What does history explain about the future? Part 1
The last 20 years have given us three major market shocks. These resulted from the end of a tech bubble, a financial crisis and now, a global pandemic. During this time, investors have experienced every emotional high and low that can be imagined, yet in general, the approach to investing delivered by the financial services industry has not fundamentally changed. Today’s note establishes the case for why this has to change. Read on…
“The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of a doubt, what is laid before him.”
- Leo Tolstoy
What stands out to me about Tolstoy’s quote is the power of BELIEF. It is the idea that anyone can learn something if they resolve to have an open mind but even the most gifted person intellectually will struggle with new concepts if they hold on to existing ideas too tightly. While I like Russian literature as much as the next guy, as a resident of North Carolina, I prefer the following:
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
- Credited to Mark Twain
As an asset class, U.S. stocks are the undisputed standard for long-term investing. I have not traced the lineage to the origins of this belief, but it has clearly been the case for my entire life. And if U.S. stocks are the preferred ‘what’ in investing, then “Buy-and-Hold” is the predominant ‘how’. One will frequently hear prognostications on CNBC and other outlets about individual stocks that should be bought and sold but the overarching theme for American investors is buy stocks, hold stocks, rinse, repeat.
Even among target date or lifecycle-based funds aimed at creating an automated glidepath toward retirement, the prevailing investment right up until the latter stages of the investment cycle is stocks. In fact, we noted in a piece last year that the target allocation to stocks in most lifecycle funds has INCREASED since the Financial Crisis, not decreased.
As a firm highly curious about investor behavior, we find fascinating this obsession with one type of investing and in one particular asset class.
A Blind Investment Taste Test
Is this characteristic of the prevailing American investing psyche more a function of investors deciding to buy stocks, or one of being sold stocks? Let’s start by looking at two investments going back to the beginning of this century.
Investment B almost doubles the return of Investment A with significantly less volatility and a fraction of the drawdown. Both are considered mainstream investments, but Investment A is a fixture as the largest holding in almost all portfolios while Investment B is relegated to a minor allocation at best. As you might guess by now, Investment A is U.S. stocks (in this case represented by the S&P 500). Investment B? It’s Vanguard’s Long-Term Treasury Fund. That’s right, U.S. Bonds…and not even of the Corporate variety.
The New 20-Year Stock Chart
So, what’s the point? With interest rates at near zero for the last decade, will bonds repeat this performance? It is highly unlikely, which tells us a different approach is called for going forward.
As our readers know by now, we are clearly not bond traders or advocates for changing the 60/40 portfolio to a 40/60 portfolio. In fact, we frequently refer to the 60/40 Problem, which is to say we think this commonly used approach has failed to achieve its stated goal over this same time period. Moreover, we generally use equities as our primary means to generate returns even if we are not fixated on them.
The point of calling out this dominant perception in American investing against the backdrop of Tolstoy and Twain’s musings is to hopefully have advisors and their clients take a step back and open their minds to different forms of asset management.
Going with the flow is generally a safe way to go about your business, but as the recent Coronavirus crash has taught us, things are not always what they seem, and change comes quickly.
As risk managers, the fixed reliance on one asset class through one style of investing to deliver the lion’s share of performance needed to meet one’s goals is unnecessary and potentially harmful. Consider that the most recent 20-years in the S&P 500 (through March ’20) has produced a compound annual growth rate of 4.8% with three peak-to-trough drawdowns of greater than 35%.
For investors beginning their accumulation phase in the early 2000s, it seems highly unlikely that the expected return needed for retirement could be less than 5%, which is the equity return noted above. This also assumes that client would exhibit exceptional fortitude and sit through those emotionally charged periods, which is also unlikely. Furthermore, we believe there is a better way.
The Action Required
Investment decisions are made emotionally and justified intellectually. Intellectually, history tells us that a new approach to asset allocation is required to do two things: 1) increase the probability of achieving the client’s investment goal; and 2) to better manage investor emotions during future shocks. Because they will come; that we glean from history!
The obsession with equities during a prolonged period of relative underperformance being heightened by a potentially game-changing pandemic is a broad topic with many consequences. Going forward we plan to address the many facets with additional data and perspective.
In the meantime, we hope this serves as a fitting prelude to set the table for additional thoughts and discussions. As always, we enjoy hearing from you and welcome a conversation.
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Not a recommendation of any security or strategy. Intended for informational purposes only. Past performance is not indicative of future results. Information contained within has been obtained from third party sources and is accurate to the best of our knowledge. Historical data is presented for informational purposes only. Investing contains significant risks including the risk of loss. Investment decisions should be made based on the investor’s specific financial needs and objectives. For more information on Blueprint’s process and asset allocation strategy visit www.blueprintip.com.