Lessons From the Past

Wow. Just wow.

 

What a crazy period of time we have just lived through, and there’s more to come! Winners, losers, mystery, fear, greed, plot twists, you name it—we’ve had it all over the past 18 months.  And if you think we’re talking politics, you would be wrong. So, please, keep reading.

 

Do you remember the news stories from the first quarter of 2016? Oil had fallen to near $25 per barrel and there was fear that the global economy was headed for recession. Between December 2015 and February 2016, stocks fell 11%. This quote from an investment strategist at LPL Financial on 2/11/16 pretty much summed up the mood on Wall Street:

 

“There’s a broad-based lack of confidence. Everything suggests this market is heading lower in the short term. Psychology is too frail.”

 

If by the short-term, he meant one day, he was right. Looking out a bit further, however, he couldn’t have been more wrong. On 2/12/16, the S&P 500 Index closed at 1,864, which turned out to be the low for the year. Stocks moved sharply higher in the next 60 days and have continued to climb (with a few minor hiccups along the way). Yesterday, the S&P 500 closed at a new all-time high of 2,388, or 28% higher since that ill-timed quote.

 

That was only one of many market surprises we encountered last year. Another that most pundits got wrong was interest rates. In December of 2015, it was basically a foregone conclusion that the Fed was going to begin removing the punch bowl of “free” money which would cause interest rates to rise. Amazingly, the opposite happened. Rates fell during the first half of the year and the ultimate procrastinators received yet another chance to refinance their mortgage at historic lows.

 

And what about the schizophrenia of election day? Sorry, couldn’t help but include one political reference. Stock market futures were down double-digits in the middle of the night, only to recover prior to the opening bell and end up posting a gain by the close of trading.

 

We could go on and on about the energy wasted by extremely smart people who try (unsuccessfully) to forecast the future, but you get the point. However, you might still be wondering if there is a way to take advantage of historical data to improve expected returns. The good news is that THERE IS! But the answer might be a different from what you are thinking (or hoping).

 

As humans, we tend to look back on our successes and failures, and consider what we might do differently going forward to increase the probability of good outcomes in the future and decrease the probability of bad outcomes. As investors, we are especially prone to looking back and judging ourselves (or our managers) on past performance. It’s certainly easy to do with all the data that is readily available for consumption and comparison.

 

For example, if the investment return of our own portfolio over the past 12 months was positive, we might feel good about our situation. That is, until we learn that our neighbor did significantly better because they invested in something we did not own. At that point, we might say to ourselves, “I should have done more of that last year” or maybe, “I’m going to try that this year”. After all, it seems so obvious in hindsight that we should have had more money invested in so-and-so rather than this-and-that. Right?

 

Sadly, this is precisely the point where so many investors begin to sabotage their well-designed and well-diversified portfolios. Chasing performance is a common and well-documented “sin” in the investment world. Basically, it boils down to this: People tend to buy what they wish they would have bought. For example, when a mutual fund or asset class finds its way on to a “top-performing” list, there is a high probability that money will continue to flow into that fund or asset class in the days and weeks following the publishing of said list.

 

Those money flows, however, are often short-lived and do not guarantee good investment returns. Mark Hulbert is a well-known analyst who monitors the performance of investment newsletters. He looked at previous annual winning and losing investment recommendations over a 20-year period, and then recorded how those “winners” and “losers” performed over the following 12 months (after they made the list).  In most cases, the losers continued to underperform, but interestingly, the average winner also produced a negative return in the 12 months following his/her appointment as “investment genius”. Simply remaining invested in a broadly diversified stock fund over those twenty years would have produced an average annual return of close to 10%, or more than 25 percentage points greater than the average “genius”.

 

 

 

 

The root problem is this—overconfidence. Investors tend to be a confident bunch. No matter what happens or is expected to happen in the economy, all active managers assume that they are smart enough to trade profitably. Simple math, however, proves that this will never be the case. If you decide to sell a stock because you think the price is going to fall in the future, there’s obviously someone on the other side of that trade who is buying those shares because they think the price will be higher in the future. Regrettably, you can’t both be right.

 

Comparing investment performance of several asset classes from 2015 and 2016 offers a stark contrast in how quickly and dramatically sentiment can change over a short period of time:

 

  • In 2015, large cap growth outperformed large cap value by 9.5 percentage points. For the 5-year period ending 12/31/15, large cap growth outperformed large cap value.
  • In 2016, large cap value outperformed large cap growth by 10.3 percentage points. For the 5-year period ending 12/31/16, large cap value outperformed large cap growth.
  • In 2015, large cap growth outperformed small cap value by 13.1 percentage points. For the 5-year period ending 12/31/15, large cap growth outperformed small cap value.
  • In 2016, small cap value outperformed large cap growth by 24.7 percentage points. For the 5-year period ending 12/31/16, small cap value outperformed large cap growth.

The stock market can be so irritating. It seems to know just how far to push us until the temptation to make a change is unbearable and…we give in. No sooner does one abandon their disciplined approach then…WHAM! The market reverses course and taunts us for our hubris in thinking we are smarter than all the other market participants who get up every morning to perform their own calculations of intrinsic value.

 

It’s not that markets are perfectly efficient. We know that’s not true because humans still trade stocks, and humans tend to be emotional and sometimes irrational beings. Perhaps the point is best summed up by Burton Malkiel (economist, professor and writer) when he says:

 

“What efficient markets are associated with, which is wrong, is that efficient markets mean that the price is always right—that the price is exactly the present value of all the dividends and all the earnings that are going to come in the future. That’s wrong. The price is never right.  In fact, prices are always wrong. What is right is that nobody knows for sure whether they are too high or too low. It’s not that prices are always right, it’s that it’s never clear that they are wrong.  The market is very, very difficult to beat.”

 

This will never be a flashy headline or intriguing sound bite, but you can absolutely achieve your financial goals with a higher probability of success if you are willing to follow an evidence-based investment approach and remain disciplined with respect to saving, investing and spending.