictions are high enough to survive the volatile period that may be yet to come. Part of that process is asking questions. Some of the more common questions I’ve received lately have been addressed in a separate attachment. I hope you’ll take the time to review them and ask more questions until you are strong and firm in your conviction that we have the right strategy to help you weather any coming storms.
- The 7Twelve Portfolio by Dr. Craig Israelson (or watch one of his You Tube videos like this one: https://www.youtube.com/watch?v=yGdBXHkWk1Q)
- The Ivy Portfolio by Mebane Faber and Peter Swenson, PhD, manager of the $25 billion Yale Endowment Fund http://seekingalpha.com/article/1620582-ivy-portfolio-strategy-keep-it-simple-stupid
- What Wall Street Doesn’t Want You to Know by Larry Swedroe (or any of his books for that matter)
- A Random Walk Down Wall Street by Burton Malkiel, PhD
Part 2: Conviction Building Q & A
Q: Are we missing lost opportunities by not being more US centric?
A: Don’t be fooled by the fact that US stocks have recently had a good run. Emerging market stocks had a great run 2004 to 2008. Gold shined even more brightly from 2000 to 2011. Every asset class eventually has its day in the sun. Today’s winners become tomorrow’s losers. The timing may be unpredictable, but the fact that every asset class will spend time at both the top and the bottom of the performance chart is baked in the cake. Novice investors often fall into the trap of thinking that yesterday’s winners will always be winners, then invent stories to justify the increasingly lofty prices. “It’s different this time” becomes the rallying cry. Such investors often navigate through a rear view mirror oblivious to the dangers that lie ahead.
Most investable asset classes have strong multi-year runs from time to time. They are inevitably followed by steep declines. We saw this with silver (1981-1984), US bonds (1981-1987), technology stocks (1997-2000), emerging market stocks (2004-2008), gold (2000-2011), and real estate (2003 to 2007). All of these periods ended with major givebacks, some as much as 50% or more.
Q: I understand that US stocks go down at times (just like everything else) but at some point and historically they bounce right back to their original place and go beyond, right?
A: At some point? True. If you can patiently wait 10, 20 or even 30 years! It took more than 25 years for US stocks to recover from the lows of the great depression. After the crash of 1929 and 1930, US stocks didn’t get back to those same levels until 1957, a full 28 years later! More recently, after the crash of 2000, it took 10 years for US stocks to get back to their former levels. http://www.yardeni.com/pub/sp500corrbear.pdf
Q: I understand that 2008 was a trying times for stocks because of the financial meltdown, but when was the last time that happened, in 1930's?
A: Oh no! Big corrections are the norm, not the exception. Most individual asset classes, including US stocks tend to get over-extended and suffer a severe correction every 6 to 10 years, sometimes sooner. For US stocks the corrections of 25% or more occurred in these years:
1981 -27% 8 years after the prior 25%+ correction
1987 -34% 6 years after the prior 25%+ correction
2000 -49% 12 years after the prior 25%+ correction
2008 -57% 8 years after the prior 25%+ correction
2017 ? 9 years and counting. We’re due!!!
Given this history, is it any wonder why we choose to broadly diversify?