If history has taught us anything, it is that markets are cyclical. They rise and they fall, and just when investors convince themselves that something has changed, the pattern continues. Investors who understand this about the markets possess a distinct advantage.
A prolonged bull markets for stocks. A new political administration. An uncertain future.
It is easy for investors to convince themselves that we have entered a new era of investing, that this time it’s different. But there is a good reason those ha ve been called “the four most dangerous words in investing.”
This time it's different. The four most dangerous words in investing"
-Sir John Templeton
If history has taught us anything, it is that markets are cyclical. They rise and they fall, and just when investors convince themselves that something has changed, the pattern continues.
Investors who can place what is happening right now within the greater context of history possess a distinct advantage. Not only can they look past the flawed notion that today’s environment is somehow unique, but they can use the cyclical nature of the markets to create consistent success within their investment portfolios.
It is a frequent mantra in all aspects of life, from science to politics, sports to, yes, investing. Thinking that current times are different arises from many things, including both objective analysis and people’s flawed biases.
The current financial markets have many investors feeling that we may be entering a new, never-before-seen type of investment environment. There are aspects of today’s environment driving investors to that seemingly logical conclusion, including:
The S&P 500 Index has generated positive returns for eight straight years, and a 192% total return since the end of the financial crisis.1
Simultaneously, declining interest rates have fueled a multi-decade run of strong bond performance, with the Bloomberg Barclays U.S. Aggregate Bond Index delivering positive returns in all but two of the last 20 years.
Source: Barclays. Past performance is no guarantee of future results.
Such sustained strong performance across both stocks and bonds is a situation that many investors simply have not experienced or cannot remember.
Investors trying to make sense of the current environment have a lot to process. Among the many important changes taking place are:
These developments are fostering somewhat optimistic but diverse sentiment among investors. A recent AMG Funds survey of U.S. high net worth investors revealed that 58% believe the U.S. economy will improve over the next year.2 And when it comes to the stock market, nearly half of Americans remain bullish while the remainder are split between neutral and bearish perspectives.
Source: American Association of Individual Investors (AAII) Sentiment Survey, as of Jan 4, 2017
Not only are the outlooks among investors varied, so too are their priorities. When asked to identify their most important investment goal moving forward, high net worth investors are decidedly fractured.
Source: AMG Funds Wealth Management Trends in America survey, January 2017.
The combination of a dynamic investment environment, differing sentiment and disparate goals can lead many investors to perceive today’s environment as unique. Is that perception reality?
In a word, NO. There’s a reason “this time it’s different” has been called “the four most dangerous words in investing.” 3
While recent market dynamics and short-term uncertainty makes the perception of a new, never-before-seen investment environment appear rational, taking a step back enables a better view of the big picture. In considering their long-term investing futures, investors must consider two factors:
People are subject to more than 70 different cognitive biases,4 the many systematic patterns in human thought processes that lead to poor conclusions or bad judgment. Many of these biases apply directly to investors’ perceptions of the markets and subsequent behavior. One in particular is important to consider: recency bias.
Recency bias reflects the human tendency to overweight recent information relative to what has happened over the longer term. One manifestation of this bias lies in the “gambler’s fallacy”: 5
Think of the gambler who doubles her bet at the blackjack table because she's won her past couple of hands—her odds haven't changed any, but her perception of them has."
Recency bias affects investor perception as well, with the dot-com bubble of the early 2000s among the most famous examples. On January 6, 2000, 75% of investors were bullish about the future of the stock market, an all-time high.6 A multi-year run-up in stocks led investors to be very optimistic about their investment futures, only to see:
The idea among some investors that today’s markets represent an unprecedented environment is in part influenced by similarly flawed thinking. Investors possess fresher memories and recall more details of the recent past, which may lead them astray. This makes it critical for investors to have a good understanding of the second factor.
A well-established maxim in investing is that markets are cyclical. They rise, they fall, and the pattern continues to repeat.
For example, there have been eight occasions where the S&P 500 Index has fallen by more than 20% since 1926. 8 A decline of this magnitude is referred to as a "bear" market. In every case, the market then proceeded to rise, with an average gain of 496% over the subsequent 9+ years.9
The reality of long-term cyclicality, paired with the potential flaws in the way people digest information, not only challenges the notion that today’s markets are different, but actually provides investors with a powerful tool to seek success in the future.
In summation, while markets have been and will remain cyclical, investors’ success does not need to be.
Source: Dow Jones. As of December 31, 2016. Past performance is no guarantee of future results.
Maximizing long-term results amid market cycles requires investors to recognize two fundamental realities when it comes to building and managing portfolios. These can be viewed as a sequence, with one directly informing the next:
More importantly, these truths help ground investors’ thinking and successfully manage for the long term.
Since 1980, the S&P 500 Index has provided an average annual return of just under 10%. 10 While this is helpful to know, it is just as important to realize that stocks infrequently deliver an “average” year. Instead, since 1980 the S&P 500 Index has provided an annual return within five percentage points of the average—that is, a 5-15% return—less than 30% of the time. In fact, the Index has only come close to it's long-term average return of 9.8% once since 1980 and that was this year. It returned 9.5% in 2016.
The rarity of average results over shorter timeframes is critical knowledge that aids investors in developing an appropriate mindset and expectations for their portfolios.
If markets were consistently average, investors’ portfolio allocations would remain intact. However, bull or bear markets in a given asset class can result in investors being over- or under-allocated in that asset class. In other words, varying returns cause portfolios to drift over time.
To use an extreme example, consider the long-term ramifications for a traditional 60/40 portfolio (60% stocks, 40% bonds) that is left to drift with the markets from 1976 through the end of 2016. As the chart on the next page illustrates, the investor is left with a portfolio that is:
Over shorter timeframes investors can see similar, though less severe, allocation drift and elevated risk. These unintended results directly reinforce the simple idea that investors must keep a watchful eye on their portfolios. This does not mean an endless stream of short-term adjustments but a periodic assessment of two straightforward questions:
Revisiting these questions on an ongoing basis enables investors to take stock of their portfolios. Having done so, the final step is to take the current investment environment into consideration.
The relative performance of various investments in recent years is likely to have driven changes within many investor portfolios. In order to limit undesirable results moving forward, consider three key issues.
Investors whose portfolios fall short on any one of these three issues need to consider how to best adjust their portfolios for the next market cycle.
So where does all of this leave investors? It boils down to:
1 Applies to return since market bottom on March 9, 2009. Source: Factset, Standard and Poor's, MSCI
2 AMG Funds Wealth Management Trends in America, January 2017
3 Sir John Templeton
4 Source: Grunbeck, Jochen. “71 Essential Cognitive Biases for Optimising Your Conversion Rate.” Scenario. GetScenario.com. Sept 7, 2016
5 Source: Silver, Nate. “Nate Silver’s Theory on ‘Recency Bias’.” Esquire. Esquire.com. Feb 9, 2009
6 Source: American Association of Individual Investors (AAII) Sentiment Survey, as of Jan 4, 2017
7 Source: Factset, Dow Jones, NASDAQ.
8 Source: First Trust Portfolios L.P. “History of U.S. Bull & Bear Markets Since 1926.”
10 Source: “S&P 500 Historical Annual Returns.” Macrotrends LLC.
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