Predictions, Predictions, Predictions: Process Wins Over Prognostication
By Steven Karsh, MBA
If you had a crystal ball what would it tell you? People love making predictions, whether it’s sports (who will win the championship in football, baseball, basketball, hockey, golf, tennis, etc.), finance (will the markets be up or down, will interest rates rise or fall) or elections. Making predictions is fun, but how often are you right? How many pundits predicted Donald Trump to win the 2016 election or at the beginning of 2020 forecasted one of the steepest and shortest bear markets in US history? Do you have a crystal ball that consistently gives you the answers you are looking for?
As investment advisors, we get asked the “crystal ball” finance question quite frequently. Many advisors consider numerous factors (consumer confidence, unemployment, GDP growth, inflation, wages, etc.), make short term predictions, and act on those predictions, but are often wrong. Requests to make investment predictions frequently
Asset Class Returns by Calendar Year
Source: Barclays, Bloomberg, FactSet, MSCI, NAREIT, Russell, Standard & Poor’s, J.P. Morgan Asset Management. (1)
occur when there is a lot of volatility in the markets (up or down), as well as during election years. This year has been no exception with the COVID-19 pandemic, a presidential election, and social equality issues all influencing the current investment environment. One of the most common questions in 2020 has been, “What should I do with my money depending on who wins the election?”
The following chart (right) illustrates why we think no matter the circumstances driving the markets, make a long-term plan, know your tolerance for risk, periodically rebalance your portfolio and most importantly stick to the plan. Consistently predicting which investments will be the best from year to year or when to get out of the market and jump back in is impossible.
The white “Asset Allocation” box in the graphic shows how a diversified portfolio (with an allocation to each of the asset classes) results in more consistent returns with below- average risk.
Return Chasing Does Not Work
Many investors like to pile into what has generated the strongest investment returns, expecting the trend to continue. However, the information below shows how investing in what did best has resulted in very sub-par performance compared to being diversified across all asset classes from year to year.
The table below compares a typical “Return Chaser,” who invested 100% of their assets each year in the asset class that did best the previous year and repeated annually for 14 years. In comparison, the “Diversified Investor” each year allocated assets across all nine asset classes listed in the above chart.
For the 14-year period ending in 2019, the patient Diversified Investor earned almost three times as much money as the Return Chaser. Even more important, the Return Chaser lost money over the 14-year period. It is also important to note that the Diversified Investor rebalanced the portfolio back to the target allocation at the beginning of each year. Systematic rebalancing has been shown to result in better performance over time so the investor isn’t underweight to those asset classes that recover after a downturn (like equities in Q1-2020) or overweight to asset classes that have outperformed and tend to revert back to long term averages. Rebalancing also allows investors to bank gains and redeploy them into other asset classes and opportunities.
Not only do Return Chasers typically underperform, but so do classic Market Timers. The chart below compares starting with $10,000 and staying fully invested in the S&P 500 for 30 years, versus missing the best 10, 20 and 30 days. There was a stark difference in returns over the past 30 years.
Staying Invested
When markets decline it is easy to get spooked and want to pull all your money out of the market. An investor starting 2020 with a 60% stock/40% bond portfolio who pulled all their
money out during the pandemic would have locked in a 19.4% loss if they had liquidated their portfolio on March 23, 2020, the day the stock market hit its low for the year. Had that investor remained patient and stayed fully invested, they would have recovered all they lost and would have been up 6.1% (assumes no rebalancing back to target 60/40 allocation) for the year through September 30, 2020.
The chart below separates bull and bear markets since 1950. If you remain invested and stick to your long- term plan, chances are you will be much better off than trying to time the market. Over the last 70 years bull markets have lasted much longer than bear markets. Patient and process-focused investors were rewarded.
Politics and Markets
When it comes to politics and elections, there are an abundance of predictions as to how markets may react with divided government (i.e., President from one party and congress split) or with one party in power (i.e., same party has the Presidency and both houses of Congress). As the chart below indicates, making a prediction on how markets will perform is an exercise in futility. In the long term, there has not been a meaningful difference in stock returns based on this metric.
Many other factors have a more direct impact on long-term equity returns, including equity valuations, Fed policy, interest rates, consumer spending, and economic conditions. All of these issues need to be considered, with none of them viewed in isolation. The article began with the question, “If you had a crystal ball what would it tell you?” For all the prognosticators expecting accurate statements about the financial markets from their crystal balls, the simple answer is: