By: Frank Armstrong
By: Frank Armstrong, CFP, AIF
It’s hard to go back in time. But, if an investor could, this is what it might have looked like. For the sake of today’s exercise we are going to give our investor access to some market indexes that wouldn’t have been generally available at the time. (Economists have had to cobble together some of these index returns long after the fact.)
Our hero examines several US market segments as well as foreign large and small stocks. Because Japan is such an important part of foreign market performance, he also follows its performance. Finally, he compares all these equity markets to bonds and inflation rates.
Armed with past ten-year return information, he plans to invest in the world’s most profitable markets. He reasons that ten years seems like a long enough time to measure performance, and the world has changed so rapidly that longer term performance is meaningless. After all, it’s different this time.
Here is what he sees as he examines the previous ten year’s performance:
His analysis is aided by his understanding of current events and economic trends. Everybody knows that the US is in big trouble. The last decade has seen the humiliation of defeat in Vietnam, civil unrest, and public scandal. The hippies have no work ethic, productivity is low, and American products both inferior and overpriced. Inflation and high interest rates being permanent, hard assets like real estate, oil, and antiques are the only sure things.
Only losers would invest in the S&P 500. Those are yesterday’s companies, and you note smugly that they failed to even match Treasury bills and underperformed inflation. Smaller and value companies seem to much more adaptable than the dinosaurs, but overseas investing led by an emerging Japan really shines.
He places your bets on small, value and foreign equities.
Ten years later he is not surprised to see that the rust belt S&P 500 still lags every other index except the US small companies. What happened to the small company premium, anyway? Japan is still powering along, pulling all of EAFE with it, and is poised to buy most of the US with their tremendous hoard of accumulated trading profits. The decline of the US economic model seems assured.
The Japanese understand the new world. Clearly market share is preferable to profits, lifetime employment is good, and consensus management rules. US companies just refuse to get it. You can’t give away an American car. Business Week asks, — Where will Japan Strike Next?– Meanwhile, the US Government Deficit is spiraling out of control, threatening to suck the entire economy dry. There is no political will to contain it. The dollar is on a steady downhill slide along with US self-confidence. It doesn’t get much worse than this!
Of course, this time it’s really different. Americans can’t keep up, and when they do have a good idea, somebody else makes all the money on it. Computers will change the world. But, they will probably be made in Taiwan.
He is fed up. Patriotism only goes so far. He loads up on foreign equities with emphasis on Japan and awaits certain riches.
Results didn’t quite match expectations again. How could the Japanese do that to us? And whoever fell for all that consensus management drivel, anyway? Who could have known that mini-vans would rule the road, and that Americans would be making them? Who knew about this Internet stuff, and how are these guys from Intel suddenly making money with computer chips? Who would have guessed that a Democrat President would balance the budget, and even turn in a surplus? It hardly seems fair.
How could such a smart guy have been so wrong? What happened? Next week we will take a look at lessons learned.
Part Two: Lessons learned
Before we all give up on foreign, value and small stocks, to buy the S&P 500 and tech stocks, let’s take a look at what we might have learned from our trip down memory lane.
Unless you are deluded enough to believe that you can predict the future, diversification is a great investment tactic. You will notice, that in every ten year period, an equally weighted diversified equity portfolio held up pretty well. You didn’t have to guess the top performing asset classes in order to have good results. Of course, we always had reasons to regret. Something we owned was always in the dog house.
But, look at the results we would have had over the entire 30 year period! All of our equity asset classes performed well, and just about in the order that we might have expected.
While ten years may seem like many, many lifetimes in Internet time, it’s really a pretty short time in financial economics. Many of the relationships that we expect from both practical experience and financial economics take a long time to work themselves out.
For instance, we expect that stocks will outperform bonds. Yet, there was a 19 year period during the 70′s and 80′s where Treasury Bills outperformed the S&P 500. After nineteen years of dismal performance, you might have been tempted to give up on stocks forever, and many folks did. Of course, they missed out on the greatest bull run in history.
Our expectations are based on long-term data. That’s the most rational approach to financial modeling. But, the long-term data hides lots of short-term aberrations. And these can run for what seems like a very long time indeed until they self correct. Economists call these aberrations noise, and have learned to expect them as a matter of course. They try to filter them out by referring to the longest-term data available. Investors should too.
Reversion to the mean
Think about it. If one company, industry, country, or market segment grew faster than the rest of the economy forever, eventually they would own all the assets in the world! Now, that’s never happened before. And, when something has never happened before, you ignore it at your peril.
Economists expect that there will be reversion to the mean because when a company or industry seems to be making excess profits, others will enter the industry. As more and more resources flow to the industry, prices will rise while competition will force profit margins down and equilibrium will be restored.
Of course, when a segment does poorly, resources will flee to more profitable ventures, asset prices fall until the remaining investors can expect market returns on their capital. Markets could not work without this self-adjusting mechanism.
Stock markets show very strong reversion to the mean. Even the strongest runs eventually end. Unfortunately, we don’t know when a run will end, just that it must. But, any strategy that fails to anticipate reversals is doomed to fail.
Projecting recent past experience
One of the biggest mistakes that investors make is to project recent experience forward. Unfortunately, it’s just human nature to feel that when the market is going well, it will continue up forever. If it is doing poorly, recovery seems impossible. Investors know in their heads that markets are cyclical, but emotions drive them to act as if it weren’t true. Unable to see the future, many investors plot their strategy through the rear view mirror. In the process, closer, more recent experiences appear larger; so, the view of reality gets distorted.
Investing takes discipline. A good strategy may take time to pay off. Noise, temporary aberrations, market reversals, fits of irrational exuberance followed by deep despair, and constant but irregular reversion to the mean are the norm. That’s life on Wall Street. Because we cannot force the market to meet our expectations, out guess it, or predict it, we must take the market on its terms and adjust to its cadence. Over time each market should earn the appropriate returns according its risks. Meanwhile, while nothing is ever guaranteed in the world’s equity markets, a well-diversified portfolio has the highest chance of a satisfactory result over both the long and shorter terms.