It is well understood in the field of behavioral economics that markets are built as much on human emotion as they are on fundamentals. During periods of market euphoria, we become over-confident and prone to taking greater risk. During periods of market gloom, we become despondent and head for the hills. These behaviors of course are the exact opposite of what prudent investors should be doing. Buying low and selling high sound very simple, but are nearly impossible to do, especially on a consistent basis. Market timing holds great psychological appeal, but in the real world it rarely ends well. Markets can defy logic and go on to become even more overpriced after you sell. And nobody rings a bell to give the âall clearâ sign when markets reach the bottom and let us know when to jump back in. So given the artificial environment, and the nagging feeling that it wonât end well, what is a prudent investor to do?
Our best hope is to tame our emotions and ride out the ups and downs by building strong conviction around a sound investing discipline. There is overwhelming evidence that diversification across a very broad spectrum of asset classes (including those that are currently out of favor) is the key. Your individual asset allocation and return expectations should be based on both your financial and emotional ability to withstand market downturns. Extreme diversification offers a degree of safety that, while not perfect, does offer some protection to shield us from market extremes. Thatâs not a free lunch though. Diversifying may offer some protection against short term stock markets declines, but it also comes at the cost of not fully benefiting from stock market runs on the upside. For most of us thatâs a small price to pay for greater consistency and increased peace of mind. Moreover, study after study offer compelling evidence that this approach delivers stronger and more predictable long term returns.
Yet the urge to fully participate in the euphoric action is too much for many of us to resist. Many otherwise intelligent people jumped on the bandwagon in 1998-99 to board the tech stock rocket ship, or the second home craze in 2005-07, only to crash and burn.
Likewise many otherwise intelligent people couldnât resist the powerful urge to sell their underperforming emerging market stocks, international bonds, commodities and gold at recent market lows, only to lock in real losses, possibly just before the stage is set for another bull market run.
Fear and greed are inescapable emotions for human beings. Even intelligent individuals who are very knowledgeable and disciplined can become victims. Thatâs why so many professional investment managers have other professional investment managers handle their personal portfolios rather than do it themselves. They know how easy it is to succumb to these emotions when it is your own money at stake, and where a formal âinvestment policy statementâ no longer rules the day.
Discipline is hard. It requires not only a cerebral understanding of the ups and downs of markets and individual asset classes, but pre-emptive emotional preparation to remain calm and focused when markets or individual asset classes go to temporary extremes in either direction. The secret may be to plan ahead, imagine those periods of extended euphoria or the feeling of the pit in your stomach during horrendous market declines, and rehearse in your mind how you will respond. If you know that you wonât be able to handle it, take proactive action now by giving me a call to talk about adjusting your exposure to the equity markets. Weâll discuss if the resulting change in long term return expectations will support or conflict with your long term goals and weâll make changes if needed.
The Yale endowment philosophy that we follow is part of the solution. I refer to this as a âphilosophyâ and not a âportfolioâ as the approach refers to the practice of spreading your assets across a very wide variety of different asset classes in equal or relatively equal proportions, not to a particular asset allocation formula. While it hasnât always been wrapped in the âYale wrapperâ, this philosophy has been what we have followed since founding my firm more than thirteen years ago in 2002. The philosophy is best known as a result of its successful implementation by David Swenson at Yale University and is now followed by most of the Ivy League university endowments and a growing number of professional investors worldwide. Its popularity stems from the significant amount of empirical research that demonstrates that it outperforms all other investments models over time.
This philosophy of extreme diversification over a wide variety of asset classes with relatively equal weighting and routine rebalancing takes advantage of the fact that every asset class eventually has its day in the sun. It respects the fact that we canât predict which asset class will take its turn next. Rebalancing adds incremental return by forcing us to sell a little of the asset classes that are rising and becoming more expensive, and buy a little of those that are falling and becoming better values. A wide body of independent research offers compelling evidence that this enhances long term returns by a significant sum.
The practice of diversification, relatively equal weighting and routine rebalancing is widely respected in the academic world as the only reasonable way to participate in the modern investment markets. Study after study demonstrates its superior long term performance, always beating all other approaches in any rolling 10 year period going back hundreds of years both in the U.S. and abroad. The philosophy recognizes that none of us, no matter how gifted, can accurately predict the future much less get the timing right for entry and exits to markets or individual asset classes. Not only is that impossible to get right consistently over time, but it is also unnecessary. The disciplined approach we follow offers compelling risk adjusted returns for long term investors without all the angst and second guessing that goes into haphazard or trend based strategies that almost always underperform over long periods of time.
The chart below helps to illustrate the unpredictable nature of the markets and the wisdom of owning a little of everything. Youâll notice that over time every asset class has itâs time near the top. There is no predictability, only randomness.
Intuitively you can see what empirical studies so clearly demonstrate; chasing performance by only investing in those things that have already reached the top (rear view mirror investing) is a loserâs game. Successful investors own all the asset classes and remain patiently focused and disciplined. They rebalance routinely, harvest losses for tax purposes occasionally, and patiently watch as each asset class eventually takes its place at or near the top. Embrace the fact that none of us can pick tomorrowâs winners. Better to own them all.
Note: As we face increasing economic and political uncertainty in the fall of 2016, you should take some comfort that we are the guys in white.