October 2, 2019
Written by Nathan Erickson, CFA®, CAIA, Managing Partner and Chief Investment Officer
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According to an article published by the National Science Foundation in 2005, the average person has 12,000 to 60,000 thoughts per day. Approximately 80% of those thoughts are negative, and 95% repeat each day. In another study from Cornell University, scientists found that approximately 85% of what we worry about never happens. Of the 15% of worries that do happen, approximately 80% of the people involved in the study said that they could either handle the worry better than they expected, or that the experience taught them a lesson worth learning.
What does this mean? Humans are designed to survive, which means we are hyper-sensitive to negative stimulus. We’ve all heard of fight or flight: the natural chemical response to danger. We can all relate to the physiological response of fear or danger. Just think about the last time you had a near car crash, or looked over the edge of the Grand Canyon, or were startled by something. Our responses to negative stimulus are visceral and, in some cases, traumatic.
Not only are we hyper-sensitive to negative stimulus, it tends to weigh much heavier than positive stimulus. The late John T. Cacioppo, a psychologist at Ohio State University, called this the “negativity bias”. In his studies, he showed participants pictures related to positive feelings (food or a flashy car), negative feelings (a dead animal), and neutral feelings (a dish or hair dryer) and recorded the electrical activity generated by the brain for each of the pictures. He found that the more negative the picture, the more activity generated by the cerebral cortex. Our brains care far more about bad things than good things, intuitively because good things are nice, but bad things can kill us.
How does this relate to investing, especially as we’re in the middle of the tenth year of a market recovery? While there may not appear to be risk on the horizon, most will agree that at some point we will either enter a bear market, a recession, or both. How we feel and how we respond when that occurs is worth discussing, as it can have a long-lasting impact on our investment success.
“Everyone has a plan until they get punched in the mouth.” – Mike Tyson
As advisors, we’re far more concerned about the emotional preparedness of our clients than whether the portfolios we’ve constructed can handle a tough market. Client portfolios have been thoughtfully diversified and defensive for some time, and they have been that way for two reasons. The first is that we don’t know when the next downturn is coming. We don’t think anyone does. When you believe that downturns can’t be predicted, it leads you to invest in a manner that can handle a downturn at all times. While our allocations have changed as conditions have changed (e.g., falling interest rates), we do not participate in market timing or build highly concentrated portfolios.
Unfortunately, investing this way through a ten-year bull market inevitably leads to diversified investors feeling like they have missed out. Diversification is a cornerstone of investing, but as bull markets lengthen, it is common for investors to get focused on positions that have recently worked the best, and there is none better than the U.S. equity market over the last ten years. We own many diversifying assets in portfolios on behalf of our clients, including reinsurance, farmland, life settlements, and private debt. While the returns of these assets may look stable and defensive during drawdowns, the returns may look less attractive during other periods. We pay a price for owning these assets when performance is concentrated in stock market returns.
Strong bull markets create another challenge around risk tolerance. Investor risk tolerance is not static but shifts with market performance. Our instincts imply that risks are rising when markets are falling. In 2008, as the S&P 500 was falling 50%, it was actually becoming less risky, yet it felt extremely risky. The price investors paid for company earnings became much cheaper, and the probability of higher returns in the future was increasing. Yet most investors’ instinct at the time was to cut stock market exposure, not add to it. On the flip side, a ten-year bull market can lull investors into a false sense of security when, in fact, markets are getting more expensive and the probability of higher returns in the future continues to decrease. Today, markets don’t feel very risky, but they are probably riskier than they’ve been over the last ten years.
The second reason we remain diversified and defensive is this: We know investors are likely to be far more upset about losing money in the next downturn than they are about missing out on higher returns over the last decade. Recall the beginning of this article. Humans are hyper-sensitive to bad news, and it tends to last longer than good news. As disappointed as someone may feel about the S&P 500 outperforming his or her portfolio by several percent, our biggest risk right now is not how portfolios are invested, but that we haven’t educated clients enough about why they’re invested the way they are and what could happen during the next bear market. We have a plan, but we don’t want the plan to change when the proverbial punch in the mouth of a market decline happens.
“Comparison is the thief of joy.” – Theodore Roosevelt
As American investors, the challenge to not abandon diversification in the late innings of one of the longest bull markets on record is even more difficult. By nature of our place in the world and the media we consume, we have a much narrower perspective on our investment performance. Our neighbors to the north or across the ocean have a more moderate view of their investment experiences and perhaps more rational expectations because they haven’t seen 13% annualized returns in their home country market over the last decade.
Our market has performed the best, which means it feels the safest of all markets. It probably also means it is the most expensive and has a lower probability of high returns in the future compared to many other markets.
As Roosevelt said, comparison is the thief of joy. We’re disappointed when we compare our portfolios to the S&P 500, but we would be wise to consider what the S&P 500 has done to investors in the past.
Over the last 50 years, the S&P 500 has had five occasions where it declined by at least 20% from its peak. These events occurred roughly once a decade. The worst was the most recent global financial crisis, when the S&P 500 was down 50.9% from top to bottom. However, the median decline was still -42.6%. In those “punch in the face” moments, investors had to act rationally for anywhere from one to two years while chaos ensued. That’s a long time.
In those periods, our instincts kick in. As we mentioned previously, your risk tolerance shifts when you are losing money (I want cash!). Your time horizon shrinks while, at the same time, you see no end to current trends, and the media headlines tell you it will get worse. You also tend to exaggerate the importance of recent information and forget the longer-term historical context. Volatility breeds volatility. As markets continue to decline because investors are selling, more investors want to sell. Investors become desperate for answers, latching on to anyone who can alleviate the misery they are feeling.
“Nothing gives one person so much advantage over another as to remain always cool and unruffled, under all circumstances.” -Thomas Jefferson
Making thoughtful decisions and acting rationally during chaotic environments are the moments that separate successful investors from everyone else. Poor decision making in these environments can impact long-term performance more than any other decision an investor makes. Markets have always recovered, meaning they tend to do much better after bad periods. One-year returns following market bottoms range from 23.2% to 59%, with a median of 38%. Investors who panic in the moment may miss out on the best opportunity to get back what was lost.
The challenge with living in America and comparing ourselves to the S&P 500 is that we run the risk of chasing recent returns and dialing back portfolio diversification just before markets turn. Then when markets turn, our regret is compounded by the fact that we are far more aggressive than we intended to be, and we’re likely to dial back that risk in the midst of chaos.
For all of our clients, our objective is to accumulate adequate assets and, at some point, meet spending requirements while still keeping strategic portfolio exposures (which are based on the long-term investment objective) near their targets in any environment. Being diversified means owning some assets that will lag while others lead and will inevitably underperform some concentrated portfolios over shorter windows, but it will provide a much smoother ride and superior returns over the long term. Investors may not like being diversified now, but in the midst of a bear market is the worst time to try and get more diversified.
As stated, we have no idea when the next bear market will occur. Even with more signs of weakness in the economy, U.S. equity market downturns and economic recessions do not always overlap. Our job is not to predict, but to protect. While we’ve built portfolios and planned for the next downturn, we also have a plan for when it occurs. In the moment when stocks are struggling, valuations are attractive, and volatility is high, we want to approach clients with a plan to buy, not sell. Investors who remain cool and unruffled in the tough times will reap great rewards by rebalancing into cheap assets and selling off expensive ones. There will be a time to buy more U.S. equity, but it is not in the 7th, 8th, or 9th inning. As we all wait together for the opportunity to present itself, we will continue to educate about why we are allocated the way we are, and keep the long-term objective as our focus throughout all market environments.