September 2020: The Importance of Sticking With It

MODERNIST’S ASSET CLASS INVESTING PORTFOLIOS ARE STRATEGICALLY INVESTED WITH A FOCUS ON LONG-TERM PERFORMANCE OBJECTIVES. PORTFOLIO ALLOCATIONS AND INVESTMENTS ARE NOT ADJUSTED IN RESPONSE TO MARKET NEWS OR ECONOMIC EVENTS; HOWEVER, OUR INVESTMENT COMMITTEE EVALUATES AND REPORTS ON MARKET AND ECONOMIC CONDITIONS TO PROVIDE OUR INVESTORS WITH PERSPECTIVE AND TO PUT PORTFOLIO PERFORMANCE IN PROPER CONTEXT.

Autumn is a time of harvest, which is why we schedule time with clients for their Financial Plan Update meeting, to better understand the ways their portfolio is driving the success of their goals and whether any adjustments need to be made.

When looking at market performance in recent years, U.S. stocks have outperformed international stocks and growth stocks have outperformed value stocks. This has led many to question the benefits of diversification and to ask what they should do when an investment strategy performs poorly compared to what they’re hearing on the news.

In this letter, we dig into how can develop an investing mindset that helps us remain disciplined in the face of short-term concerns about performance. We’ll begin by choosing the appropriate lens to use when considering investment strategy performance. Then we’ll address several biases that fog our lens and make it hard to stay the course of our investment strategy.

Our investment strategy is grounded in three key principles.

First, we believe markets are highly efficient pricing mechanisms. This leads us to conclude that active management is a loser’s game.

Second, because we believe markets are highly efficient, it follows that all unique sources of risk (asset classes) have similar risk-adjusted returns; not similar returns, but similar risk-adjusted returns.

Third, because all unique sources of risk have similar risk-adjusted returns, we also believe portfolios should be diversified across many unique, or independent, sources of risk and return. Moreover, the premiums associated with these unique sources of risk and return should be: persistent, pervasive, robust, implementable, and have intuitive (risk-or behavioral-based) explanations. In other words, we want to see the evidence that this risk-adjusted diversification has produced strong returns over very long periods of time. No gambling here, friends.

These three principles form the foundation of an investment process that culminates in a portfolio fine-tuned to provide the greatest probability of achieving your life and financial goals.

Having a process in place, however, is the easy part.

Sticking to it is the real challenge.

As Warren Buffett noted, “Investing is simple, but not easy.” While diversification has been called the “only free lunch in investing,” it doesn’t eliminate the risk of losses. Diversification requires you to accept that parts of your portfolio will behave entirely differently than the portfolio itself. And your portfolio may underperform a broad index like the S&P 500 for a long time, in large part because the portfolio is far more broadly diversified.

The result is that diversification is HARD. And, because misery loves company, when the media reports on the market daily, losing unconventionally (because your portfolio doesn’t look like the S&P 500) is harder than losing conventionally. In addition, living through difficult markets is harder than observing them historically – another reason it’s so hard to be a successful investor!

Which leads us into how we’re wired to react when times get tough
aka behavioral bias

Hindsight bias, or the tendency after an outcome is known to see that outcome as virtually inevitable moving forward, contributes to the mistake of resulting, the belief that you can predict an outcome based on the past.

To avoid this mistake, John Stepek, author of “The Sceptical Investor,” advised:

You must accept that you can neither know the future, nor control it. Thus, the key to investing well is to make good decisions in the face of uncertainty, based on a strong understanding of your goals and a strong understanding of the tools available to help you achieve those goals. A single good decision can lead to a bad outcome. And a single bad decision may lead to a good outcome. But the making of many good decisions, over time, should compound into a better outcome than making a series of bad decisions. Making good decisions is mostly about putting distance between your gut and your investment choices.”

The bottom line is that because we live in a world of uncertainty where at best we can only estimate the odds of investment outcomes, the quality of a strategy should be judged before, not after, the outcome is known. Otherwise, you risk the mistake of confusing strategy with outcome.

Next up, recency bias, in which recent observations have a larger impact on our memory and, thus, our perception of what will happen next. It leads investors to focus on the most recent returns and project them into the future. This can result in buying what has recently done well (at high prices, when expected returns are lower) and selling what has recently done poorly (at low prices, when expected returns are higher).

Buying high and selling low does NOT lead to investment success. Yet the research shows that this is exactly what many investors do, presumably because of recency bias.

While achieving diversification is simple, living with it is hard.

Warren Buffett believes that emotional temperament, a source of the discipline needed to adhere to a well-considered plan, is more important than intelligence when it comes to investing.

Knowing your tolerance for discomfiting news that the S&P 500 is up, but your portfolio is down (known as tracking-variance risk) and then investing accordingly, will help keep you disciplined. Yet, taking more of this type of risk than you can stomach could lead to failing decisions like selling when financial news is bad, or buying when the financial news is good.

If you have the discipline to stick with a globally diversified, evidence-based asset class strategy, you are likely to be rewarded for it.

We hope this serves as helpful insight as we all head into the next financial news cycle,

Georgia + Team Modernist