Simple but not Easy
We’re all plenty familiar with the axioms of investing: spend less than you earn; keep investment costs low; create clear, appropriate investment goals; choose an appropriate risk profile and a balanced asset allocation; diversify; rebalance; to name just a few. They’re pretty straightforward – true? – and not so difficult to believe. 2022 has also tested investors’ abilities to follow a few additional teachings: maintain patience and discipline; don’t try to time the market; keep your focus on the long-term; don’t chase the latest “great idea.” Even given the backdrop of this difficult financial year which we are now concluding, these principles are no less intrinsically simple. Yet successfully adhering to them in this evolving, sometimes wrenching, global society and marketplace which we inhabit is not so easy.
Why? We’re human. And thank goodness for that! The human experience is rich with goodness and fulfillment and meaning. Our large brains are a tremendous benefit to us, enabling us to thrive as well as simply survive all manner of risks and situations over the eons as well as in our own lifetimes. But it is in fact these large, active brains of ours which nonetheless complicate certain elements of our lives. Financial management is one of them. The reason lies in the reality that good investing, specifically, is not the result of a specific skill, dominated by the “smartest” among us. It relies upon a set of skills. A set of skills combined with a set of demeanors. More accurately, we can say that sound investing is born of a set of appropriate demeanors supplemented by a set of complementary but diverse skills. Ah, this is where the hard comes in: the foundational humility, balance, and patience required for this job are not always found within the same minds which possess the greatest analytical aptitude. This is an emotional exercise as well as an intellectual one. And while our intellects might tell us not to zip in and out of a particular investment because the timing looks good, for example, finding the discipline to resist such temptations, including to “just do something,” can be, well, a little harder. In fact, it’s our observation that the investment management arena tends to attract more of the analytical types than those of a tempered demeanor, both on the professional and personal sides. Testosterone is prevalent, as is an accompanying overconfidence.
This past year offered no shortage of opportunity to turn the simple into the not-so-easy. Take the question posed at the beginning of this past year and every year by prognosticators brimming with self-assurance: how will markets perform in the year ahead? Market forecasters, who are a foolhardy lot, base their divinations on the two elements of the widely used price-to-earnings ratio: the price of stocks, and the earnings they will produce. Interestingly, in 2022 analysts were remarkably accurate with their predictions on how much the companies of the S&P 500 would earn, missing the actual target by less than one-half of one percent. The part they failed to envision completely “blew up” their formula, to use the vernacular: the price that investors would be willing to pay for those corporate earnings. The reasons: inflation, Federal Reserve Bank policy, and the resulting surge in interest rates and Treasury Bond yields.
To call 2022’s stock and bond returns “a perfect storm” would be to flatter the storm. US stocks have historically declined an average of approximately once every four years. For US bonds, it’s approximately once every nine years. US stocks historically have suffered double-digit percentage declines approximately every 8 years. Bonds’ double-digit declines are far more rare: they’ve only occurred once in about 100 years. According to Edward McQuarrie, an emeritus professor of business at Santa Clara University, this year’s performance in US bonds is the worst ever recorded since 1794. Double-digit bond declines at the same time as double-digit stock declines? This is literally one for the history books. There’s a reason this year has made your stomach hurt.
The good news is that all of us who don’t get paid to make and back up such predictions don’t need to get mired in such mathematical rabbit holes. Yet plenty of “investors” still do. By thinking that we “know” one or even several variables of an equation we can lose the humility required to recognize that the equation may be far more complex than we imagined. Did I mention that this involves foretelling the future for each of these inherent variables? We can see how quickly deviations from perfection in any predictive model multiply into a forecast which is materially off-course. The fact that individual investors meaningfully underperform the broad US stock market on an annual basis is a testament to the hard. Why is this the case? Friction: buying when markets look attractive and selling when they look scary; high investment or investment management fees. Doing things; when we’d be better off…just…being…patient. Contrary to the narrative of investing bravado, “just” earning the market return would in fact be distinctly more profitable. This is not a competition. All we’re trying to do is financially benefit our future selves. Other people’s attempts to find shortcuts really aren’t relevant. We’re just setting up our money to run ahead of ourselves for a period of years or even decades.
A further lesson for us all: while longer-term economic and investment behaviors demonstrate discernable patterns, short-term market returns can be wildly unpredictable. More bluntly: short-term market forecasting is a foolish exercise. (We haven’t even gotten started into the concept that such short-term bets need to be successfully repeated constantly in order to actually outperform a patient, disciplined investment strategy. And that’s before taxes, trading costs, and other complications.)
We look at the markets on two levels: 1) The specific forces and global conditions which exist now. In other words, the current state of the markets and the economy, and the underlying influences which affect current pricing. 2) The broad, long-term risk and return parameters of the various classes of stocks and bonds, their relationships to each other, and the patterns which have long characterized their behaviors – irrespective of the reasons which are currently to credit or blame for the markets’ movements. Being current is necessary; but the specific reasons for past advances or declines aren’t our primary focus. How we got here matters less than the fact that we’re here. Likewise, looking forward, we fret less about any specific concern – monthly US unemployment data, Chinese GDP forecast, and so on – and remain cognizant that there is a constellation of risks which keep stock and bond prices gravity-bound. This leaves us free to tilt our heads toward the longer term: how fully valued or historically undervalued are the various segments of the stock and bond markets? What is the likelihood that their intermediate-term returns will fall within historic norms and relationships, or correlations, to one another? This points us forward, educated by both the current and the past, poised and balanced in our approach. True; this is not so easy.
The simple? Educating ourselves sufficiently to master the basics: saving, participating, maintaining balance, diversification, and low costs.
To those of you who have largely succeeded in following the simple in 2022, bravo! As such, you’ve mastered two of the great elements of sound investing: identifying and implementing good principles, and following them. This places you in surprisingly rare company. In our experience, this approach will help you build wealth over time. As investors ourselves, we feel the pain of this difficult year, but it doesn’t change our approach as discussed above. For the trust our clients place in us to execute these two disciplines, we are sincerely grateful.
One of the hardest parts? Recognizing our humanity. We’re swimming in deep, broad, efficient marketplaces populated by hundreds of millions of investors worldwide, some of whom are highly sophisticated, educated, and armed with tools of dizzying complexity. We are not likely to outsmart the aggregate, to outperform them, on a repeated and long-term basis. We must learn to compartmentalize our evolutionary instincts which scan for danger and run when we recognize it. Instead, we must practice a sort of Buddhist approach, attaching no emotion, good or bad, to a particular situation. At certain times we are even called to channel our inner firefighter and move towards danger, knowing that in the investment world, better outcomes are born of darker beginnings. We are wise to nurture our patience, our discipline, our resolve. Our emotions, our demeanor, are critical complements to our intellects.
In the words of Jimmy Dugan, the irascible manager played by Tom Hanks in the baseball film “A League of their Own,” “It’s supposed to be hard. If it wasn’t hard, everyone would do it. The hard… is what makes it great.”
By mastering the simple, “great” doesn’t have to be so hard to attain.
