“I can calculate the motions of the heavenly bodies but not the movements of the stock market.”
—Isaac Newton, after being wiped out in a stock market crash in 1768
Past performance does not predict future returns.
We have all seen this warning. If past performance does not predict future returns, then what does predict future returns? You do. Your returns are far more dependent on your behavior as an investor than on fund performance. Mabel Newcomer, former Vassar economics department professor, and consultant to the U.S. Treasury and International Monetary Fund, had an elegant way of putting it: “Have the courage to stand aside and watch for a little while. It is more important to know where we are going than to get there quickly. Do not mistake activity for achievement.”1
Jimmy Bradford, whom I spoke of earlier, told me: “I haven’t noticed a correlation between knowledge and wealth. It is more about temperament. 90% psychology and make-up and temperament, and 10% do you know what an ETF is.”2 Or, as Don Phillips with Morningstar, Inc., said in reference to the careless belief that investors simply need to blindly buy an index fund, “Indexing does not address behavioral issues.”3
Is investing failure or success mostly a behavioral problem? Dalbar, Inc., an investment research firm in Boston, calculated the compound annual returns for equities (stocks), fixed income (bonds), and inflation. The stock market did very well during the period from 1994 to 2002, returning 12.2% per year. But, the average investor only received a 2.6% annual return, or 78% less than the market.4 Fixed-income investors did a little better against the index but still significantly underperformed. Additionally, in the declining interest rate environment from 1984 to 2003, bonds were up on average 11.7%. (Whatever bull market there was in stocks over this period it was even bigger in bonds.) Here again investors significantly underperformed and were up only 4.2% on average, or 64% less than the market.5
If you doubt the validity of these figures, Dalbar ran the numbers again. From 1986 to 2005 the S&P 500 returned 11.9% yearly and the average equity (stock) investor earned 3.9%. From 1987 to 2007 the S&P 500 Index returned 11.8% yearly and the average equity investor earned just 4.5% yearly.
And if you doubt the validity of those numbers, they ran them again: “For the 30 years ending Dec. 31, 2013…equity fund investors earned an average annual return of 3.69% compared with the S&P 500’s 11.11%.”6
If you still doubt these numbers, the Investment Company Institute conducted a similar study. The results are shown in Figure 4-1. Notice the spread between Stock Funds and the S&P 500. Investors underperformed the averages in each period.
Dalbar concluded that investment return is far more dependent on investment behavior than on fund performance. Does that surprise you? It shouldn’t. Name any success or failure in your life that did not in some tangible way depend on your behavior.
What has been one of the results of this almost unbelievable sub-par performance by investors? Edward N. Wolff, an economist with NYU, told me that 40% of Americans have no financial wealth. That figure did not change between two studied periods between 1998 and 2004, despite the fact that the Dow Jones Industrial Average rose 31% over the same period.
Dalbar’s advice? “[S]et expectations below market indexes, control exposure to risk, monitor risk tolerance and present forecasts in terms of probabilities.”8 See the word risk in there anywhere?
Don’t feel bad not knowing where the stock market is going; neither did Sir Isaac Newton. You should be content knowing that you and the person who discovered gravity, built the first reflecting telescope, and was a creator of calculus have something in common.
Worse than not knowing where the market is going is knowing where the market is going. There is a special name for those who know where the market is going: insider traders. Though there are certain short-term advantages to insider trading, there are few successful long-term insider traders who are known to anyone besides curious fellow prisoners. The financial markets were created so companies can raise capital and so anyone can invest in those companies; they were not designed for gamers and manipulators.
Let’s take a look at some of the more laughable recent attempts at predicting the stock market. These are authentic book titles by market experts:9
Dow 30,000 by 2008! Why it’s Different This Time.
Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market.
Dow 40,000: Strategies for Profiting From the Greatest Bull Market in History.
Dow 100,000: Fact or Fiction.
Let me help you with the last one: fiction. When you see where the authors’ predicted the stock market (in this case the Dow Jones Industrial Average) is headed, I do not argue that one day the market will not reach 30,000, 36,000, 40,000, or even 100,000. One day the market will reach 30,000, 36,000, 40,000, and 100,000. In fact, I think I will live to see each—except the last one. My point is that the market has not (for two of the books) and will not (for the other two) reach these levels when they say it will. The math, market history, and expected returns by any reasonable measure do not get there. Each author was wrong. It doesn’t keep them from getting published. It may, though, keep you from making money. They remind me of the famed economist who predicted eight of the last five recessions.
Here are more recent attempts at predicting the stock market. “Is it all over for stocks?” sounds the lament from a woeful Money magazine writer. He even issues a puzzling defeatist challenge to the reader: “If you haven’t second guessed yourself yet, maybe you just aren’t paying attention.” To add the authoritative urgency to this air raid warning comes Rob Arnott, the formidable star of the indexing world with “we’re headed for a depression.”10
Were the country’s most popular consumer finance magazine and the index industry’s ranking luminary correct? Yes—for one calendar quarter. Then they were wrong for every quarter after. I think a picture is more compelling than raw numbers. (See Figure 4-2.) Their prediction date is at the left of this chart. Actually, their timing was pretty good. But, what they didn’t know was that they had timed the bottom not the top.
Figure 4-3 illustrates another favorite prediction:
For the 34 years, through 2014, after BusinessWeek’s headline “The Death of Equities” a dollar invested in stocks would have returned $50, an 11.82% return annually.11 It would be difficult to find a better investment for that period.
Or, if you cannot pick the top or the bottom, like the market wizards mentioned previously, then pick the top and the bottom. The media has discovered a new way to always be right. How do you do this? Predict both directions at once. On the same day and same page of a popular investing Website a professional investor named John Hussman predicted an “80% Chance of a Big Market Crash” while Forbes columnist and money manager Ken Fisher advertised, “Is Another Bull Market Around the Corner?”12 Were they both right? Were they both wrong? Amazingly enough, even when they hedged and picked both directions, both were wrong. For the next two years after December 4, 2009, the Dow Jones Industrial Average was up 8% per year, with no bear or bull market in between. How, I wonder, does this help the nervous investor?
Here is another example. I hesitate to pick on the Wall Street Journal, because it is among the most authoritative of all investment market publications, but again, this is why they and everyone else should get out of the prediction business.
On December 11 we learn that a recession is coming with this headline: “Economists Say Recession Risk Is Climbing.” Then on December 17: “Why Economists Are Betting a Recession Won’t Happen.” What happened in those fateful six days in which there was a complete reversal of opinion on the most significant of all investment predictions: Will we or will we not fall into a recession?
On the same day, December 17, the Wall Street Journal told us to forget the holidays. The markets are ruining everything in this headline: “Happy Holidays? Not for Financial Markets.” By December 22 happy days are here again: “Stocks Deliver Holiday Cheer to Finish Week.”
This habit of measuring investor, or perhaps reporter, sentiment one week at a time is an enemy to the long-term investor. If investors followed the headlines they would have bought and sold two times each in this 11-day period. Instead, it would pay to ignore all of the cheer and fear.
So much for the financial media.
Years ago the Dick Davis Digest asked Warren Buffett (the greatest living value investor), John Templeton (the dean of international investing), and Peter Lynch (one of the most successful mutual fund managers) the following question: Where do you believe the stock market is going? Warren Buffett answered, “We do not have, never have had, and never will have an opinion about where the stock market will be a year from now.” Peter Lynch answered, “I have no feeling for the direction of the market over the near term, or the next three to twelve months.…” And John Templeton answered, “Ignore fluctuations. Do not try to out-guess the stock market. Buy a quality portfolio and invest for the long term.”13
More recently Warren Buffett said simply, “I don’t know how to tell what the market’s going to do.”14
Further, Peter Lynch said: “I spend about 15 minutes a year on economic analysis. The way you lose money in the stock market is to start off with an economic picture. I also spend 15 minutes a year on where the stock market is going.”15 American Funds, Washington Mutual Fund founder Bernie Nees was asked how to make money in the stock market. He answered, “You must be invested at the bottom.” When asked how one can be guaranteed that they are at the bottom he said, “Always be invested.”16
The best answer that I have ever heard to the question Where is the market going? was again from Peter Lynch: “Which way the next 1,000 to 2,000 points in the market will go is anybody’s guess, but I believe strongly that the next 10,000, 20,000 and 40,000 points will be up.”17 He knew well that this was not a short-term prediction and that he may be describing a 10- or 20-year horizon, but he also knew that this is the only reasonable way to predict market returns.
That is a great answer. Remember that and never ask the question again. Why not? Because you cannot know the answer. It is never a good idea to ponder what you cannot know, unless you are in a philosophy class. Managing risk is not about guessing and predicting. Managing risk is about acting based on information that we do know, and not about acting on information that we cannot know. Or, as the Vanguard Group asks in one of their advertisements, Why try to predict the market when it can’t be predicted? That is a sensible question. Take note of the fact that Vanguard is one of the world’s largest money managers, and they are admitting that not only can we not predict the market, but neither can they. So, what they are saying is that you should invest but give up on this idea of trying to figure out where the Dow Jones Industrial Average will be three years from now. And over $3 trillion worth of Vanguard managed assets seems to agree.
The stock market as we know it in this country has been around since May 26, 1896. Between 1897 and 2014, it had a positive total return in 78 years and negative total return in 40 years. That is to say that the stock market has been up 66% of the time. But, it does not move quite so systematically. As Daniel Webster said, “Miracles do not cluster.” Nor do market returns cluster.
The trouble is with the news media’s minute-by-minute description of the stock market as either soaring or collapsing; with hyperventilating (and, of course, seductive) 20-year-old reporters yelling from the stock exchange floor as though they were on the sidelines of an NFL game; and with 3D color stock market updates on everyone’s computer and television. The closer we are, the more spectacular is the view. This is the intent, so we don’t take our eyes off the screen for the coming commercial.
Professional investors do not predict the market in the short term but they do in the long term. I have always thought that predicting the stock market is opposite of predicting the weather. As Gregg Ireland, portfolio counselor with the American Funds Group said, “Speculating what the stock market will do in the short term is like predicting the weather next week. It’s an unpredictable variable.”18
I do believe that there is, though, an interesting association between weather forecasting and stock market predicting. A meteorologist can tell within a degree or two what the high and low temperature will be tomorrow but has not a clue what the high and low will be tomorrow 10 years from now. Stock forecasting is the opposite: Analysts cannot tell you what the Dow Jones Industrial Average is going to do tomorrow but can tell you plus or minus a percentage point what the average annual return will be over the next 40 years. The longer the term, the more accurate the forecast. Think about that. This is the primary reason why the investment industry thinks long term and tries to get investors to think long term as well; their models get more accurate as the term lengthens. I think there is some integrity to that.
Crestmont Research president Ed Easterling would likely agree with this long-term approach. He wrote: “The stock market is not consistently predictable over months, quarters, or periods of a few years. The stock market is, however, quite predictable over periods approaching a decade or longer.…”19 And Bill Spitz, former manager of the Vanderbilt University endowment fund, said jokingly, “Avoid financial forecasting, but if you must, give either numbers or dates, but not both.”20
Finally, to this point let’s compare two professions: doctors and stock brokers. Doctors make predictions about how drugs will perform inside the human body—a closed system. Brokers make predictions about where prices will go in an open system—significantly more variables and little experiential returns data. One is possible; the other is not.
Be careful with short-term predictions, too, or it will be terribly difficult to manage your money. For example, the Nikkei 225 (the Japanese equivalent to the Dow Jones Industrial Average) returned 24.30% annually for the five-year period from 1985 to 1989. A $10,000 investment would have tripled to $29,672. Those were transformative times. The Nikkei was booming and the Japanese were buying everything from golf courses in Hawaii to Rockefeller Center. America ate sushi for the first time, the first Japanese luxury car (called Lexus) was introduced, and virtually everyone was scared and excited about the ominous glow from the land of the rising sun. I, too, was entranced after reading William Gibson’s hit novel, Neuromancer, about a futuristic make believe world in Chiba City, Japan, where man and machine were one.
Next, after this spectacular five-year market performance, from 1990 to 1994 the Nikkei 225 was down 49.3%. For the next 15 years the Nikkei would drop by another 50%. If you had doubled-down on Japan after 1989 you would have been very disappointed.
So, am I bullish or bearish? Neither. My favorite market strategist, Fritz Meyer, put it to me very succinctly: “The point is that you stay fully invested in a globally diversified portfolio and periodically re-balance—period. Being bullish or bearish has nothing to do with proper asset allocation and long-term investing. Trying to figure out whether you should be bullish or bearish at any given point implies you’re trying to time the market in some fashion.”21
When I first got into the investment business, I made the same rookie errors that all brokers make. One of the dumbest is to assemble yesterday’s star performers into a buy list for your clients. Because I have always been good with numbers I was one of the original data miners and was the only broker in our large metropolitan Merrill Lynch office to bring in a computer every day to work. Boy, was I good at predicting the past! My list of favorites was always last year’s top performers. This is like picking next year’s Oscar winner from last year’s list. In 86 years of Academy Awards only Spencer Tracy and Tom Hanks have ever won consecutive Best Actor awards. That’s probably a better record than picking top performers for stocks or mutual funds.
Morningstar, Inc., the mutual fund research firm, created the star rating system that rates funds from one to five stars. Most mutual fund managers are obsessed with star ratings and are never shy about pounding their chests when they earn the coveted five stars, the highest ranking for risk-adjusted return. Here is why. “Studies show that more than 90% of all money flowing into funds goes into issues that carry four- or five-star ratings.”22 There is only one problem: Success is fleeting. Yesterday’s five-star fund is likely not tomorrow’s five-star fund. And yesterday’s two-star fund may well be tomorrow’s five-star fund. Recent studies by one of my favorite fund managers, the American Funds Group, and the Frank Russell Company bears this out. Figure 4-4 and Figure 4-5 show two consecutive eight-year periods that show the same thing. Top performance is apparently impossible to maintain in the investment world. Notice where the first quartile money managers tend to end up four years later, and where the first-quartile money managers come from. The best get worse, and the worse get better.
The numbers were recently brought up to date. Figure 4-6 illustrates the same conclusion:
Corroborating evidence came from another authoritative research firm that concluded: “Nearly half of the value managers that earned a first-quartile rank for three-year performance in 2005 did so again in 2007. Between 2007 and 2009, only one-fourth managed to hold their top-quartile berth.”26
Another study showed that “performance typically fails to persist in the future.”27 Aye Soe and Frank Luo reviewed 1,020 domestic actively managed mutual funds and found “[f]or the five years ending March 2012, only about 5 percent of the funds maintained top-half performance rankings over five consecutive 12-month periods.…”28
None of us would crowd into Walmart after it announces it has increased its prices on all of its products, and then flee after it slashed prices. However, this is exactly how retail investors tend to behave. What they are showing when they do this is that they are predicting the stock market. Very simply, they are saying that the market just dropped, so it will continue to go down, or the market just went up so it will continue to rise. There are many examples of this. The latest example is illustrated in Figure 4-7 on page 135, in which I have combined the returns of the S&P 500 from 2008 through 2013 with a Gallup poll that shows stock ownership. Despite the stock market reaching record highs in 2013, Gallup discovered that stock ownership was at its lowest level since 1998, the year it began recording its poll.29
There is something missing in this relationship between the stock market and the investor. I believe the missing piece is the advisor. The advisor is the dispassionate third party who is aware of long-term market trends and can keep you in the stock market even when it drops. Yes, the stock market dropped 37% in 2008. But in four years, had you held on, your portfolio would have fully recovered. And after the next year you would have been rewarded with an additional 32% return. This is why advisors tend to say “think long term” and “buy and hold.” This is hard to do when you are advising yourself, as we are all naturally ruled by our emotions.
Investors tend to underperform the very markets that they are investing in. The data from multiple sources that I have included have already spoken to that. Additionally, this data from ETF.com31 shows how unlikely top performing funds will remain in their respective high positions for the next four years. (See Figure 4-8.) Almost all of the top performers lost their lofty rankings. Fund performance is much like the career of the average NFL running back that lasts roughly five years and has one peak year of the five.
However, why should I blame you (the investor) and not the fund manager for this? After all, you have no control over the fund manager and his or her performance. The reason why I am focused on you, the investor, is precisely because you have no control over fund performance. Despite this fact, investors tend to chase returns. Michael Rawson, CFA, with Morningstar, Inc. recently released data that showed that investors overwhelmingly favor past performance with their investment dollars. In 2013 investors put $228 billion into Morningstar four- and five-star funds and withdrew $192 billion in one-, two-, and three-star funds.33
Investors are making a classic blunder by investing in past performance. A better approach would be to match up asset classes with your risk tolerance and investment objectives, irrespective of past performance of funds. But, we are only in the analysis stage now. In the final chapter we will talk about more effective ways, in my opinion, to choose investments.
Quit predicting the stock market or manager performance. There is only one financial asset that you need to predict: your savings. Frankly, it is more important to ask the right questions than it is to know the right answers. Therefore, it is more important to ask where you are going instead of where the market is going. That question (Where am I going?) is always on the mind of my wealthier clients. They are internally focused, not externally focused. I believe this has to do with ego and self-preservation: They just think about themselves more than the average person—a blessing and a curse.
Let this survey illustrate my point about focusing on you before we move further. This survey was conducted more than 10 years ago, per a survey of investors, and it was promulgated by AIM Funds (now Invesco). You may have to read the questions and answers two or three times to believe it. Here are the three questions and the most frequent answers.
Retirement Study: A True Story
1) Do you think you’ll have enough money in retirement?
Yes ✓ No
2) Do you know how much you will need?
Yes No ✓
3) Have you actually started saving for retirement?
Yes No ✓
To review, the average person has not started saving for retirement, nor does he know how much he will need. What he does know is that he will have enough money. If you were looking for a definition of virtual reality, I think this is it. This might be why there are 338,000 results when you Google “investment books” and 5,110,000 results when you search for “Jell-O.” Those of us in the investment business have job security as long as these facts remain.
I believe that closing the gap between virtual reality and reality can be urged along by evaluating what type of investor you are. Expectations can be much easier managed if the investor has a better sense of his or her personal investment characteristics. I ask prospective clients the following two questions: If the stock market was up 12% in a given year, what would you expect the return on your portfolio to be? If the stock market was down 12% in a given year, what would you expect the loss on your portfolio to be? The questions are general enough to get them thinking.
The answers are often surprising. First, a disclaimer: There is a right answer. Yes, you read that correctly, I did not say that there is no right answer. There is no right answer in the fields of comparative literature, or Eastern spirituality, or modern art, but in the investment world there are right answers and wrong answers. Right answers bring you greater risk-adjusted returns over the long term; wrong answers bring you lesser risk-adjusted returns over the long term. I will give you the two right answers and the two wrong answers to the questions.
There are four possible responses to each question: You expect your portfolio return to be greater than 12% (>), or lesser than 12% (<) in an up market, and you expect your portfolio return to be greater than –12% (>), or lesser than –12% (<) in a down market. (I could have picked 10, 11, or 13%. There’s nothing fixed about the 12% number, but I wanted it to be slightly higher than average returns to stimulate thinking.)
The four types of investors:
1. Spectulator.
2. Dreamer.
3. Amateur.
4. Contrarian.
Q: If the stock market was up 12% in a given year, what would you expect the return on your portfolio to be?
A: > 12%
Q: If the stock market was down 12% in a given year, what would you expect the loss on your portfolio to be?
A: < –12%
This is not an unrealistic response. Speculators expect greater returns when the market goes up and greater losses when the market drops. Professional speculators, venture capital, and private equity might fit this category. However, the way that a professional speculator makes money is by having a strict sell discipline in a down market (or by being in so many deals that the rare supernova investment eclipses the numerous asteroids). A strict sell discipline is what separates the professional from the accidental.
I don’t think that the non-professional investor has the time, tools, or skills to monitor the risk of his portfolio to be an effective speculator. Note that I said effective speculator. We all know the ineffective speculators who simply want to beat an up market but are completely uninformed about down markets: day traders, IPO buyers, penny stock buyers, and so forth. Maybe you have known this person. Maybe you were this person.
Paul Tudor Jones is one of the great speculators of our time. Jones is primarily a commodities investor originally from Memphis, Tennessee. I met him in Atlanta years ago near the beginning of his career when he created a futures fund for Merrill Lynch. In 1987 he reportedly made between $80 and $100 million—more than anyone else on Wall Street. He currently has a net worth more than $4 billion. What philosophy guides him? “I’d say that my investment philosophy is that I don’t take a lot of risk…at the end of the day, the most important thing is how good are you at risk control. Ninety percent of any great trader is going to be the risk control.”34
2. Dreamer
Q: If the stock market was up 12% in a given year, what would you expect the return on your portfolio to be?
A: > 12%
Q: If the stock market was down 12% in a given year, what would you expect the loss on your portfolio to be?
A: > –12%
This answer is illogical and is the most dangerous investment philosophy to hold. Investment strategies that short-term outperform the market on the upside tend to be aggressive in nature, or employ leveraging techniques such as buying on margin or investing in options. Such strategies have the opposite effect in a down market and multiply losses. Now, a clever money manager might say that he employs aggressive strategies in up markets and conservative strategies in down markets, and that is how he plans on achieving superior returns in either market.
The problem is that we never know in advance whether we are in a good market or a bad market. A recent market debacle befell sub-prime bond investors; they didn’t know that they were in a bad market until a few days before they folded their business and took multi-billion-dollar write-downs. A glaring example: “On Oct. 1 the bank disclosed that it was writing down $3.4 billion in losses largely due to ill-considered bets on the U.S. subprime market.… UBS held $19 billion in subprime residential mortgage-backed securities—90% or more of it rated AAA.”35 UBS, obviously, did not know what kind of a market it was in.
The investor who expects to outperform in an up market and a down market will be disappointed and eventually divest. Even professional money managers who would describe themselves as aggressive would not expect these kinds of returns nor promise them. Of all of the four choices, this is the one the investor should be highly suspicious of if his or her investment advisor promised such results.
3. Amateur
Q: If the stock market was up 12% in a given year, what would you expect the return on your portfolio to be?
A: < 12%
Q: If the stock market was down 12% in a given year, what would you expect the loss on your portfolio to be?
A: < –12%
This investor expects lower than market averages in good years and greater losses in bad years. Most studies would indicate that this is, in fact, what average investors return. They don’t capture all of the upside but they lose more than the market in bad years. This was witnessed in the internet bubble and in any period of market excess when investors get into the market too late, thus never receiving any long-term benefit and exiting only after significant (I’m never going to do that again) losses. This is a wrong answer. If you really feel this way, you might be acting out of fear. If your fear is this great, you may not be suitable to be a stock investor.
4. Contrarian
Q: If the stock market was up 12% in a given year, what would you expect the return on your portfolio to be?
A: < 12%
Q: If the stock market was down 12% in a given year, what would you expect the losses on your portfolio to be?
A: > –12%
I believe this is the best answer for the non-professional long-term investor, and the most realistic route to positive returns. This investor realizes that the key to long-term wealth accumulation in the stock market is protection in down markets; thus he gives up some on the upside but protects on the downside.
Hedge-fund managers, whom many consider to be the savviest of professional money managers, would fit in this category. Brian Portnoy, PhD, CFA, wrote, “[M]ost hedge fund managers use hedging techniques, many of them will under-perform in up markets and outperform in down markets. This speaks to a lower risk profile, not higher.”36
Why does this work? Math. The numbers always work against you, and because they do, if your expectations and portfolio models this you are likelier to win. How do the numbers work against you? Call it investment gravity. Remember: If you lose 50% in one year how much do you need to make in the next year to break even? One hundred percent—twice as much. You need to absorb that and see how you can have investment gravity work for you. That is, realize that if you can only protect yourself during the down markets, your total return will be higher than the person who did not protect himself.
There actually is a fifth answer to the question: Whether the market goes up or down 12% you expect your returns to be neither greater than the market nor less than the market. You simply expect whatever the market returns. This answer would come from the committed index fund investor, and certainly a legitimate way to invest, as more than $2 trillion in exchange traded funds (ETF) and index funds attests.
Despite what kind of investor you are, contrarian, speculator, or indexer, in a sense your investment expectations are not important. By way of analogy, imagine that you are a physician. One of your patients who is terminal but has survived his third year of lung cancer says, “Doc, I want to live forever. Please help me.” What would you do? Would you abandon all of your other patients for this one? Would you search through the Journal of the American Medical Association for a miracle cure? Would you go home and tell your spouse that you are taking a cot down to the lab and will not be home until you have found the magic elixir for curing this patient? Would you consult with your old medical school professors to see if there was some class in immortality that perhaps you missed? No. Unfortunately your patient’s expectations are unrealistic. It is time for this patient to modify his objectives. Quality of remaining life, comfort, settling estate issues, and spiritual deliverance are more realistic.
The message for the doctor, patient, investment advisor, and you the investor is this: Expectations do not determine your objectives. Instead, your objectives drive your expectations. This is what I mean when I say to predict yourself, not the market. Example: When I meet with an older client who has significant financial assets, has plenty of income to live on, and does not need to grow those assets, what kind of investor is this? My first guess is conservative, not aggressive. I think some might say, She has plenty of money and can afford to take risks. My feeling is different. I would say, She has plenty of income and does not need to grow her portfolio according to her, so why take a risk? This is how objectives form expectations—but I could be wrong. Because I cannot predict the market, but can only predict you, based on what you have told me, I will track your objectives and build a portfolio accordingly.
The key is you, not the markets. That’s why an advisor’s first duty is to ask you scores of questions—to understand you. If your potential advisor has not asked you multiple questions, that should be a warning that you may have the wrong person.
We spend too much time trying to predict the wrong thing (the market) instead of the most important thing (you).
There is even an equation for predicting the market called the expected return formula. It says that the expected return of an investment is a sum of the returns of all the investments:
E(R) = w1R1 + w2R2 + … + wnRn
E(R) is expected return, w equals weight (or % you have in this investment), and R is the return of the investment you are calculating (stocks, bonds, commodities, etc.). It is simply a weighted average formula. And, here’s the good part: For it to work you have to predict what the returns will be for stocks, bonds, commodities, or whatever investment you are considering. Because the returns are unknown, adding these unknowns together only compounds the error.
Granted, if I had the choice, I would rather have the ability to consistently predict the future than the alternative. What is the alternative? Accepting that I cannot predict the future but investing anyway.
Don’t give up. The question Should I buy stocks or bonds? is a good one. Nevertheless, it reminds me of an old insurance agent (who was previously a pro baseball player) in Florida who was with Penn Mutual Life when I was the regional sales manager for the broker/dealer in the early 1990s. I used to call him and try to get him to do more stock business with us instead of just selling insurance and fixed annuities.
I would show him impressive and colorful “mountain charts” that started with a $10,000 investment in 1929 growing to some huge number like $50,000,000 (I made that up) over a 60-year period. He told me once, “Thanks, Andy. I got your chart. Very persuasive. What nobody tells you is that back in 1929 nobody had $10,000.”
Instead of impressive mountain charts, mountains that few investors ever actually climbed, ponder the chart in Figure 4-9. It shows the reality about us. The reality is that we are emotional creatures. Note that as stock market returns increased, investors’ willingness to take risk increased. Divide the 22-year periods into three seven-year periods. Notice that in the first seven-year period (1988–1995) the measures of “willingness to take risks” (there are two similar measures from different sources represented by boxes and diamonds) were half as prevalent as for the next two seven-year periods. However, when was it a better time to invest: when the market was lower and flatter (first seven years), or when it is higher and more volatile (second and third seven-year periods)? We tend to be more interested in investing when the market is high.
This is the folly of being led by your expectations (I think the market is going higher.) rather than your objectives (How much do I need to retire?). Those who predict themselves rather than the market determine what direction they need to go, gather the resources, and implement their plan. Those who predict the market rather than themselves are constantly in and out of the market with no long-term plan or commitment. Ultimately their entire financial livelihood is tied to how they feel, instead of what they need.
Maybe this will help you understand what I am trying to say. Do you remember the movie Caddyshack? The clubby Ty Webb (Chevy Chase) instructs his caddy Danny Noonan (Michael O’Keefe) how to master the game of golf.
Danny. I’m going to give you a little advice. There’s a force in the universe…that makes things happen. All you have to do is get in touch with it. Stop thinking. Let things happen…and be…the ball.
In a sense, I am saying Be the investment. Focus on you and your objectives, and not the markets, investments, or the complex language around the world of investing.
