Today’s headlines seem to be constantly filled with frightful stories of risk and peril. These are not unusual circumstances as the media for decades has been trending away from the “feel good” story, to the “if it bleeds it leads” mentality of reporting. It is in this context that it is more important than ever to reflect on one aspect of our investment strategy; time horizon. Without a proper perspective of the investment universe, it is easy to get paralyzed by the worry of the day or make emotional investment decisions.
The Bumpy Road
In a perfect world, you could predict market movements and be in the right place at the right time and make money or avoid losses with a high degree of precision. This investing panacea is sought by some in the investing world, but logic tells us that if there were a simple system for this, everyone would follow it (or at least most) and it would cease to be effective as returns would degrade to virtually nothing (no risk, no return). However, this does not stop a large number of investors from engaging in this activity of marketing timing and crystal ball reading with their whole portfolio.
Every emotional aspect of our being wants a low risk/ high return strategy. The challenge is that it is very hard to be “right” both in time and over time. Many studies show the devastating effects on long-term returns of missing just a few of the best trading days over long periods of time (hundreds/thousands of trading days). Some trading systems that entail rules-based methods for getting in and out of the market may work in certain market environments and then fail in others, or simply stop working as others adopt the system too. Traders using discretion have an equally challenging problem. The reason the short-term game is so hard is two-fold.
First, there are an incalculable amount of variables that go into the markets. This makes it easy to overestimate the impact of one variable versus another variable that wasn’t considered. If you have ever seen one piece of news that was very positive only to see the market drop, you have probably experienced this perplexing phenomenon of missing an important variable. The second and probably most frustrating for a professional is what Charles Mackay called the “madness of crowds”. In the short-run, markets behave like a voting machine and emotion and sentiment often win the day. Many interesting periods of history have illustrated booms and busts fueled by emotional investors.
Despite fundamental economic variables, the market can get spooked or irrationally exuberant, or not move at all…and these reactions are not as easy to predict as we might think. The result is that in the short-run markets can move in all sorts of directions and even astute investors who make a short-term predictions are engaging in a large dose of guessing (some more educated than others). This is not an indictment on all “active management” or a recommendation to “buy and hold” forever, but simply an observation about total portfolio management and the variability of short-term returns (risk).
In general, because the game of short-term prediction is so uncertain and after fees, taxes, etc., is often a lower returning strategy, we choose not to rely on this method but rather allocate our assets across a diverse group of investments to achieve the desired level of risk and potential return.
A Smoother Ride
When you stretch the investment time horizon over several years, a few things start to disappear. The longer the time frame, the more things like political shenanigans, weather, corporate faux paus, etc. start to turn into static noise. Many of the days’ headlines become unmemorable after just a year or two, despite feeling very important at the moment. Over time the emotional market and “mad” crowds of investors casting millions of votes on stocks, bonds, currencies, etc. start to moderate from the extremes and arrive much closer to the more economic and mathematical “value” of the investment. This is an amazing phenomenon. This is not to say that markets can’t stay irrational for a long time, but over-time markets tend to follow fundamentals. The price you pay for a stream of corporate earnings or interest payments seems to settle in a much tighter range and the world starts to make more sense. Risk, or better said the risk of loss, starts to dissipate the longer the time horizon and what may have once looked risky (over a short time frame), can start to look much different.
By focusing on economic fundamentals and long-term valuation trends and avoiding short-term emotional decision-making, we have the underpinnings of a prudent strategy. Not only that, but by being “fearful when others are greedy and greedy when others are fearful” (Warren Buffett) there is a chance to capitalize on others’ myopia and emotional frailty.
The challenge is that while this sounds like an “easy” strategy, it is not easy to do. It takes a strong and focused process to evaluate true fundamentals, as well as discernment to apply the lessons of market history. In addition, one must also try to tune out the “noise” of the news while staying aware of current events, which may shape actual long-term fundamentals. It is difficult to think long-term in a short-term world. Being a contrarian sounds exciting on paper, but in practice, it often means doing the opposite of what prevailing “wisdom” may be on CNBC. There is often a feeling that we must “do something”, when sometimes patience is the right strategy. Long-termism takes intestinal fortitude and this is not always in down markets; sometimes it’s the restraint to not reach for returns in bull markets when everyone else seems to be being rewarded for taking excessive risk.
Perhaps the biggest challenge to any successful investment strategy is sticking with it long enough to allow it to work and not counting the score or calling the game too quickly. In a football state like Alabama, fans know to that games have ups and downs and seasons have ups and downs. Judging a strategy’s success based on a possession, quarter, or game is not particularly helpful, but persistent application of the fundamentals is a worthy endeavor.
Plan Your Journey
Our goal as planners and wealth managers is to help clients achieve their lifetime financial goals; which in many cases are goals with long time horizons. It is important to track progress to your goals with the understanding and perspective that investment returns are “lumpy” and often come with a mix of great and unpleasant results along the journey. Careful portfolio construction along with monitoring and appropriate saving and spending rates can make a large impact over time. In many cases, these planning-based decisions throughout your life will have a greater impact than even some portfolio decisions we spend so much effort to make. It is for these reasons we choose to use a long-time horizon investment strategy that is well-rooted in a planning-based relationship as our recipe for financial success.
Zach Ivey, CFA, CFP®
Chief Investment Strategist
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.