Monday morning quarterbacking is a great pleasure for sports fans. In sports, as in many areas of life, decisions that produce bad outcomes are endlessly replayed, generating innumerable, unanswerable “what if” questions.
Investing shares a lot of similarities with sports. Good decisions often lead to bad outcomes and vice-versa. In order to fairly judge decisions based on outcomes alone, one needs a large sample size, rather than just a few anecdotes. Investors with long track records of above-average performance almost always employ a process that puts the probabilities in their favor.
One of the most important contributors to successful long-term investing is asset allocation. Investors evaluate the tradeoff between higher returns on riskier assets, such as stocks, and lower returns on more stable assets, such as U.S. Treasury bonds. In constructing a portfolio, they try to balance their desire for maximum returns with their ability to withstand volatility. Long-term data clearly demonstrates that stocks, though more volatile than bonds, have rewarded investors with higher returns. Statistics compiled by Ibbotson Associates show that since 1926, stocks have produced an average annual return of 10% while U.S. Treasury bonds have returned less than 6%. Long-term investors in stocks have been well rewarded for accepting the risk of short-term loss. Obviously, if one could avoid owning stocks in the negative years, one’s return would be even higher (and one’s risk would be lower) than if one used a buy-and-hold approach. With this in mind, many investors attempt to time their investments in stocks. But almost every study has concluded that trying to time the market is futile for most investors.
And yet, despite all of the evidence that stocks are the highest returning asset class over the long term and despite all of the evidence that almost nobody can time the market, the financial media usually treats bears as being more thoughtful than bulls. This is a pet peeve of mine because I believe it is a disservice to individual investors. Much like with Monday morning quarterbacking, investors need to consider the probabilities. Since the stock market has to either go up or go down, you might think this is a 50/50 proposition. However, the S&P 500 Index has had 24 down years since 1926; in other words, in 88 years, only 27% of the years have produced a loss. The probability of a down year has been about the same as the probability of an eight-point underdog winning a football game. It happens, but it isn’t a bet you’d make unless you got good odds. In short, history shows a much higher burden of proof is on the people who predict that the market will fall, rather than on those who predict it will go higher.
When we look back on the S&P 500 gaining over 30% in 2013, it will seem like owning stocks was an easy call. The market had been moving higher in preceding years, valuations weren’t demanding, and the economic recovery was still quite young. But the bears argued that it was foolish to invest after stocks reached a new high in March. They argued that slowing growth in China threatened our economic recovery and that it was too risky to invest when our government was so dysfunctional that it shut itself down. Additionally, they predicted that the Fed tapering would bring a screeching halt to the positive returns. As Gilda Radner’s Saturday Night Live character Roseanne Roseannadanna said 35 years ago, “It just goes to show you, it's always something--if it ain't one thing, it's another." There has always been something for investors to fear, not just last year but every year, yet the market has averaged a 10% annual gain and has gone up in 73% of the years since 1926.
Our message is not that the stock market is unusually cheap right now, nor are we saying that we believe it is poised for a great 2014. We don’t believe we have specific market-timing skills. Clearly, the 125% increase in the S&P 500 over the past five years was not matched by an equally high increase in intrinsic business values; so by definition, stocks aren’t as cheap as they were. However, when looking at metrics such as price-to-earnings ratios, stocks appear to be priced consistent with historic averages. And when stocks have been priced near average levels, returns have typically been near average, too. Looking at the probabilities, “average” isn’t a good reason to be bearish.
Our message is the same as it almost always is – don’t let current events keep you from following your long-term financial plan. Periodically reexamine your asset allocation and take the steps needed to put your portfolio back into long-term balance. Restoring balance won’t always deliver an immediate profit. Sometimes a kicker misses a 47-yard field goal attempt. Sometimes a field goal attempt gets returned for a touchdown. Neither is more likely than not, but they happen. In an uncertain world, all that investors can do, like good coaches, is to position themselves so that the probabilities are in their favor. And remember, the stock market bulls start the year as an eight-point favorite.
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The
views expressed here are that of myself or the cited individual or firm
and do not constitute a recommendation, solicitation, or offer by
myself, D2 Capital Management, LLC or its affiliates to buy or sell any
securities, futures, options or other financial instruments or provide
any investment advice or service. D2, its clients, and its employees may
or may not own any of the securities (or their derivatives) mentioned
in this article.
Disclosure: Oakmark Fund and Oakmark International Fund are components of D2 Capital Management's investment portfolios. I own D2 Capital Management Investment Portfolios.
The Jacksonville Business Journal has
ranked D2 Capital Management in the top 25 of Certified Financial
Planners in Jacksonville. The Firm is also a member of the Financial Planning Association of Northeast Florida, the Jacksonville Chamber of Commerce, the Southside Businessmen's Club, and the Beaches Business Association.
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