"The fact that your brain becomes more risk seeking in bull markets and more conservative in bear markets means that you are neurologically predisposed to violate the first rule of investing, 'buy low and sell high.’”
"Every past decline looks like an opportunity, every future decline looks like a risk." - Morgan Housel
If 2017 was the year you couldn’t go wrong, 2018 was the year you couldn’t do right. Nearly every investable asset was in the red for 2018.
In case you’re wondering, the topmost bar is a measure of volatility in the stock market, the “VIX”.
What can we learn from 2018?
1) The best periods for returns frequently follow the worst periods, and vice versa.
The chart below details some of the worst declines of the U.S. stock market (S&P 500) dating back to 1926, and the performance in the following one, three, and five year periods.
Make note, the average return in the five years following the average decline has been 91.3%.
Buying and holding is one of the more challenging endeavors we can embark upon as emotional investors. But if avoiding the downturns is impossible, and it most certainly is, then we must remain invested to reap the rewards.
2) Diversification can feel like punishment, until you’re reminded of why it’s necessary.
The chart below is from 01/01/17 through 12/31/18. The red line represents the U.S. stock market (the Russell 2000). The blue line represents the U.S. bond market (the Barclays Aggregate Bond Index).
In 2017, most of us were asking: "Why do we own bonds? They're a drag on our stocks." In 2018, most of us are asking: "Why do we own stocks? They're a drag on our bonds."
The answer is that by avoiding stocks altogether, you would be giving up an additional 3-4% average annual return compared to bonds alone. The resulting return would likely not even keep pace with inflation, leading to decreasing purchasing power for your future self. As a result, you would either have to save more money or spend less in retirement, neither of which may be a trade-off you're willing to make.
3) We can’t know precisely what the next year will bring.
Each colored block of this chart represents a general area that you can invest in, such as stocks, bonds or real estate, etc. The ones at the top provided the best returns for that given year, the ones at the bottom provided the worst return.
Obviously, there is no consistent pattern. Thusly, we keep our eggs in many baskets, and in the aggregate, should do well over the long-term with history as our guide.
How long-term are we talking? The longer the perspective you can take, mentally and financially, the better.
We see that, on any given day in the stock market, there's a 54% chance that it’s going to be positive for the day; barely better than random, as you would expect of something that is on a gradual upward slope. As you increase your time invested, you dramatically increase the probability of experiencing a positive return; 82% at 1 year and 91% at 10 years.
4) Take a breather, especially from the media.
There is an inverse correlation between the frequency with which an investor checks their accounts, and the returns they earn, as most of us have a bias towards doing something, even when the optimal thing to do is frequently nothing. In fact, the investors that earned the most at Fidelity were actually the ones that forgot they had an account there in the first place!
So take a break, especially from the sensational media, and just breathe.
So what might 2019 hold in store for us?
I think we need to be leery of both creating forecasts and of placing much faith in the forecasts of others, as we’ve touched on this year. Alas, our clients appreciate a general idea, which is perfectly understandable. For that, I would point towards John Bogle, the founder of Vanguard, who has declared 2019 to be the year of caution. In his interview with Barron’s, he cited concerns over increasing corporate debt, the U.S. - China trade war, the United Kingdom leaving the European Union, and a general slowdown of global growth.
[To play the devil's advocate here, can you name the specific economic and geo-political concerns from even 5 years ago? Me either.]
Bogle states, “Trees don't grow to the sky, and I see clouds on the horizon. I don't know if and when they'll arrive. A little extra caution should be the watchword…”
I think a few key points surrounding what he said are just as, if not more important, than his word of caution itself. For one, he acknowledges that he doesn’t know when these clouds may arrive, or if they will at all. Secondly, he calls for “A little extra caution”, and not to completely cash out of your investments. In a world seemingly full of experts that are absolutely certain we’re either heading for a prodigious boom or an apocalyptic bust, this is a refreshingly balanced perspective. And I would note, one that has been historically accurate more often than not.
He goes on to suggest that an investor with 40% of their portfolio allocated to bonds might consider increasing that to 50%, in order to make the portfolio slightly more conservative. In other words, he’s not suggesting dramatic changes here.
In reference to longer-term goals, such as retirement, Bogle states, “Keep investing, no matter how frightened you are.”, which is a nod to how financially rewarding investing has been if you’ve stayed the course through thick and thin.
With that said, you may find comfort in knowing that there have only been four instances since 1929 when the S&P 500 declined two or more years in a row.
I think the key here is preparation, and not prediction. Now is the time for us to revisit your financial plan and portfolio to ensure that we are taking an amount of risk that you’re both comfortable with and that will help you reach your goals. As always, we will control the things that we can: how much we're saving and how much we're withdrawing, utilizing investments with the correct balance of risk and potential return that are low-cost, being mindful of portfolio adjustments that can generate unnecessary taxes, and doing our best to avoid emotionally charged decisions in order to earn the returns that history says we likely will.
We wish you the very best in 2019.
C Garrett Moore