The AtwoB Report - 4th Quarter 2018
The World Got Better in 2018. Why Doesn’t It Feel Like It?
The world got better in 2018. And we don’t feel like we’re going out on a limb by saying so. That’s because the world typically does get inexorably better each year, without us taking much notice. We bring this up not merely to be “glass half full”, but because it’s generally true and may have implications for long-term investors. Poverty continued to decline worldwide, along with illiteracy, disease and deadly violence. More of the energy we produce is coming from renewable sources and should continue to climb. Life expectancy has gone up. Peruse Our World in Data, a great website to help visualize the progress humans have made over time, along with some great books like Hans Rosling’s, “Factfulness: Ten Reason’s We’re Wrong About the World – and Why Things Are Better Than You Think”, and it becomes hard to argue that the world is not objectively improving. As a long-term investor, this gradual march of human progress is a bedrock principle to keep in mind.
We know what you’re thinking though. If the world is getting better, why doesn’t it feel like it? Objectively, things are steadily and gradually improving. But subjectively, we have a hard time believing it. Here’s a great example from Factfulness:
Rosling asked 1,005 Americans the following – “Has the percentage of the world’s population that lives in extreme poverty almost doubled, almost halved, or stayed the same over the past 20-years?” The answer – extreme poverty has been cut in half. How many got the answer correct? Only 5%! Rosling notes that a Chimpanzee selecting at random would have done much better. There are many other questions he asked just like this, with similar results. Our perception of the world around us can be shockingly off as compared to reality.
The potential reasons for this disconnect are varied. The most compelling of the reasons is that good news doesn’t “sell” like bad news, because it is gradual and not sudden. A story about the steady decline in violent crime is less likely to get read than a rare act of random violence. As Rosling states, “In the media the ‘newsworthy’ events exaggerate the unusual and put the focus on swift changes.” To be clear, there are many serious problems in the world today, but it can become very easy to become fixated on the problems while ignoring the progress. The contradiction between steady human progress and our ongoing struggle with recognizing, appreciating and taking advantage of it, has implications for our everyday lives, and specifically for investing.
Why does investing generally work over time? Human Progress
To answer this question succinctly, see above. In general, investing works over time precisely because the human race has been remarkably adept at making progress throughout recent history. As investors, we strive to participate in that progress and growth via our ownership stakes in companies (stocks) and/or loans we make to entities (bonds). When humans make progress, economies grow and companies make profits, which are then passed along to investors in the form of dividends, price appreciation or interest paid on loans. We believe, these are tenets that allow us to compound positive rates of return on our money over the long-term. In general, the long-term rates of returns for investments like stocks and bonds are positive over most every 10, 20, and 30-year rolling period going back a hundred years or so. We believe, if you start investing, and remain invested for an adequate period (10+ years), and adhere to some basics long term tenants that we discuss below, you stand a very high likelihood of making money. In our view, the persistence in human progress and ingenuity helps lead to the persistence in long-term, positive financial compounding over time.
Why doesn’t investing work all of the time? (Mis)Perception and The Human Psychological Pendulum
Over shorter periods of time, however, investments can lose (or make) money in substantial amounts. We think these more extreme periods are due to both the nature of cycles and our perception of risk, which as we’ve seen, can often be highly exaggerated or just plain wrong. While stocks, measured by the S&P 500 TR over 30 years, have delivered an average annual return of around 10% in the long run, it almost never lands around 10% from year to year. Instead, returns are generally well above or below the average.
The economic, profit and credit cycles all have a significant hand in determining how short-term market outcomes can deviate substantially from the long-term market average returns. But, the truth is that economic growth is not terribly volatile. And, while corporate profitability can be more volatile, it still tracks long-term, real economic growth fairly well over long periods. So why does the market fluctuate as much as it does? In our opinion, the most volatile factor impacting returns in the short-term is the swing of the investor’s psychological pendulum. The pendulum swings from fear to greed and back, spending very little time in the “rational” middle. Put simply, the pendulum of human perception in the short-term, deviates from both the level and pace of human progress in the long-term. These deviations can create extremes in the investment cycle, both positive and negative, that often lead investors to buy high and sell low, as opposed to doing the opposite.
In our view how investors handle the swings in pendulum over time is a primary determinant of a successful investment experience. We believe the key is to take the long view while managing the potential impact of the pendulum in the short-term.
Capturing Progress: 6 Ways to Take the Long View While Managing the Short-Term
- Adopt a Financial Planning First Mindset – We believe, the most important strategy is to take a step back and realize why you are investing in the first place. The investment component of your plan may help you to accelerate your financial progress, but is not the end unto itself. You invest for your family, a secure retirement, to have fun, to live the life you enjoy today and want tomorrow. Getting the order right can make a huge difference in your financial effectiveness over time. If you have a good sense that your long-term financial plan is resilient against both average, and more importantly, below average investment scenarios, it becomes much easier to sustain a long-term orientation. Remember, it’s not about short-term investment return, it about your long-term ability to do what you intended.
- Align People with Portfolios – We believe that aligning people with portfolios is paramount to managing short-term investment risk. If you don’t know your threshold for accepting the potential risk of investing, you can leave yourself vulnerable to making poor decisions during difficult periods like we just went through. An accurate assessment of your risk tolerance or “comfort zone”, which should be reassessed from time to time, may help you align your portfolio with your ability to withstand difficult market performance. It’s our view that a diversified portfolio of stocks and bonds that allows you stay invested, even if it has a lower expected return, is often superior to a higher potential returning portfolio that creates a sense of fear and discomfort. From our perspective if you can’t stay invested, you’ll be unlikely to harvest the higher return in the first place. Find the right “comfort zone” for you.
- Diversify Properly – We believe, the process of combining different asset classes into a diverse portfolio, works effectively over time, as it reduces investment risk for a given level of potential return or can increase potential return for a given level of investment risk. It’s often referred to as the only “free lunch” of investing. When attempting to diversify properly, the majority of Bonds should be high quality, so when the risks of stocks flare-up and safety is desired, the bonds in your portfolio should move up in price. Alternative investment strategies, which can generally take advantage of rising or falling market prices, s, should have little correlation to stocks or bonds, along with a positive expected rate of return. We believe, by taking care to ensure that the “non-stock” investments in your portfolio do not behave like stocks, you may potentially improve the balance of your portfolio, smooth out the investment roller coaster ride, and reduce the uncertainty embedded within your financial plan.
- Harvest Asset Class Returns Efficiently and at Low Cost – By harvesting market returns at low cost, we believe your investment results will benefit, particularly on an after-tax basis. We feel, while market/security prices may not always be right at a given time, they are efficient enough to make it very difficult for “active” stock investors to outperform the market with consistency. Over time, index investing, which seeks to capture/mimic overall market returns at a low cost, generally outperforms active management – which seeks to “beat” the market by deviating from the overall market and/or trying to time it. Quite simply, in our opinion, the consistency of capturing returns at minimal cost is an advantage that is difficult for stock pickers and market timers to erode. We believe fees, expenses, transaction costs, and taxes can be controlled by utilizing low-cost index funds and mutual funds.
- Periodically Adjust to Sell High and Buy Low – An effective way to take advantage of long-term progress while smoothing the impact of the swings in the pendulum, is to periodically sell what has done well and buy what hasn’t. Once you’ve established and aligned the proper mix of stocks and bonds with your comfort zone, the simple act of rebalancing back towards your long-term target will instill a discipline of selling at higher prices and buying at lower prices. Too often, the psychology of investors leads them to do the exact opposite. Rebalancing helps to short circuit the natural human greed and fear impulse that leads to chasing positive short-term performance and abandoning the unloved assets in the market. While the pendulum will always swing from one extreme to the other, investors with discipline may mitigate the impact of the swings in the cycle.
- Limit Financial Media Consumption – While knowledge is generally powerful, the short-term “insights” in the financial media and on Wall Street, are for all intents and purpose, useless. Remember, “In the media the ‘newsworthy’ events exaggerate the unusual and put the focus on swift changes.” So more times than not, the media focus du jour will be on the fear and greed extremes of the investing world – which exaggerates the impact of the psychological pendulum. There will be extra scary headlines in bad markets and extra enticing stories about how to make money in good markets. Remember, a short time ago the only thing anyone wanted to talk about was the parabolic ascent in the price of Bitcoin? Yeah, it was down over 70% last year. The purpose is not to help you, it’s to keep your attention. Not a paper would be sold or financial TV show watched if they focused solely on the long-term investment tenets that have worked over time. We feel that’s because they are boring, if not incredibly effective. But always keep in mind that while the financial media has a short-term focus, you are a long-term investor. Acting on impulses created by regular financial media consumption is rarely a profitable strategy for your long-term financial plan.
The Key Takeaway
The world continues to get better as human progress continues its inexorable march forward. We should not expect that humans will stop making progress any time soon. Human progress leads to economic growth, which leads to corporate profitability, and long-term investors may benefit and participate in this progress by owning stocks and bonds. But the world doesn’t always feel like it is getting better. The recency effect of today’s real problems and the 24/7 news cycle coverage of the world can lead us to perceive progress in a very different way than objective reality dictates. As a result, it can become very easy to become fixated on the problems while ignoring the progress.
We believe, long-term investors have a high probability of earning positive rewards for funding human progress and growth, if they can withstand the swings in the economic, profit, credit and human psychology cycles that create an ongoing pendulum of fear and greed. The key for investors is to take the long view on human progress, while managing the potential impact of the psychological pendulum in the short-term. We believe a successful investment experience emphasizes a planning first mindset, the alignment of people and the proper portfolio mix, thoughtful diversification, low-cost return harvesting, periodic rebalancing and reducing financial media consumption.
In this context, we’d be remiss if we didn’t mention the recent passing of John Bogle, the founder of investment the behemoth, Vanguard. By creating the index fund and advocating for lower costs in the investment industry, he may be one of the most impactful persons the investing world has ever known. More than almost anybody, he was acutely aware that by participating in human progress in a disciplined low-cost manner, the average investor could achieve positive financial outcomes on par, if not better, than Wall Streets feted “experts”. To capture the investment returns on progress most easily, his advice for investors was simple, “Don’t just do something, stand there”. For investors, the swings in the pendulum have proven to make that advice much harder than it sounds. Our mission is to make that easier for you and your family so that you can realize the promise of your financial plan. Thank you for placing your trust in us and we look forward to your continued progress in the years to come.
If you have any questions regarding this report, please contact us at firstname.lastname@example.org or 914.302.3233
Point B Planning, LLC d/b/a AtwoB | 23 Parkway, 2nd Floor Katonah, NY 10536 | www.today2b.com
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