The keys to maximizing the probability of successful investor outcomes are maintaining simplicity and focusing on efficiency. Investors are conditioned to hunt or search for opportunity. The search for opportunity is almost always complex. Complexity leads to greater infrastructure which leads to greater fees. Simplicity is boring and does not always garner the attention that it should. Simple portfolios are easier to understand and also easier to re-balance. It's easier for investors to hold things that they understand and proper re-balancing may potentially increase returns and reduce risk over time.
Regardless of philosophy, a key to any investment methodology is discipline. Taking a step back periodically and looking at things with a long-term perspective makes staying disciplined easier.
While it may be natural to draw predictive conclusions by looking for patterns in the charts shared in this piece I’d caution this sort of thinking as the market rarely repeats itself. Making switching decisions is difficult enough with a large specialized investment team and enormous amounts of data and computing power.
The following two graphs are of the S&P 500 index. The first one highlights inflection points and the second provides a 25-year average for a variety of valuation metrics. I’d offer the following key take-aways:
1) P/E, a measure of valuation is not significantly higher than at the first two low inflection points in December of 1996 and October of 2002.
2) Valuation hasn’t been all that useful as a predictor of the direction of the market.
3) The S&P 500 Forward P/E of 16.1 equals its 25-year average, which perhaps makes it difficult to argue that the market is overvalued.
The next chart shows annual returns for each year and includes intra-year declines. This chart provides perspective on the ups and downs investor must endure in order to capture market returns without timing or switching.
The next chart shows the S&P Composite index in Log Scale. Log scale is a nonlinear scale. In looking at the markets return over a very long period of time the impact of compounding makes early periods look insignificant. A log scale normalizes compounding making each period equally prominent visually. I’d offer the following take-away from the graph:
1) The recent period of strong equity performance is significantly shorter than the prior two periods from the early 50’s through late 60’s and early 80’s through late 90’s. While I don’t think this suggests anything it at least shows that the market could continue to go up for quite a while.
The next chart shows the yield curve (an illustration of several yields or interest rates across different maturity lengths). I’d offer the following to take-away in regards to high quality fixed income yields.
1) Over the last 5-years the curve has flattened significantly. Investors aren’t receiving significant yield premiums for taking on greater maturity risks.
2) Even though the Federal Reserve has increased short-term rates we haven’t seen 10-year and 30-year rates rise. The fact that they have fallen highlights the inability for the Federal Reserve’s actions to influence the direction of intermediate and longer dated fixed income securities.
The next chart looks at rolling period returns of 1, 5,10 and 20 years looking back over 67 years. The narrowing dispersion highlights the importance of thinking about equity investments in 10+ year time periods. Looking at them in 1 and 5 year periods could increase an investor’s propensity to switch to other assets that have not shown the same long-term potential for return historically such as cash or bonds.
In the bottom portion of the next chart it shows 20-year annualized returns by asset class and includes a Dalbar estimated average investor performance for that period of time. I believe the average investor does not achieve market returns for physiological reasons. It feels more comfortable to buy when something goes up and it’s scary not to sell after something goes down. These tendencies lead to switching decisions that nearly eliminate the return over time for the average investor.
The key to success is creating a customized investment plan that each investor can stick with and implement it in an unwavering disciplined way. The goal of sharing this information was to provide a framework for discussion to help investors look past the short-term volatility and noise that global financial markets inherently contain.
Disclaimers and Disclosures:
A copy of our Form ADV Part II is available upon request.
This material is provided for educational purposes only and contains the current opinions of the authors (as of the date appearing on this material), which may change without notice. This material includes information drawn from third-party sources believed reliable but not independently verified or guaranteed by WealthFactor. We do not represent that it is accurate or complete, and it should not be relied on as such.
This material does not constitute investment advice or contain investment recommendations, which would need to take into account a client’s particular investment objectives, financial circumstances and needs. Investments and strategies discussed herein may not be suitable for all readers, and you should consult with an investment, legal, tax, and/or accounting professional before acting upon any information or analysis contained herein.
This material does not constitute an offer to buy or sell any security or to participate in any investment strategy, and may contain statements based on forward-looking asset class return, risk, correlation, tax and other modeling assumptions. Forward-looking statements expressed herein are subject to may risks and uncertainties related to the underlying assumptions and modeling processes. Actual portfolio results may vary materially from hypothetical results expressed herein due to market, data, modeling and other risks. Past performance does not guarantee future results.