Let’s pretend we could turn back time to January 1st of this year. What if I gave you the following series of facts and asked you to predict the market’s return?
- A pandemic came out of nowhere and led to extended periods where most of the country was required to stay home.
- Economic activity fell dramatically and unemployment reached levels not seen since the Great Depression.
- Businesses that require consumers to leave their houses like restaurants, and airlines and cruise lines were decimated with many losing most of their revenue.
If I gave you those facts in advance and asked you what you would have done with your portfolio for 2020, what would you have said?
Maybe you would have shorted the stock market. Maybe you would have bought long-term bonds for protection. Maybe you would have just put all your money in cash to weather the storm. I know those would have been the things I would have considered.
And all of that would have been completely wrong. And even without the benefit of hindsight, many investors, myself included, are having difficulty understanding how the market can continue its advance despite the economic realities we face. It seems obvious to many that this will eventually end badly and we are in for a major decline.
I went through some of the reasons the market has performed so well relative to the economy in a previous article, so I won’t cover all the reasons here, but as a result of a variety of factors, including the massive government stimulus we have seen, what would seem like an obvious outcome has not played out in a way most people expected.
Although the current situation is certainly extreme, the concept of something that seems obvious in the market ending up being far from it is not rare at all. And that fact can get many investors in trouble. Take a step back and think about how the market works. Every day, you have tens of thousands of market participants, many of which are among the smartest people on this planet, analyzing every market and every asset class and every individual security. You also have computers that are capable of combing through more data than any human could in hundreds of years.
What are the odds that the market clearing prices that all of that leads to are far from what the true market price should be? What are the odds that any individual market participant can be smarter than the collective wisdom of all those smart people and computing power? It isn’t impossible, but the odds are certainly against it.
Every time a market outcome doesn’t make sense to me, I try to remind myself of this point. Even if I don’t agree with what happens, I have to respect the collective wisdom that led to it and ask myself whether my individual wisdom exceeds that. When I do that, things that seemed obvious to me in the first place seem much less so.
Is the 60/40 Portfolio Dead?
Let me give you another example.
The yields on government bonds right now are at all-time lows. Investors typically hold bonds because of the interest payments they make and because they offer protection during deflationary shocks like the Coronavirus crisis we just went through. But with yields close to zero, it is easy to argue that neither of those benefits exist today.
By owning bonds right now, I get very little income and unless you believe we are headed for negative yields, it would seem the protection they offer from deflationary shocks is limited as well. But many experts have been arguing those same things for years now. It seemed obvious that bonds were in for below average returns going forward long before the Coronavirus hit. But despite their low yields going into it, they did their job and offered diversification benefits during the crisis. They may very well do the same thing when the next crisis hits, even if very few people to expect them to.
I really like the way Morgan Housel of the Collaborative Fund looks at his bond portfolio. He sees its main goal as offering the protection needed to prevent him from having to sell his stocks during times of panic. Even if it might seem obvious that bonds don’t look like a good investment going forward right now, it seems to me that his logic would still support continuing to have them play a significant role in most investor’s portfolio.
The Benefits of Challenging the Obvious
These are just a couple of examples, and what seems obvious to one person may be different than what seems obvious to another. It could be that you think it’s obvious that the FAANG stocks will continue to outperform for a long period of time. On the opposite side of the coin, it could be that you think it is obvious that value stocks will beat the market over the next decade. But regardless of what it is that you think is obvious, the principle still holds.
Investing is hard. I have found in my career that the times when it seems easy can be the times when I make my biggest mistakes. For me, the obvious decision has often not been the correct one. So next time you think something in investing is obvious, it might be a good idea to take a step back and think about the level of intelligence contained within the collective wisdom of the market and ask yourself whether you are able to make superior decisions to that. The answer will likely be no.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.