Research

How to Invest in Uncertain Times (part 1)

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The market has been rocked. In the last two weeks (March 3-16, 2020), the S&P 500 has lost over 22% of its value. It’s the fastest 20% descent we’ve ever seen, and no one knows exactly where the bottom will be (or if we’ve already hit it). The market has moved in percentage multiples, both up and down, every day last week, an incredible level of volatility. The leading cause, which still feels surreal, is the propagating Covid-19 virus which has led to mass closings and increasing restrictions. Suffice it to say, it’s been a crazy couple of weeks.

In many ways, we’re in uncharted territory, which means we’ve got questions, like how are we supposed to respond to all of this? What’s the right thing to do when we’re confused about what’s happening? To add some clarity, I’ll offer up a few investing principles throughout this week.

 

Market timing doesn’t work.

  • No one knows what the market will do tomorrow. Many make predictions, but no one really knows. Don’t try to guess where the bottom is, or when we’ll hit it, or when to pull money out of the market, or when to put the money back in. The market is efficient.
  • Let’s say you really want to get out of the market because you don’t believe we’ve hit the bottom yet and you’re not interested in sticking around to find out. In order to successfully time the market you have to get two bets right: you have to get out of the market before it hits the bottom, and you have to get back in at or very near the bottom. The odds are not favorable.
  • A market study conducted at the University of Michigan measured returns from 1963 through 2004 (a period of 42 years). They found that 96% of the positive returns over that period came from 0.85% of trading days (90 out of 10,573 total trading days).
  • Another study done by A. Stotz Investment Research observed a 10 year period, from November 2005 through October 2015. After running the data through several simulations, they concluded that if you missed the 10 best market days over the specified 10 year period, you would stand to lose, on average, 66% of the gains you would have captured by staying in the market.
  • When the market moves up, it moves up quickly. Whenever your money is on the sidelines, you risk missing some of the best days the market has to offer. So stay invested, don’t panic, and anticipate the rebound.

Year-end investor review

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We made it, another year is in the books and everyone has an opinion on where the market is going. My line of work involves me adamantly advising people not to try to predict markets, but even I have an opinion about what might happen in the future. Thankfully, there’s a difference between having an opinion and making a poor investing decision.

So where are we now? We’re coming off of a historically great period of market returns, especially in the category of U.S. large growth companies (the S&P 500, which happens to be the category we almost exclusively hear about in the news). Since U.S. large growth companies have faired well, so have investors, because the vast majority of investors have the majority of their investments in large U.S. growth companies. That’s great news right now. But it’s also a problem.

Large growth companies are historically one of the poorest performing asset categories in the free market. This holds in performance data going back one hundred years, but it also makes sense a priori. Large growth companies are inherently less risky than small and value companies, they stay in business longer, they seldom go bankrupt (it happens, just not as often), and their prices don’t fluctuate as significantly. Small companies are often younger, less established, and more susceptible to tough markets. Value companies are often distressed and sometimes never recover. These small and value companies default more often and their prices are more volatile, they’re riskier.

You’ve heard the principle, risk equals return. That applies here. It makes sense that as entire asset classes, small companies and value companies outperform large growth companies by a significant margin over time because their additional risk brings additional return. The fact that large growth companies have performed so well over these last ten years is great, but it also means that at some point we’ll see these returns balance out. Now, I would never pretend to know which asset classes will perform better or worse next year, that’s a fool’s errand which we refer to as ‘market timing.’ But I do know that most years will favor a diversified portfolio that leans toward small and value asset classes instead of a heavy weighting towards large growth companies. Next year the most likely circumstance is that you’ll be happy to have left your large growth company portfolio to get into a more diversified situation, which, incidentally, is true at the end of every year.

So the obvious question is how to diversify with a lean towards small and value companies. I’ve covered this before, but total market index funds won’t help you here, because of cap weighting total market funds are invested almost entirely in large growth companies. Index funds have become very popular over the last 20 years and, while they’re certainly an improvement over active funds, they’re inherently flawed. To get into an ideal portfolio takes an advisor committed to the academics of investing utilizing structured funds (a solution to the index fund problem).

Take the opportunity to review your portfolio as we head into the new year. The returns may look great, but that doesn’t mean you’re in a great portfolio.

There are only two ways to invest (part 2)

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carolina-pimenta-J8oncaYH6ag-unsplashSo we’ve identified the two basic ways you can invest. That’s great, but how do you know which one to choose? Let’s talk about the active option.

Active investing feels right. We’re active people after all. We shop around for deals, we love sales and Facebook Marketplace. We check weather forecasts on the regular, we set future plans on our calendars. We do research before we buy things (some of us perhaps to a fault), we read reviews, we ask our friends. All of these things are active. So then active investing just seems like the normal way to do things, look for underpriced companies, do some stock research, make a prediction about the future, nothing too out of the ordinary, right?

There’s just one small problem, investing isn’t like normal life. We’ve got really smart people positing that the stock market is efficient, which means there aren’t actually and sales or deals on underpriced companies. Sure, stock prices will generally move upwards, but not because a company is underpriced. New news and information comes into the market and affects stock prices, new things happen that we can’t know for sure beforehand are going to happen. Research into specific stocks is great, professionals are doing it all of the time, but no one person can possibly have a complete understanding of a company, let alone how unknown events in the future will affect the company. There’s just too much data to make picking stocks a long-term viable strategy. Predictions in the stock market are not like weather predictions, we don’t have a radar watching a storm-front move in. And if people believe there is a storm front coming, it’s already priced into the stock prices because again, the market is efficient.

It’s really tough to be a good active investor. Even professionals fail to outperform the market at an extraordinary rate (over the last 15 years, 92% of active funds trading in the S&P 500 have underperformed the S&P 500), and even those who seem to be good at it tend not to repeat their performance. So maybe you’ve guessed by now, I don’t advocate active investing. If you really believe that the market is not efficient and that you or someone you know has a special ability to buy and sell the right stocks at the right time then active investing is the way to test your belief. Unfortunately, the odds are not in your favor.

In part 3, we’ll talk about the alternative option.

Index issues (part 2)

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Alright, so we know passive investing trumps active investing, and we know that index investing, while passive, has some serious deficiencies. So what’s left?
We want to own the market passively, but that doesn’t mean we’re restricted to index funds. There is a much more responsible way to allocate money to different companies and sectors – structured funds. Structured funds deal with each of the index funds issues:

1. Instead of an arbitrary grouping of companies, a structured fund can make it’s own set of rules to decide which companies are in an asset class or fund and which are not. The S&P 500 is 500 of the largest companies in the U.S., but what if that’s not the best way to own the U.S. Large growth asset class? The same question can be asked of any index. Instead of abiding by the arbitrary index rules, a structured fund makes its own rules based on a century of market data. Just like the S&P 500 has rules to decide which companies are in and which are out (largely based on that 500 number), a structured fund has a set of rules that a company has to meet (size, profitability, book to value ratio, etc.) in order to be included in that fund. It’s still passive (in fact, often more passive than index funds), the rules are what determine which companies are in and out not an advisor’s gut feelings, but it’s a different type of investing. And it’s based on actual market research instead of arbitrary measurements.

2. We know that small companies outperform large companies over time, but indexes, by necessity (because of cap-weighting), own the least amount of the small companies. Even small company indexes like the Russell 2000 (which owns the smallest 2,000 companies in the U.S.) have much more money invested in the larger several companies than in the smaller hundreds of companies. If you’re in a target dated fund (the ones with a year at the end) in a 401k or a total U.S. market index fund, you’re missing out on the best returns the market has to offer because of cap-weighting.

3. Structured funds are not as cheap to own, and they’re much more scarce than index funds. You’ll probably have to work with an advisor to gain access to them. They rarely let investors put their finger on the trigger. Over time, these funds outperform traditional index funds because they’re designed to maximize return. An index fund would have to pay you to achieve similar returns, even after the additional costs of structured funds are considered. And because investors can only access them through an advisor, the likely-hood that investors consistently realize the returns (instead of hopping in or out or all around at the wrong time) increases significantly.

Often times index funds are the only decent option available (this is true in many 401k accounts), but when the options are open, a good advisor offering good structured funds is the best option.

What does ‘efficient market’ mean?

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‘Efficient market’ is one of the most important terms to understand when it comes to investing. It’s important because what you think about the efficiency of the market will dictate how you practically invest your money, which will shape your retirement and legacy.
So first, what does it mean? If the market is efficient it means that stock prices react to news and information really fast. For instance, news breaks that a company has committed fraud, and the stock price of that company falls immediately. It also extends to any small bit of news or public sentiment regarding the market or specific companies. Market prices are always moving based on new information and perceptions, and they move almost immediately upon receiving that new information. Those are signs of an efficient market. The speed at which information travels today has only made the market more efficient.
So why does that matter? Well, if the market really is super efficient, it means that picking stocks is futile. Think about it, if the market prices react and update immediately upon receiving new information, the only thing you can do to beat the market is to guess right. Unfortunately market guesses are less like investing and more like gambling. So if the market is efficient, the entire way you’ve previously thought about investing is not only impractical, it’s basically a roll of the dice. Instead of trying to beat the market, an efficient market would suggest you own the whole thing as efficiently as you can. You would diversify and hold stocks instead of research and pick stocks.
There is another important thing to recognize about investing in relation to the efficient market: people do beat the market sometimes, they sometimes pick the right stocks and get better returns than the market as a whole. It’s not often, somewhere around 90% of stock pickers underperform the market every year, but that leaves around 10% who seem to be doing something right. That 10% either figured something out, found some inefficiency in the market, or they got lucky. The thing is, it doesn’t really matter if they’re smart or lucky, and there’s not really any way to empirically test it anyways. Because the market is efficient, if a smart person does find an inefficiency it will close up before long, and if a lucky person gets lucky, they’ll also get unlucky at some point. Either way, by the time you’ve heard about their success, it’s too late. People who have beat the market in the past are much more likely to underperform the market in the future than to beat it again. In fact, they’re more likely to underperform even their contemporaries in the future. Any way you cut it, in an efficient market it simply doesn’t make sense to try to find or profit from market inefficiencies, regardless of whether or not they really exist, or to what extent.
So if the market is efficient, to whatever degree you agree, don’t try to beat it. Instead, own the efficient market as efficiently as possible.