Our Own Worst Enemy
“All I want to know is where I’m going to die so I’ll never go there.”
– Charlie Munger, Vice Chairman of Berkshire Hathaway
We human beings are a funny race. It’s amazing what all man-kind has accomplished, and yet at the same time, how distinctly flawed (and sometimes reckless) we can be. This is particularly true as it relates to money, which by the way, is the only category of human behavior we may be able to discuss with any bit of authority. And even we, as investment professionals, are not immune to the suboptimal tendencies that humans have with money – frankly, it’s just how people are wired. Nonetheless, being aware of the fact that our emotions can cloud our judgement with money decisions is the first step for preventing it. We truly are our own worst enemies.
This is, of course, not the first time you’ve heard us dip into the realm called “behavioral finance,” but we find this to be such an important topic, particularly as overall anxiety levels continue to creep upwards for anyone with money at risk in the stock market. We get it – trade wars, politics, international conflicts – how could any of these not topple the markets at the drop of the hat? Especially now that we’ve had such a good run for almost 10 years since coming out of the abyss of the Global Financial Crisis. Well, first of all, when have we not had things to worry about? If you look at all the scary events over the last century, we’ve had wars, political assassinations, international crises, recessions, depressions, you name it! And yet, in spite of all that, being in the stock market throughout that period (particularly in the US) resulted in substantial wealth creation. Even over the last 20 years (which includes not just one, but two, severe market pullbacks) the annualized stock market performance was about 7.2%, if you just held on (key=don’t sell at the low).
But it’s hard to forget about those two most recent pullbacks. They were painful. And it affected more than just Wall Street; it seeped into the lives of hardworking folks on Main Street as well. This is where our emotions can play tricks on us – we are falling into the trap of over-emphasizing our most recent experience rather than what the longer-term averages should lead us to believe. We also internalize the pain of those losses much more than the positive feelings we get from having grown our money quite well in stocks despite these tough periods if we managed to white-knuckle it all the way through (technical jargon = “myopic loss aversion”).
Here’s a fun exercise to put this concept into perspective: if you were some incredibly unlucky soul who happened to put all your money into the S&P 500 (the stock market “proxy”) at the peak on October 9th, 2007 and fell asleep from then until September 30th, 2018 (Rip Van Winkle-style), how bad to you think your portfolio would look?
Not bad at all.
The annualized performance (with dividends) would be about 8% for that “ill-timed” mistake. Remember, the average market performance for the last 20 years or so was 7.2%. Yes, there are ups and downs, and wouldn’t it be great if we had the crystal ball to know to go all cash at the peak and put it all back in at the bottom; but alas, that is not a skill we’ve found very many individuals can do consistently (or without a lot of luck involved). And to put it into perspective what 8% per year can do in that approximate 11-year time-frame, a $1,000,000 portfolio would now be worth $2,340,000 (a 134% increase!). This is just a helpful reminder to all of us that while we’re likely correct in assuming that some type of pullback will happen in the future (they always do eventually), as long as we continue to focus on the long-term (i.e. 10, 20, or 30+ years) and hold the appropriate amount of stocks for our risk tolerance and time horizon, then that is a better strategy than trying to “time the market.”
This by no means says that we should take a haphazard approach to investing. As your time horizon for needing the money shortens, the range of potential outcomes widens (meaning, the potential best and worst cases can be more extreme). There is no doubt that the stock market can be quite volatile in the short-term (even random perhaps). So, the key here is, as we have spoken to you before, getting the appropriate asset allocation correct (i.e. mix of stocks, bonds and cash) is the most important thing (in fact 90%+ of your end result is a function of this decision). If you a) don’t have a long enough time horizon to smooth out the peaks and valleys; and/or b) you get a little too sea-sick when you’re riding the waves, then you have no business having a high exposure to stocks. That’s where our boring bonds come in, to provide more stability and predictable income relative to stocks (we mean boring in the best possible way!).
We feel honored to be trusted with your wealth to help you and your families live prosperous lives. As always, we welcome your calls and emails and appreciate the continued confidence you have in NPF.
Norris, Perné & French