Cosmo P. DeStefano's Blog, page 5
April 19, 2023
Market Cycles Teach Us, But Do We Learn?
History doesn’t repeat itself but it often rhymes. —Mark Twain
Almost every modern-day investment for sale to the public comes with a version of the following disclaimer: “Past performance is no guarantee of future results,” but that doesn’t mean the past should be ignored, or worse forgotten—especially as we view our financial plan with a holistic mindset. When it comes to understanding financial planning and investing, having a firm grasp on the history of the markets can calm your mind when those around you are losing theirs.
Throughout history, the markets have repeatedly been through boom and bust cycles (think dot-com bubble, the Financial Crisis, the COVID-19 induced drop, or for a much older perspective, tulip mania to name just a few). And more broadly when not booming or busting, the markets are usually traveling less dramatically up over time, and then down (or correcting) over time. Cycles, extreme or not, are remarkably persistent.
It’s déjà vu all over again. —Yogi Berra
So, if cycles repeat, why don’t we simply follow the pattern to buy at the bottom and sell at the top? Cycles mimic the past in general terms (e.g., what goes up usually comes down and vice versa), but timing and duration don’t have identical historical timelines. Industries, companies, information flow, political climate, investor sentiment, etc., constantly change and shift. That’s why pinpointing the beginning or end of a particular cycle does not subject itself to formulaic analysis.
As an investor, however, understanding the history of financial markets and the relative position within a cycle (e.g., early- or late-stage; over- or under-valued) can help you assess risk and evaluate investment opportunities; but as far as pinpointing the exact optimal time to execute a trade, not so much.
Whether market returns have been strong to date (higher than long-term averages), or weak to date (lower than long-term averages) will help us assess where in the cycle we sit. And from this vantage point (the current relative level of returns) we can start to make an informed assessment of where returns are likely headed, even if we can’t say exactly when.
Prices and future returns are inversely related
Unless current market returns are approximately equal to the long-term historical average, you should not expect to receive the average return going forward. As the current market’s yield moves away (up or down) from the long-term average, your expectations about future returns should move as well; in the opposite direction!
For 25 years, JP Morgan has been producing its annual Long-Term Capital Market Assumptions (LTCMA) providing their assessment of 10–15-year return projections for various asset classes.
Reversion to the mean
History teaches us, and JP Morgan reiterates this fundamental truth: prices and future returns are inversely related. As the price of stocks rises, future returns will likely be lower. And the converse is true: As prices fall, future returns will likely rise. Reversion to the mean pulls averages towards their long-term trend line.
Your life expectancy and withdrawal timeline play an enormous role in the outcome of your Financial Independence (FI) plan. If you have decades before reaching your FI date, using long-term market average returns might be a reasonable planning assumption for now. If you are close to your FI date (say within 5-7 years), the long-term averages are less relevant, and you should focus on variable rates based on current valuation levels.
Those of us close to or actually withdrawing from our FI Portfolio should be focused on income and capital preservation. In such a scenario, your FI plan should manage the real risk of a drop in near-term equity returns. For example, consider holding more cash. Rebalance within equities to focus on dividend payers vs. pure growth investments. Interest, dividends, rents from real estate, etc. all serve to cushion the blow of market value declines. Investing in growth stocks with high valuations combined with a short timeframe is the opposite of conservative.
Don’t confuse ‘average’ with ‘expected’ return
The long-term average market return (S&P 500 Index) is approximately 10% (1957-2022). The average is a simplistic summation of the long-term, but it doesn’t tell us much about the here and now. This reminds me of some statistician humor: There is a rather tall gentleman who lives in a rather small house. When he lays down his head is in the oven and his feet are in the freezer. When asked how he felt, he responded, ‘On average, I feel fine.’
Annual market returns are anything but average. How often does this S&P 500 Index average return actually occur within the ‘I feel fine’ range of say 8-12%? In the 65 years since 1957, the annual return has been in the 8-12% range exactly 5 times. That’s it. And the actual range of returns has been negative 37% (2008) to a positive 43% (1958)—a spread of 80 percentage points!
Smart money is simply dumb money that’s been around the block a few times
Following the 1932 bottom, the market return for the next 20 years averaged 15.4% per year. For the 20 years following the 1974 bottom, 15.1% per year. And for the 11 years following the March 2009 financial crisis bottom, 16% per year. Investing near the bottom of a market has proved time and again to be a profitable long-term strategy, but it takes a strong stomach to jump in and stay in when it seems that everyone else is running away.
What to do? If you’re an investor in individual stocks, do your homework, and focus on company fundamentals. If you’re a passive index investor, keep investing. Yes, indexes come down too, but index funds don’t file for bankruptcy and lose 100% of an investor’s capital even if an individual company contained in the index does disappear.
See the present with clear eyes
As individual investors, we can learn from historical markets and our own investing experiences. Keep your head out of the sand and pay attention.
Our goal with better understanding the past is not to predict the future but to see the present with clear eyes. To understand on a relative basis where the markets—and its participants—are today so we may better position our portfolio (aggressively or defensively). It is about relative decisions, not absolutes.
Be mindful of your goals
It’s not about trying to time the exact top or bottom of a market. It is about situational awareness. For long-term investors, it’s evaluating where we are in the current economic cycle so we can better assess what is likely to follow (but by no means guaranteed to follow). Don't go on your merry way investing with your eyes wide shut.
For example, if in your estimation, the markets are closer to over-valued than under-valued maybe consider keeping a little extra dry powder (i.e., cash) on hand to take advantage of tactical opportunities, opportunistic investing, but not wholesale strategic changes. Remember, our goal is meeting our future FI spending needs not timing or beating the market.
Practice situational awareness
It’s not our planned actions that usually get investors in trouble, but rather our unplanned reactions to market events (e.g., selling after a crash; or chasing overvalued stocks ever higher.) We need to develop our situational awareness. We can’t possibly predict every bear market cycle or market crash, but we can better prepare psychologically for when dramatic market fluctuations inevitably arrive.
So we beat on, boats against the current, borne back ceaselessly into the past. —F. Scott Fitzgerald
In 1997, Barry P. Barbash of the U.S. Securities and Exchange Commission delivered a speech at the ICI Securities Law Procedures Conference in Washington, D.C. In summarizing his thoughts, Barbash observed, “We must remember the past because it has so much to teach us…We have an opportunity to learn from history and, in doing so, to avoid the pitfalls of the past. I can only hope we take full advantage of the opportunity.” Channeling the philosopher, George Santayana, Barash concluded, “Some of us would prefer not to remember the past…But perhaps the only thing worse than remembering the past would be to relive it.”
We need to use all the information we have at our disposal to make better informed, probability-based decisions while always weighing the cost and consequences of being wrong.
You need to understand the current landscape and monitor changes that might impact the future. And when you fold those observations into your plan, do not forget or unlearn the lessons history has taught us.
As always, invest often and wisely.
The content is for informational purposes only. It is not intended to be nor should it be construed as legal, tax, investment, financial, or other advice. It is merely my own random thoughts.
Thanks for reading Wealth Your Way Insights! Subscribe for free to receive new posts and support my work.
April 12, 2023
Diversification - Don't Miss Out On Your Only Free Lunch
Of all the truisms about investing that Warren Buffett has come out with over the years, perhaps the most important one for investors to understand is this: “Risk comes from not knowing what you’re doing.”
Most investors, including professionals, are simply unable or unwilling to acknowledge how little they actually know, or the risk that they’re taking as a consequence. Smart investors, by contrast, know their limitations, and instead of trying to predict the future, simply buy and hold a broadly diversified investment portfolio.
Peter Lynch is regarded as one of the greatest stock pickers of all time. Over his 13-year tenure, he turned Fidelity’s Magellan fund into the world’s largest mutual fund and a financial juggernaut. From 1977 to 1990, he averaged 29.7% annually, beating the S&P 500 in 11 out of 13 years, while never having a down year.
But Lynch didn’t build Magellan into a behemoth by broadly diversifying across the entire market. On the contrary, he made calculated, concentrated investments in his skillfully researched portfolio. So also did Warren Buffett in growing Berkshire Hathaway; and Bill Ackman who maintains highly concentrated bets in his Pershing Square fund. So why diversify?
With respect to your investment strategy, are you as good at picking individual companies as the likes of Peter Lynch, Warren Buffett, Bill Ackman, George Soros, John Templeton, or other investing greats? If you are that good, you can stop reading. If you’re not, you may want to read on.
Be good, get good, or give up
When it comes to investing for retirement, giving up is not an option, so either you are already good, or working to get good.
The Merriam-Webster dictionary defines ‘ignorance’ as a lack of knowledge, education, or awareness. When it comes to financial planning, self-awareness is crucial. As average investors, we generally do not have the in-depth knowledge, experience, intestinal fortitude, and time needed to properly research concentrated stock investments for our entire FI Portfolio.
We need to understand the outer edge of this border where our knowledge ends and our ignorance begins. This is where diversification comes in handy. For the average investor, unlike the notables mentioned above, diversification is part of getting good.
Protection against ignorance
Diversification is not how you make money in the stock market; it’s an insurance policy against incurring crippling losses. If you are familiar with the game of tennis: diversification is more akin to avoiding an unforced error than hitting a winning shot.
Risk is a direct descendent of fear. The brain’s fight or flight response to big change is based on fear – the brain perceives risk and tries to get away and avoid that risk. Knowing what you are doing, helps eliminate the fear and reduce the risk. As it turns out, Lynch and the others didn’t want or need the insurance because they had strong convictions in their company research and selection process, and the guts to stick it out. Can you say the same?
Concentrate on not losing
A concentrated portfolio (in winners!) is the best chance for outperforming the market but the cost of being wrong can be catastrophic. Diversification is the embodiment of the adage: the best offense is a good defense. A diversified portfolio is not playing offense to win, but rather playing defense to not lose. According to Buffett, investing Rule Number One: Never lose money. Rule Number Two: Never forget Rule Number One.
Whether you are in the wealth accumulation stage or withdrawal stage, diversification provides safety and protection from the permanent loss of a significant chunk of your FI Portfolio. It helps you to preserve your wealth, which in turn allows your wealth the opportunity to grow. It positions you to achieve your long-term FI goals.
A cost worth paying
The relative safety that diversification provides, however, comes at a cost. The cost is giving up a shot at excess (market-beating) returns. But as we will discuss elsewhere, this is a worthwhile trade-off since we don’t care about beating the market or keeping up with the Joneses. We do care about reaching our personal FI goals, and frankly, being able to sleep at night.
An S&P 500 Index fund provides a lot of diversification, but don’t lose sight of how it interacts with your personal timeline and goals. While the S&P 500 index is a large group of 500 companies and has performed remarkably well over the long-term, it represents only about 12% of all the listed companies in the US and an even smaller subset (1.2%) of the 41,000 listed companies around the world. In the long-term, it might represent enough diversification for you, but if you have a shorter timeline, maybe not.
The “Lost Decade”
As an example, let’s think about a retiree at the beginning of 2000 with a $1m portfolio invested 100% in the S&P 500. For the next decade, 2000-2009, the S&P 500 returned zero (actually, slightly less than zero; an annual average of negative 0.95%). An unlucky and unpleasant position for our recent retiree. After the first ten years of retirement, our retiree’s portfolio value (before taking any withdrawals) would have declined by almost $100,000.
This so-called “Lost Decade,” however, turned out to be a good decade for investors who diversified their holdings globally beyond US large cap stocks and included other parts of the market— for example, companies with small market capitalizations, or value stocks.
A more diversified portfolio (for example, US stocks, foreign stocks, emerging market stocks, bonds, and real estate) averaged 6.7%--all during a timeframe that included the dot-com bubble, 9/11, the Iraq War, and the 08-09 financial crisis.
[NOTE: The following decade, 2010-2019, the S&P 500 return stormed back and averaged 13.5% per year for a cumulative two-decade average of 6%. And for those curious, the average annual return for the S&P 500 since adopting 500 stocks into the index in 1957 through 2021 is 10.67%. The long-term has been spectacular for the S&P 500 index, but the short-term is often a bumpy ride.]
Here is a mathematical fact: a concentrated bet in the RIGHT individual stocks will produce a better return than the S&P 500 or almost any other index. But what is the probability that you can pick the right stocks and stick with them for decades? And what are the consequences of you being wrong?
Winners and losers
If you had picked one of the best-performing stocks at the beginning of the Lost Decade, Green Mountain Coffee, a $10,000 investment would have grown to a tasty $889,000 over the 10 years (assuming you didn’t sell and take your profits somewhere along the way of that meteoric rise).
Alternatively, if you had instead chosen to put your entire portfolio into JDS Uniphase (a high-flyer coming out of the 1990s), you would have lost 99% and be looking at less than $100 remaining in your account.
So, do you have the chutzpah to pick one or two individual stocks for the next decade and invest your entire FI Portfolio in them?
And don’t be dissuaded from diversification by the following observation. By being properly diversified, you will never have the best-performing portfolio. There will always be other portfolios that perform better than yours. Being diversified means that some of your investments perform worse than others (e.g., since all your money was not in Green Mountain). On the bright side, it also means that you will never have all your money invested in the worst performing investments (e.g., JDS Uniphase throughout the Lost Decade)! Avoiding catastrophic losses is more important than capitalizing on big-win opportunities.
Time is your friend
Professional money managers may overweight their favorites to capitalize on what (they think) they know, but even they still diversify to some extent to protect against what they don’t know. No professional has a portfolio consisting entirely of just their single highest conviction pick!
No matter how bumpy the ride is in the short-term, the long-term is your friend. Here are the WORST long-term compound annual growth rates (using rolling 20-year periods) for a sample of popular U.S. asset classes from 1980 through 2021 (i.e., the 1980 annual result would be for the 20-years ending with 1980):
• Large-cap blend stocks 5.9%
• Large-cap value stocks 6.4%
• Small-cap blend stocks 9.0%
• Small-cap value stocks 8.9%.
You can invest in low-cost ETFs for any or all of these asset classes. Looking for one-stop shopping? A total stock market fund, such as Vanguard’s Total Stock Market Index ETF (ticker: VTI) might be a good place to start your search.
Don’t miss your one free lunch
As Harry Markowitz said, diversification really is the only free lunch in investing—and it’s a healthy one too.
Failing to diversify as an investor is like going grocery shopping and simply filling your cart with 17 different brands of potato chips. That might work in the short-term, but for your long-term health, you also want to find room in the cart for staples like grains, fruits, vegetables, and of course, filet mignon!
As always, invest often and wisely.
The content is for informational purposes only. It is not intended to be nor should it be construed as legal, tax, investment, financial, or other advice. It is merely my own random thoughts.
Thanks for reading Wealth Your Way Insights! Subscribe for free to receive new posts and support my work.
September 14, 2022
Introducing...
This newsletter is dedicated to helping you level-set your core understanding of financial freedom. It will also focus on developing default behaviors that are well suited to assist you with planning for and achieving your financial goals while living and enjoying your best life now.
There is no one-size-fits-all plan for that. But there is a strategy to create a purpose-built, goals-driven plan tailored to you. You may be a Gen Z coming of age, a millennial with oppressive student debt, or a boomer playing catch-up, but for all of us financial planning boils down to this simple mantra: think about what to do, go do it, then do as little as possible after that! PCR: Plan, Course-Correct, Repeat.
Over time, the newsletter will cover a wide range of personal finance topics that will shed light on some of the issues and challenges you may face, and offer up suggestions as you work through your personal financial planning process.
My goal here is to help you with how to think about growing your wealth, rather than simply what to think. Empowering you to grow your knowledge base, increase confidence in the choices you make, and own your financial plan.
Financial independence buys you the most valuable asset on the planet—freedom. The freedom to spend your money, and more importantly, your time, however you see fit.
Financial independence is not just a number—it is a state of mind. It provides freedom in a broad sense, and isn’t that what we all ultimately desire?
As always, invest often and wisely.
