As the S&P 500 reaches new highs, it is interesting to think about the volume of bad news we have faced over the bull market of the past 4 years. We were subjected to what seemed to be an epidemic of economic challenges, from the fear that Troubled Asset Relief Program (TARP) would lead to runaway inflation, to the debt ceiling debate and the “fiscal cliff” we were sure to tumble over at the beginning of the year. There was news of more global concerns over the world, with new challenges faced in feeding and providing fresh water for the ever growing global population, which now exceeds 7 billion people. There have been many headline stories building a case for a grim outlook of the future. It seems to me that the good news is usually more subtle and harder to find.
I recently picked up a copy of “Abundance – The Future Is Better Than You Think.” The authors, Peter Diamandis and Steven Kotler, make a case for optimism. They present a neurological reason for why we are more sensitive to bad news than we are at recognizing opportunity. Fear has served the human race well in many ways for many years; it activates our limbic system, which manages our “fight or flight” circuitry. Diamandis and Kotler then look at how we have solved problems of scarcity in the past, and examine amazing advances in science and engineering that are being made right now.
This book presents a different perspective than we are bombarded with in the daily news, and I think it’s worth reading. Diamandis and Kotler explore some very exciting new technologies that are making giant strides against some of the world’s biggest challenges, like scarcity in access to energy, clean water and good medical care.
“I’m not saying we don’t have our set of problems; we surely do. But ultimately, we knock them down” -Peter Diamandis.
Before finding the book, take a few minutes out of your day to listen to his inspirational and educational TED talk here.
From time to time, a piece of economic news will surface that leads people to question whether it is really a good time to be invested. The announcement of round 3 of quantitative easing (QE3) was one such news item that worried some of our clients (interestingly enough it added optimism to others), and it provided us at Merriman with a great opportunity to reiterate why we think making large changes to your investment portfolio based on economic news is a bad idea.
The evidence is overwhelming that markets are not predictable. If you had asked me for a reason to stay in the market in, say, 1999 or 2007 when economies looked extremely healthy, I could have given you a long list of reasons. But what followed each of those years was a sustained drop in stock prices. On the other hand, if you posed the same question in 2002 or at the end of 2008, there was hardly any good economic news to point to. And what followed? An incredible market rally that recouped market losses much faster than anyone expected. Selling and buying based on our read of the news has a high risk of whipsawing us in and out at the worst possible times.
There are always a host of positives and negatives weighing on the markets. It’s important to remember that economic news, and everyone’s expectations of its impact, is already factored into current market prices. We believe the academics’ argument that the sum of everyone’s expectations is far more accurate than the predictions of any one “guru.”
The risks of high levels of debt, uncertainty around upcoming tax changes (known as the “fiscal cliff”), and continued weakness in Europe may drive prices lower. While current trends, including a dramatically improving housing market and declining unemployment, may drive prices higher. We believe the best way to capture growth over time is to stay invested in a portfolio designed to satiate your appetite for growth while staying within your tolerance for risk, and rebalancing when your portfolio’s mix has materially changed.
If you feel like the risks have become overwhelming, there are some additional things you should consider before deciding to throw in the towel. You need to think ahead to your next move. What will you do after going to cash?
There is risk in not being invested in the markets: First and foremost, cash provides no defense against inflation. Your money may need to be defended against inflation for a long time, and cash does not provide a good defense. Beating inflation is one of the main reasons we advise people to stay invested through retirement.
If markets drop, when will you get back in? Each of the last two market rallies began well before any good news was to be found. Waiting for good news meant missing the bulk of the market gains. On the other hand, if there is a continued market rally after you sell – if markets grow faster than you expect – what will you do then? My experience is that it is very difficult for investors to get back in the market at higher prices; there tends to be a very real fear that the next challenge will cause a decline after having just missed an unexpected rise in values. We have found that over time, disciplined rebalancing has been a better way to buy lower and sell higher than “timing” based on your expectations of the future.
Our strategy is based on the academic philosophy that the future is unpredictable and our clients need to be able to stay the course through unexpected events and drops in the market in order to reap the benefits this strategy has to offer.
Simply being invested is not good enough; you have to be invested the right way. We feel that massive diversification with exposure to large and small companies in both U.S. and international markets, with a healthy allocation to bonds, is the best defense against a range of risks affecting your retirement portfolio.
If you’re ever feeling doubts about your investment strategy, I highly recommend speaking to your financial advisor right away. Rather than moving to cash, it may simply be time to re-evaluate your appetite for risk and returns. An adjustment to the percentage of your portfolio allocated to bonds may be enough to ease your mind.
In the meantime, here are some additional online resources you might find encouraging:
This piece from Marlena Lee’s presentation at the Institute of Advanced Financial Planners Annual Symposium in Vancouver presents research showing that even as the market continues to be volatile, history shows that equities are the best way for clients to earn the returns necessary to meet their goals.
Behavioral finance is a fascinating field to me. It’s the study of how our emotions and judgment can affect decision making with regard to investments. In the time I have spent advising people on their investments, I have witnessed the power fear and greed can have over logic and reason. The good news is that the more we understand where our intuitions and biases come from the better chance we have at making good investment decisions.
Studies continue to find that investors earn lower returns than the funds in which they invested. Dalbar, a market research firm, issued their 2011 report showing investors achieved a mere 41.9% of the S&P 500‘s performance over the twenty years ending December 31, 2010. In other words, investors managed to leave a staggering 58.1% on the table. What could possibly explain missing out on these returns? It is largely due to investor behavior.
The goal of investing is to buy low and sell high – that’s a given – but our emotions, intuitions, and bias frequently work against us. Most investors did not begin buying technology related stocks in the early 90’s when prices were still reasonable; the vast majority bought in the late 90’s at astronomical prices, just before the “tech bubble” burst. Similarly, it was incredibly difficult to keep many investors positive about the prospects of the future during the first quarter of 2009 – the market bottomed on March 20, 2009 from the “housing bubble”- just before the markets began a climb to double in less than 2 years.
I won’t re-write their book for you here, but Swedroe and Balban have done a great job of compiling a list of the most common mistakes and what you can do to avoid making them. This book will help you better understand why our investment strategies work, even though they can sometimes seem counterintuitive.
If you are not a client of ours and are considering hiring an advisor, this book may help you understand the mistakes a disciplined investment strategy can help you avoid.
By studying history and behavior, we can learn to avoid the same mistakes in the future. We can also understand why the disciplined investment decisions are sometimes the most uncomfortable. If we do our job well, you’ll be encouraged to stand by them anyway, knowing that discipline will pay off in the long-run.
The authors of “Freakonomics: A Rogue Economist Explores the Hidden Side of Everything” maintain a blog. University of Chicago economist Steven Levitt and New York Times journalist Stephen J. Dubner use statistics to test many social ideas. I found their recent podcast titled “The Folly of Prediction” to be quite interesting, especially as it relates to investing.
The gist of the podcast is something like this:
Human beings love to predict the future.
Human beings are not very good at predicting the future.
Because the incentives to predict are quite imperfect – bad predictions are rarely punished – this situation is unlikely to change.
Are you a participant in a 401(k) or similar retirement plan? If so, do you know what that plan is costing you? Ron Lieber of the New York Times thinks you don’t, and I think he is right. In a recent article, he says there’s really no way you could know what your plan is costing you – but the total might add up to thousands of dollars in hidden fees over the years while you work and (if you leave your money in the plan) after you retire.
To understand the issue, it helps to know that employee retirement plans typically have four players. The first is you, the employee. The second is your employer, who offers to withhold money from your pay and (sometimes) to match part or all of what you contribute. The third is a corporate administrator hired by your employer to operate the plan and choose investment options. The fourth player consists of the mutual funds, brokerages and insurance companies that provide those options. (more…)