Three Core Beliefs
Since the Covid-19 outbreak, many people have contacted me concerned about the decline in value of their investment accounts. I sense that there has been more anxiety this time than during the previous bear markets, when stocks plunged even more. This is probably because the coronavirus has caused economic uncertainty in addition to a public health crisis, unlike anything we have seen before. This time it is different.
We are in the midst of a recession that will be deeper than what we have seen since the 1930’s. Please note that I didn’t say worse than other recessions – I said deeper. I’m hopeful that it will not last long – at least the worst of it, but there is no question that a mandated shut down of the economy is unprecedented and will have some lingering effects. Even though this time is different – that doesn’t mean that we should respond differently.
To be a successful investor, I think you need to hold some fundamental beliefs and then adhere to them to the best of your ability. When it comes to investing, I have three core beliefs that inform my personal decisions and the advice I give to clients.
My first core belief is that I believe that our system of capitalism and free enterprise offers the opportunity for boundless prosperity.
Especially in recent decades, globalization and technology developments have spurred productivity gains, and advanced our standard of living and lifted billions of people out of poverty worldwide. If you look at a chart of the global economy over the last 150 years, you see relentless growth. Some recessions aren’t even visible on the graph, and even the Great Depression is just a blip on the chart. Humankind has a tremendous capacity for ingenuity to solve problems and improve our way of life. When hard work and creativity are rewarded, it provides the incentives for individuals to act in ways that benefit all of us.
Americans are especially adaptive and resilient. The amazing things that we’ve seen the last few weeks from our friends and neighbors is a great example of the innate creativity and spirit of people everywhere. The heroic efforts and unselfishness of the healthcare workers as well as the willingness of ordinary citizens and private companies to assist in any way possible during the pandemic demonstrate our ability to overcome any obstacles. This same spirit and work ethic has allowed us to recover from wars, terrorism, natural disasters, financial crises and other pandemics.
The stock market simply mirrors the global economy. There is an almost perfect correlation between global GDP growth and stock prices over long periods of time. While the private sector doesn’t comprise the entire GDP, it certainly is the driver for growth. Stock market levels are really just the consensus estimate of the present value of all future corporate profits into perpetuity – and a proxy for future GDP growth. If you believe that the global economy will be higher in ten, fifteen and twenty years, you have to also believe that the stock market will be much higher. The inevitable conclusion is that if you have long term goals, you want at least some portion of your portfolio in the stock market.
My second core belief is that the future is unknowable and investment decisions are made under extreme uncertainty.
You should be skeptical of anyone who claims to have the ability to predict future events with any precision or certainty. This includes bloggers, market timers, active money managers, speculators, and media commentators. Nobody really knows any more than the rest of us about the future. We are all working from the same information, which is already reflected in security prices. For every buyer, there is a seller. With most trading done by institutions these days, generally there is a very smart person (or a computer) on both sides of every trade. Ultimately, prices converge to a rational and fair value that will not change much until new information becomes available. By definition, that’s the future - which is unknowable.
Please don’t misunderstand me, I do not think the financial markets are perfectly efficient. People are not always sensible, so the market is not always rational. That said, the markets are very efficient at processing information, which makes them rational enough. The stock market often turns out to be wrong in hindsight, but in the moment it is the best estimate we have and generally works fairly well. It is almost impossible for anyone to gain a clear advantage.
Some realizations flow logically from this core belief. The obvious thing is why pay fees for any advice that is based on an ability to foresee the future or to “beat the market”? Any type of human interaction that involves tactical maneuvers to gain market advantage is a complete waste of money. There are tools like index funds to allow you to own the entire market cheaply and easily, so predictions are not necessary. It doesn’t make sense to spend money to beat the market when we know it can’t be done consistently.
If experts can’t predict future events, nor outperform the market, you might also think twice about trying to do it yourself. As they say, hindsight is 20/20, but I don’t know anyone who truly predicted the 2000 and 2008 bear markets, or this year’s precipitous drop in stocks for that matter. It’s hard to resist the urge to react, especially in the face of falling investment values. However, by the time you realize it is happening, the damage has already been done and it’s too late.
When you accept that the future is unknowable, it leads to another conclusion. If you don’t know what is going to happen, you should prepare for a multitude of possibilities. This is where another core belief comes in.
For my third core belief, I believe that an individual must have a plan to address the myriad of investment decisions that must be made.
Like going on a trip without a defined route, you might get lucky and end up at your desired destination. Arriving at your desired destination in an expeditious manner is much more likely if you have a map. Without something to guide you, many things can go wrong along the way. You need to protect yourself from getting sidetracked by an unforeseen event and also guard against self-inflicted wounds. The best way is to start with a knowledge of the reasons that you are investing in the first place and make sure that your actions are consistent with those goals.
Diversification is an essential component of any portfolio. While diversification is necessary, it is not sufficient. Proper balance is also essential to make sure that you employ the right types of investments and in proper proportions. This is called asset allocation. Each asset class has a unique risk and return profile, which means it has advantages and disadvantages under diverse economic conditions. For example, regular US treasury bonds should perform well during deflationary times but get hurt when there is excessive inflation. Treasury inflation protected bonds (TIPS) hedge against unexpected inflation, but they will underperform at other times. Since you don’t know what lies ahead for inflation – and nobody really does - wouldn’t you want to own both?
Decisions must be made about what to include in a portfolio, and what to exclude. I don’t know how you would do this without a plan and setting your priorities. There are tradeoffs to consider. Standard pie charts are not the answer. They are typically based on the investor’s age. Asset allocation should include an individual’s entire financial situation. For instance, someone with a strong desire to leave an inheritance might invest as aggressively as a much younger person because in effect they are investing on behalf of a younger person. In contrast, if your primary goal is to maintain your standard of living during your lifetime, you will probably allocate more conservatively.
Individuals also vary in the way they respond to volatility, so temperament and willingness to assume volatility should be considered. An allocation isn’t appropriate if it won’t allow you to stick with the plan, or worse cause you to panic and sell out at the first sign of trouble.
During a turbulent and fearful time like the present, if someone asks me if they should make adjustments to their portfolio, I would first caution against making any sudden changes when the market is unusually volatile on a daily basis. Sometimes it’s better to do nothing and let things settle a bit. Since it has been a few weeks since stocks hit the low point in late March, prices have recovered somewhat and there is a little more stability. I think it would be appropriate to make changes at this time if necessary to have a portfolio that fits your situation better.
Further, a portfolio should be structured to allow you to weather all types of market conditions. The Covid-19 pandemic presents a unique challenge, but it is not the last time we will have major turmoil in the economy and stock market. The catalyst for the next disruption is unknown, but history tells us it will happen again. History also suggests that when your goals are many years away, you should continue to invest in the stock market in order to enjoy the long-term benefits.
Consistent with my core beliefs, I would make sure that the portfolio is not based on speculation about future events or rely on unsupported assumptions. You can probably tell that I’m optimistic about the future, which I don’t view as speculation. Over a reasonable time period, growth in the stock market is sure to follow the inevitable progress of the global economy. I’m confident that innovations in artificial intelligence, automation, digital technology and biotechnology will lead to enormous gains in productivity in the years to come.
At the same time, I’m a realist. I would not assume the worst is over or that we will see a quick return to the stock market high in February. That could happen, but it’s not likely when the economy is struggling to return to normalcy. While I think that we will manage through this public health crisis, the shock to the economic system will take time to fully recover. I think we are talking years, rather than months. Stocks tend to recover faster than the economy as a whole, but even so these disruptions could linger for a while.
For the near term outlook, I think there might be more downside risk than upward potential. Fortunately, investing by its nature is a long term proposition and we don’t have to rely on short-term forecasts. That’s a good thing because mine are no better than anybody else’s. For long term investors, I’m much more confident in my forecast. Having core beliefs – and staying the course in times of trouble - can help you to weather any storm and take you safely to your destination.