No Safety Flags In Investing

In case the latest bout of stock market volatility, which we explored earlier in a pair of articles about putting market moves in perspective and the danger of market myopia, is tempting you to sell now and wait for safer times, remember that to benefit from market timing you have to be right twice, not once. I hope the following explanation helps you to decide on the right strategy.

If you go to the beach to ride the waves and you want to know if it’s safe, you simply look to the lifeguard stand. If the flag is green, it’s safe. If it’s red, the ride might be fun, but it’s also too dangerous to take a chance. For many investors today, the market looks too dangerous. So, they don’t want to buy, or they decide to sell.

Here’s the problem. While the surfer can wait a day or two for the ocean to calm down, there is never a green flag that will let you know that it’s safe to invest. You might think that is the case (as many investors did in the late 1990s), but it never is.

Recall the litany of problems the markets faced from March 9, 2009 (when the bear market ended) all the way through 2017. There was never a green flag letting you know it was safe. It was red the entire time.

And for much of that period (2013 onward), you had highly regarded market gurus such as Jeremy Grantham warning that the market was massively overvalued. Yet the market ignored those warnings and provided returns well above the historical average.

Conjuring Green Flags?

So, if you decide to sell, you are virtually doomed to fail as you wait for the next green flag. Even worse is what happened to some investors who only thought they saw a green flag.

Consider an investor who, after watching the S&P 500 Index crash from about 1,450 in February 2007 all the way to 752 on Nov. 20, 2008, finally throws in the towel. He cannot take the losses any longer. He is worn out by the wave of bad news. So, he decides to sell.

However, he knows there is a problem. With interest rates at their current level, there was no way he could achieve his financial goals without taking risks. And he certainly does not want to buy riskier fixed-income investments (such as high-yield corporate bonds, preferred stocks or emerging market bonds), having watched how poorly they were performing.

The mistake of confusing yield with return is one he was not going to make. Thus, he designs a strategy to get back in. He will wait until next year to see if the market recovers.

By Jan. 6, 2009, the S&P 500 had risen almost 25% to 935. Of course, he had missed that rally while he waited for that green flag. But now he feels it’s once again safe to buy. Unfortunately, by March 9, 2009, the market had dropped back all the way to 677. So, now he sells again. How likely do you think it is that he would ever find the courage to buy again? That is the essence of the problem.

Additional Data

Here’s some further evidence that might help you avoid panicked selling. As mentioned in my earlier article, there have been only two months in the last 78 years when the S&P 500 Index fell more than 15%—October 1987’s loss of 21.5% and October 2008’s loss of 16.8%.

How did the market perform after those losses? While November 1987 tested investors with a further loss of 8.2%, the following 12-month return (November through October) was 14.7%. And while November 2008 also tested investors with a further loss of 7.2%, the following 12-month return was 9.8%.

Over the last 78 years, we have also experienced four quarters in which the S&P 500 lost more than the 20%—the four quarters ending September 1974 (-25.2%), December 1987 (-22.6%), December 2008 (-21.9%) and June 1962 (-20.6%).

Over the next 12 months, returns ranged from 17% to 38% (averaging 28%); over the next 36 months, returns ranged from 49% to 73% (averaging 60%); and over the next 60 months, returns ranged from 95% to 128% (averaging 112%).

Let’s try to summarize what we have learned.

5 Lessons To Be Learned

First, it’s important to understand that bear markets are a feature of the stock market. Without them there would be no risk and therefore no equity risk premium. As investors, we would not like that.

If we were to look back at every other market decline, we would see there were investors who thought the only light at the end of the tunnel was the proverbial headlights of a truck coming the other way. In each instance, it turned out that wasn’t the case. And it’s likely that isn’t the case now either. In other words, every past decline looks like an opportunity; every current decline feels like risk.

When the stock market is meeting our best expectations, thinking about the market’s inevitable up and down cycles and the benefits of a disciplined approach sounds reasonable, even easy. Yet when the market goes down, it often feels different, maybe difficult. That is explained by the tug of war between our emotions and our reasoning.

Which side wins? French philosopher Blaise Pascal declared: “All of our reasoning ends in surrender to feeling.” Can you prove Pascal wrong?

To help, write down your reasoning in an investment policy statement (IPS) tied to your specific goals. That way, when emotions grow strong and threaten to overrule reason, reason can prevail. For instance, your IPS should include data about past downturns, which are expected to occur periodically.

Don't Be Easily Swayed

Second, your investment strategy should be based on evidence, data and logic. You should not be swayed to change your strategy unless you are convinced the underlying assumptions on which your strategy was based have changed. There is nothing in today’s environment that should lead you to conclude your assumptions no longer hold.

Third, there are always things to worry about. It’s why during bull markets stocks are said to climb a wall of worry. Thus, it’s important to remember that while you might be worried about such issues as still-high U.S. equity valuations (the Shiller CAPE 10 remains about 27, though it is well down from its January 2018 level of 33.3), a slight inversion in the yield curve, the potential of a major trade war, and the shutdown of at least part of our government, you can be certain the sophisticated institutional investors now accounting for about 90% or more of trading volume, and thus are setting prices, are also well aware of those issues. Thus, the risks are already incorporated into prices.

That means that unless the outcomes are worse than expected, markets should not fall further. Remember, it doesn’t matter whether news is good or bad, only whether it is better or worse than already expected.

In addition, the news on the economic front is good. What’s more, fiscal policy is very loose (with a record deficit) and monetary policy is far from tight. Thus, there is little reason to expect a recession any time in the near future.

Strategy Doesn't Equal Outcome

Fourth, don’t make the mistake of confusing strategy with outcome. “Fooled by Randomness” author Nassim Nicholas Taleb had the following to say on confusing strategy with outcome: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (that is, if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”

Unfortunately, in investing, predicting results is notoriously difficult. Thus, a strategy should be judged in terms of its quality and prudence before—not after—its outcome is known.

Fifth, I’ve always believed that the greatest anomaly in finance is that, while investors idolize Warren Buffett, they not only fail to follow his advice, but often do exactly the opposite of what he recommends. That is what led me to write “Think, Act, and Invest Like Warren Buffett.” Let’s consider the following advice offered by the “Oracle of Omaha” in his 2004 Berkshire Hathaway shareholder letter:

“Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.”

“There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”

Simple, But Not Easy

The above observation is perhaps why Buffett has stated that investing is simple, but not easy. The simple part is that the winning strategy is to act like the lowly postage stamp that adheres to its letter until it reaches its destination. Investors should stick to their asset allocation until they reach their financial goals.

This understanding allowed Buffett to ignore all the critics who criticized him for his “outdated” value strategy during the dot-com boom of the late 1990s, when growth stocks far outperformed value stocks. He didn’t abandon his beliefs then (and was rewarded over the next decade when value dramatically outperformed), and I’m confident he hasn’t abandoned them now.

The reason investing is not easy is that it is difficult for most individuals to control their emotions—emotions of greed and envy in bull markets, and fear and panic in bear markets. In fact, bear markets are the mechanism that serves to transfer assets from those with weaker stomachs and without investment plans to those with stronger stomachs and well-thought-out plans—with the anticipation of bear markets built in—as well as the discipline to adhere to those plans.

Are you following Buffett’s advice? Let’s see:

Does your investment methodology have a focus on low costs (both expenses and taxes)?
Is your investment methodology based on academic research and facts, not opinions? (Buffett advises you to ignore all market forecasts.)
Is your investment plan built around a disciplined approach, not market timing?
Are you accomplishing Buffett’s advice to be greedy when others are fearful, through disciplined rebalancing (while taking advantage of loss-harvesting opportunities)?

Summary

The bottom line is that the evidence demonstrates a strategy of buy, hold, rebalance is the most likely way to achieve your goals. Doing so in the face of so much uncertainty, and the stress created by bear markets, is what makes being a successful investor so difficult, despite how simple the winning strategy is. The inability to control one’s emotions in the face of uncertainty is why so few investors earn market rates of return and thus fail to achieve their objectives.

To help you keep things in perspective, and not focused solely on negative news, it’s worth noting three pieces of information related to markets. The first is that the yield on the 10-year Treasury bond has fallen from a high of 3.24% on Nov. 8 to 2.77% on Dec. 24. The second is that the Fed has signaled to the market that it has lowered expectations for further interest rate increases. The third is that China announced that on Jan. 3, 2019 it will lower tariffs on 700 goods—signaling progress on reducing the risks of a trade war.

Finally, it’s critical to take the long view, avoiding myopic loss aversion. We have lived through 15 serious bear markets over the past 100 years. While each one was caused by unique circumstances—which leads many to believe that this time it’s different—there really is nothing new in investing, just the investment history you don’t know.

Investors who have remained disciplined generally have been rewarded for their patience. The key to having patience is to be sure you have not taken more risk than you have the ability or willingness to assume. One way to avoid making that mistake is to not take on more risk than you must.

This commentary originally appeared January 3, 2019 on ETF.com.

Larry Swedroe is the director of research for The BAM Alliance.

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