In early January of 2018, the financial media watched in awe as the Dow Jones Industrial Average broke 25,000. This event made national headlines. The stock market defied skeptics, continuing its long run higher and rewarding investors with a gain of over 50% in just the prior two years. Yet, the most amazing thing during this period was the S&P 500 producing positive results 14 months in a row. This occurred with such an extremely low level of volatility that it was nearly unprecedented.
Following these strong gains and with the return of volatility, you might be wondering if this is the time to change your investment strategy. None of us want to miss out on the opportunity for attractive rates of return. But there is a nagging feeling that the market can't continue to rise like it has. Even stronger is the fear that that the market may drop again and give back its recent gains.
Before you make any decisions about how to respond to this extended period of market growth, I'd like to provide some perspectives that have served our clients well for decades.
What Goes Up, Must Come Down… Then Probably Go Up Again
For the record, I want to make it clear that I do not have a crystal ball and cannot predict the future. I cannot say with certainty what the markets will do over the next 12 hours or 12 months, let alone the next 12 years - nobody can. But I do believe that investors can look through the lens of history at the performance of the markets and make some reasonable projections of what might happen in the future.
The continued rise in stock prices we’ve witnessed for the last couple of years has been much stronger and lasted longer than most expected. We also have gotten used to extremely low levels of volatility. From a historical perspective, we know that the recurring up and down cycles for the stock market usually include 3-5% declines several times each year. On average, once each year, the market will be down 10 to 15%.
These trading patterns are usually a result of investors’ perceptions. Emotions turn from positive to negative, usually without any change in the fundamentals. This is in sharp contrast to a bear market, in which stock prices don’t bounce back and may extend the losses to 20% to 30% or more. These downturns used to occur every four years or so and were usually related to an economic downturn. More recently, the cycles have lasted longer, but the extent of the losses has been just as painful.
So what do we make of the ups and downs? They are normal. Throughout history, stock prices have risen approximately two-thirds of the time and one-third of the time they have gone down. Would it be possible for the market to again rise 14 months in a row? Seems unlikely, but you never know what the next move will be.
I’m convinced that trying to predict the future is neither advisable nor effective. Why? Because none of us can control the future trends of the market. Instead, my counsel is that you focus on those things you can control. That puts you in the most likely position to actually achieve your goals.
How I Make Decisions
My role, as the Chief Investment Officer at Whitnell, is to lead the investment committee, to develop investment frameworks and policies and to provide well-researched investment options for our clients. So how do we go about deciding what to do? There is no substitute to doing the hard work guided by a disciplined process as we evaluate hundreds of different strategies each year.
First, consider the investment objectives. We ask ourselves - what are we trying to accomplish? I think about and try to identify a set of investment options that are most likely to have the characteristics to meet the needs for income, liquidity and long-term growth. If portfolios are properly diversified and designed to meet the long-term objectives, we don’t have to worry about trying to guess the short-term trends in the market.
Second, carefully analyze the risks in each investment and evaluate its appropriateness. We ask ourselves - what risks are we willing to take and what risks do we need to take to accomplish our objectives? A key tenet of investing is to not take unnecessary risks. Finding the right balance of risk-taking can be challenging, but this is necessary to achieving long-term financial success. The biggest mistake I see investors make is that they don’t want to take on the risks that they should. This is usually a result of focusing on the short-term trends in the market.
Third, it’s essential to do the research. The bottom-up research we do analyzes the fundamentals of each investment, evaluating the riskiness and potential returns. This takes time and effort, but I believe it is necessary to give us the confidence to stick with an investment even in times of market turbulence. We also do consider the trends in macro-economic conditions, like interest rates, wider market indicators and external factors as they might impact each of our investments.
Fourth, don’t make decisions based on feelings. The data is the data. But information overload can be a problem in the investment world. Our natural tendency is to focus on those things that agree with and support how we feel. Therefore, it is important to spend time digging into the details of each investment and to always be looking for information that might lead us to a contrary opinion. Regardless of how we feel, we need to remind ourselves that we don’t know what will happen.
How Do These Principles Work In The Real World?
Sometimes these principles don’t feel right and at times they may not seem to be working. In fact, most successful investments go through periods of time where it does not look like they will achieve the results that we expect. Yet, the long-term success of the best managers is almost always tied to their fortitude and willingness to stick to their strategy for the long haul.
For instance, in the late 1990s, I avoided most “.com” stocks, especially those that weren’t profitable. The pressure to buy them was intense. It seemed as though everyone else owned them and the market continued higher, boosting the prices of these stocks. But my value disciplines kept me away.
For the most part, the stocks I owned in 1999 did have attractive investment characteristics. But they didn’t keep up with the high-flying tech, telecom and media stocks during the last days of the bull market. Over the years that followed, value-oriented strategies performed well while many of those high-flying internet stocks fell and never recovered.
So back to our question on what do we do now? The performance of growth stocks has far exceeded value stocks in the past year and low-quality stocks did much better that high-quality. However, we know that any trend doesn’t go on forever; they go in cycles and the timing of when any particular cycle begins and ends is usually unpredictable. We believe a sound strategy has to work over the course of a full market cycle.
Most of us judge decisions and decision-making based on the immediate outcome. If we get a great result, we feel like we made a great decision. If we get a poor result, we feel like we made a poor decision. This might not be the case. Sometimes we just got lucky that things turned out well. But depending on luck is not a good long-term plan.
Here is what I’ve come to believe after being an investment professional and advisor for many decades. A sound process of making decisions is always advised. Putting things in the proper framework does not necessarily mean you’ll get a good outcome every time. But sound decision-making is something that you actually can control among a universe of variables you cannot control.
What Should You Do When The Markets Go Up?
Stick with quality.
Lower quality investments tend to do best early in a cycle, but then may have a bigger downside when conditions change. Also, generally time is on your side when you buy quality investments and you can often stay with them through the whole cycle. To be successful in lower quality investments, you may have to have more of a trading mentality to buy and sell at the right time. A high-quality investment program helps you keep a long-term perspective.
Don’t fall into the trap of taking on more risk as the market rises or becoming more and more risk averse after the market falls. Practice a value orientation. Don’t pay too much for an investment. It is natural for our confidence to rise when things happen as we expected. Remember, we still don’t know what comes next.
We don’t buy everything, but we also know we can’t predict the future. We believe all of our investments will be successful, but the future is still uncertain. So diversification is essential.
Do your homework.
Make sure you understand, as best you can, all of your investment choices. It works much better to stay invested in a diversified portfolio of investments you chose (or are chosen for you by an investment advisor), rather than trying to move in and out of the market.
Practice a long-term horizon. Don’t get nervous when the markets take a dip or fear you’ve missed out if you are still waiting to put some cash reserves into the market. Price will usually follow fundamentals over time and the fundamental outlook looks good today.
Investing takes a lot of time, energy and discipline. Most of our clients want their wealth to grow, but they prefer to spend their time and energy focused on other things, like their careers, businesses, families and charitable organizations for which they feel a strong sense of commitment.
I think it’s important to remember that the goal is not to beat the market or the person next to you. Your goal is to construct a portfolio that achieves your long-term financial objectives and allows you to live the life of your dreams. If you feel like your investment strategy could use a tune-up and fresh perspective, let’s have a conversation.
© 2018 Whitnell & Co. The information contained in this article is provided for informational purposes only.