On the Merits of Being a Financial Historian

“You can’t predict. You can prepare.” – Howard Marks

I received a decent amount of comments and questions on my recent post on the 60/40 portfolio. Some were constructive, but others missed the point so I thought I would take the time to clarify a few things.

These are my thoughts on using historical data to shape your current and future investment stance based on some of the feedback I received from readers:

(1) One of the most important aspects of being a good investor is becoming a financial historian. You absolutely have to learn about the history of the financial markets if you are ever going to be able to control your emotions and behavior when making decisions about the future.

Of course looking back at historical performance data of any asset allocation strategy has absolutely no bearing whatsoever on future returns.

You cannot make the assumption that future performance will follow the same exact path as past returns.  One of the biggest mistakes investors make is using the recent past to shape their investment stance by chasing past performance.

But this doesn’t mean that we discard historical results altogether just because they can’t be used to make perfect market forecasts.

(2) Although the future will always be different than the past, you can still use history to guide your actions from a probabilistic point of view.

The history of stock and bond returns tells us nothing about the future returns of either asset class, but they are useful as a measure of risk.

We know that the stock market can drop in upwards of 50% in short order while it can rise by the same amount just as fast.  The bond market can also lose money but it generally doesn’t crash like the stock market because bonds produce income on a regular basis and have a much different investment risk profile.

This is why looking back at historical long-term returns is so important. In my 60/40 piece I looked at 15 year returns on the strategy to show how important having long-term focus is for participating in market returns.

The collective engine of innovation has produced dividends, earnings, income payments and growth for many years. When you  compound these factors over time they can yield fantastic wealth-building results.

This is why you need a process that takes into account historical market movements. Preferrably one that doesn’t rely on every past outcome occuring the same way again.

Of course anything can happen on any given day.

But what normally happens based on past situations? How many times has this happened in the past? Could this happen again? What has been the prior range of outcomes and are they possible again?

History provides us the context to be able to think about the probabilities of different scenarios occurring.

(3) Remember that the risk/reward relationship means that by taking more risk you should increase your expected returns.

This says nothing about your actual performance. No asset allocation strategy promises certain returns in the future and many risky asset classes exhibit long stretches of underperformance on both a relative and absolute basis.

There is no be-all-end-all, permanent, all-weather, stock-like-returns-with-bond-like-volatility investment strategy. IT DOES NOT EXIST.

There is nothing magical about a 60/40 portfolio (or 100/0, 80/20, 40/60, etc.). You could run thousands of simulations (and many advisors do this) but at the end of the day the asset allocation you choose isn’t nearly as important as your ability to follow it through the ups and downs in the markets.

The only allocation that really matters is the one that works for your willingness and need to take risk that helps you achieve your financial goals. Your risk profile, personal circumstances and time horizon all come into play, but there’s no perfect mix that will optimize your results.

(4) The 1980s & 1990s (and even into the 2000s for bonds) was an unbelievable two decade stretch to be an investor.

The S&P 500 returned around 18% a year in each decade.  Ten Year Treasuries returned almost 12% a year in the 80s and nearly 8% a year in the 90s.  Both stocks and bonds performed well above their historical long-term averages.

I got a quite a few comments about the fact that investors can’t expect a stock/bond portfolio to produce similar performance going forward. This is obvious and stock investors learned this lesson this hard way in the first decade of the century.

Investors are often nostalgic of those boom times when looking back at those staggering returns yet many forget that it was not a walk in the park the entire time.

In the early 80s we were fighting severe inflation, double digit unemployment and sky high interest rates.

Then in 1987 stocks fell over 20% in a single day.

There was a recession in 1990-91 along with the Gulf War.

In 1994, the Fed unexpectedly raised short-term interest rates and bonds got slaughtered.

Investors also had to deal with the fallout from the emerging markets crisis in 1997-98 with Russia’s debt default and Long Term Capital Management’s enormous losses.

Anyone that thought long-term and kept their investment strategy relatively simple throughout this period did phenomenal. Yet every single study shows that investors earned far less than market returns.

Investors tried to time the market, guess which way interest rates were going to go next, fell prey to the recency effect by buying investments only after they had good performance and sold investments only after they had bad performance and made their decisions based on the predictions of talking heads or the changes in perceived economic activity.

The point is that even during the best of times it will still never feel like the right time to invest. There will always be issues that will make you feel like staying out of the financial markets.

You best bet is to have a solid process in place that you can use no matter what happens so you don’t miss out on the long-term performance by misbehaving.  That way you don’t have to have the 80s & 90s occur every cycle for your investment plan to succeed.

(5) Cycles, trends, fundamentals and investor sentiment are everything in the financial markets. Future returns are driven by some combination of all of these factors.

But cycles and trends can be driven by investor emotions, not necessarily fundamentals which don’t matter until they do. Confused yet?

Legendary investor Howard Marks taught me in The Most Important Thing that markets are always and forever cyclical. Here’s what he had to say:

I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.

Markets are highly dynamic, and, among other things, they function over time to take away the opportunities for unusual profits.

Few (if any) people have the ability to switch tactics to match market conditions on a timely basis. So investors should commit to an approach – hopefully one that will serve them through a variety of scenarios.

There are no profit centers that last forever no matter how smart you think you are.  An understanding of financial history can lead to the self-awareness required to keep you humble enough to recognize this dynamic.

This is why I think broad diversification is so important however you choose to implement your strategy. It allows you to prepare for a variety of scenarios.

(6) Historical numbers aren’t perfect, but what other choice do we have as investors?

Past markets and the current environment help set your base case.  From there you see what happens and make adjustments as necessary.

As Warren Buffett has famously said, “I would rather be approximately right than precisely wrong.”

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