“The subjective experience of traders is that they are making sensible educated guesses in a situation of great uncertainty. In highly efficient markets, however, educated guesses are no more accurate than blind guesses.”
Daniel Kahneman, Nobel Prize Winner, Economics
Author, Thinking Fast and Slow
“A big adverse surprise – like the election of Donald Trump in the US – would likely cause the stock market to crash and plunge the world into recession.”
Simon Johnson, Professor of Economics, MIT, October 2016
“Clients just want a smoother ride here,” said Robert Williams, a managing director at Sage Advisory Services. Mr. Williams said the firm has been reducing exposure to the U.S. stock market broadly and high-yield debt and instead is planning on buying this month the iShares 3-7 Year Treasury Bond exchange-traded fund, which tracks U.S. government debt that matures within that time period.
Robert Williams, Sage Advisory Services
Wall Street Journal, Feb 10, 2016, page C.4.
Market Overview
Well, it was a pretty interesting year in the market. After the first six weeks of 2016, the phone started to ring with some “short term” concerns. Since my clients are all rational long term investors, I knew they were not really nervous:) Below are returns for the indices and periods we track for the newsletter.
| Data Series % USD | Qtr | 1 Yr | 3 Yrs | 5 Yrs | 10 Yrs |
| S&P 500 | 3.82 | 11.96 | 8.87 | 14.66 | 6.95 |
| Russell 2000 | 8.83 | 21.31 | 6.74 | 14.46 | 7.07 |
| Russell 2000 Value | 14.07 | 31.74 | 8.31 | 15.07 | 6.26 |
| MSCI World ex USA | -0.36 | 2.75 | -1.59 | 6.07 | 0.86 |
| MSCI World ex USA Small Cap | -2.74 | 4.32 | 1.36 | 8.96 | 2.69 |
| MSCI Emerging Markets | -4.16 | 11.19 | -2.55 | 1.28 | 1.84 |
| Bloomberg Barclays Treasury Bond 1-5 Years | -1.18 | 1.02 | 1.04 | 0.77 | 2.77 |
| BofA Merrill Lynch 1-Year US Treasury Note | 0.05 | 0.76 | 0.36 | 0.32 | 1.43 |
Here are 2 good visual snapshots of global markets for 2016 and the 4th quarter.
Looking at broad market indices, the US outperformed both non-US developed and emerging markets during the quarter. The value effect was positive in the US, non-US, and emerging markets. Small caps outperformed large caps in the US and underperformed in emerging markets.
Interest rates rose in the fourth quarter. The yield on the 5-year Treasury note was up 79 basis points (bps) to 1.93%. The 10-year T-note yield climbed 85 bps to 2.45%. The 30-year Treasury bond yield added 74 bps to close at 3.06%. Consequently, longer duration bonds underperformed shorter duration issuances for the quarter.
What is important to reinforce is the unpredictability of markets in the short term. As you can see from the 2d and 3d quotes at the very beginning of the newsletter, prediction of market performance is really a fool’s game, and one who follows such advice should be prepared to be wrong. I am not making any political comments by the above quotes. The point is the experts get both political predictions and market predictions wrong nearly as often as non-experts. (See summary of Professor Phil Tetlock’s research here Everybody’s An Expert). The more complex the system, such as the stock market, the harder it is to predict accurately.
If one is investing, it is better to focus on what the empirical evidence has shown works. A properly diversified passive strategy tilted to factors that matter in the long-term is an investor’s best chance for long-term success. Kahneman is right: “educated guesses are no more accurate than blind guesses.”
Rebalancing
As my clients know, we are not just “buy and hold” investors. We periodically “rebalance” the portfolio to our target allocation, which is determined by financial planning to settle on a proper risk and return allocation for each investor.
Andrew Ang, former professor of finance at Columbia University, has a good description of rebalancing in his book “Asset Management”.
“To maintain a fixed portfolio weight in stocks, an investor must invest counter-cyclically. If equity has done extremely well over the last period, equities now are above target and it is optimal to sell equity. Thus, the investor sells stocks when stocks have done well. Conversely, if equity loses money over the last period relative to other assets, equities have shrunk as a proportion of the total portfolio. The equity proportion is too low relative to optimal, and the investor buys equity.”
This rebalancing is done in a disciplined and process oriented fashion when asset weights/percentages are out of sync with their target. As Professor Ang continues:
“Thus, rebalancing is a type of value investing strategy: long-run investors are at heart value investors. Rebalancing is optimal under independent and identically distributed returns, but it turns out to be advantageous when returns exhibit mean reversion or are predictable. If expected returns vary over time, prices are low because future expected returns are high—as our investor Daniel experienced during the 2008 financial crisis; prices of many risky assets plummeted, but their future expected returns from 2008 onwards were high. Rebalancing buys assets that have declined in price, which have high future expected returns. Conversely, rebalancing sells assets that have risen in price, which have low future expected returns.”
Since we are already big believers in value investing due to long-term evidence, it makes sense to follow Dr. Ang’s advice and to systematically sell high and buy low by rebalancing periodically, which is what I do on behalf on my clients.
“In practice, rebalancing is hard. It involves buying assets that have lost value and selling those that have risen in price. This goes against human nature. Investors tend to be very reluctant to invest in assets that have experienced large losses. Investors are just as reluctant to relinquish positions that have done extremely well. How many investors can buy an asset because it has lost money? How many institutions can take capital away from traders because they have been successful and give it to their colleagues who have underperformed? The natural tendency of investors is to be pro-cyclical, whereas rebalancing is counter-cyclical. Good financial advisors play an important role in counteracting the pro-cyclical tendencies of individual investors. Maymin and Fisher (2011) argue that this is one of the areas where a financial advisor can add most value for a client.” (If you want to read more of Maymin and Fisher, the paper is here. http://bit.ly/2i1DwPv)
I could not agree more.
Goldman Sachs on Diversification
On Monday morning, January 9, 2017, I received a weekly update I get from Goldman Sachs. Although they are more of a proponent of active investing, which I disagree with, they do understand the importance of diversification. Below is the chart they posted showing the unpredictability of outperforming asset classes, with the following caveat:
“The Chart of the Week shows the pronounced outperformance of US large cap equities in recent years. However, history shows that any given asset class may outperform (or underperform) in any given year. For these reasons, we think investors should diversify for 2017 and beyond [my emphasis].”
A few other links of interest
99% of Actively Managed US Funds Underperform
Parents Pass Bad Money Habits to Kids
6 Reasons to Revise Your Estate Plan
If you know anyone that needs help with their planning, wealth management or is not happy with their present adviser, please let me know.
Until next time,
Mike