Messing With Us

Jonathan Clements

FINANCIAL MARKETS have two primary functions: They can allow us to grow wealthy over time—and they can drive us completely batty along the way. As you mull that mixed blessing, consider six additional thoughts:

1. Spreading our investment bets widely is prudent and betting everything on one stock is foolish. But over the short term, the prudent strategy can lose us money, while behaving foolishly can earn us handsome gains. The lesson: We shouldn’t judge a long-term investment strategy by its short-term results.

2. If financial markets fall sharply in price, we should grow more enthusiastic, not less so. The reason: Everything else being equal, expected returns are now higher.

3. Sensible investment risk should be rewarded. But there’s a reason it’s called risk: We won’t get the reward every year—and we could suffer a dry spell that lasts a decade or more.

4. We’re advised to build globally diversified portfolios, because it improves the odds of making money over time and it damps down the short-term swings in a portfolio’s value. At any given moment, some investments may be struggling, but there’s a decent chance others are performing well. (Did I mention that some investments may be struggling?)

5. Financial markets are reasonably efficient, meaning they reflect all currently available information. Worried about the latest news? In all likelihood, it’s already baked into the price of the stocks and bonds we own.

6. There is no Market Timing Hall of Fame. Yes, pundits occasionally guess right on the direction of stock and bond prices. But nobody does so with the consistency necessary to earn superior returns.

That brings us to today. Of late, the financial markets have done an admirable job of performing their two primary functions—making money and messing with our heads.

U.S. large-company stocks posted solid gains in 2016, making it eight consecutive years of enviable results. U.S. small-company were up even more—a relief after 2015’s losing year.

Emerging stock markets, which posted four calendar-year losses in the five years through 2015, also posted healthy gains last year. But they also gave investors a wild ride. That ride got even wilder in the wake of the U.S. presidential election, as investors fretted over the impact of a possible global trade war.

Meanwhile, in 2016, developed foreign markets delivered more of the same. Translation: They had another disappointing year, fueling doubts about the wisdom of diversifying internationally.

At first blush, 2016’s widely varying results raise all kinds of apparently awkward questions. If large-cap stocks win every year, why own anything else? If a trade war is about to break out, shouldn’t we dump emerging markets? If developed foreign markets aren’t a decent diversifier, why own them?

But even as we raise these questions, we already know the answers—and they’re contained in our first six points:

1. A long-term investment strategy is—surprise, surprise—designed to make money over the long term. We shouldn’t get twitchy about a rational strategy, just because we don’t like the results from the past five years, let alone the past 12 months.

2. Thanks to recent lackluster gains, developed foreign stock markets and emerging markets are now much cheaper than U.S. shares—which means rational investors should be more enthusiastic, not less so. Valuations are the single biggest determinant of returns over a 10-year time horizon.

3. If we take sensible investment risk—meaning we get our market exposure by owning a broad array of securities—we should be rewarded over time. So which risks get rewarded? If we keep more in stocks and less in bonds, we should earn higher long-run returns. Similarly, within stocks, we should clock better long-run results if we favor riskier parts of the global financial markets.

We won’t collect these superior returns every year, but we should collect them over longer periods. During the 15 years through Nov. 30, emerging markets were up an average 10% a year, while S&P’s small-cap index notched 10.4%. What about the S&P 500 index of large-company stocks? It averaged just 6.6%.

4. International diversification seems like a wonderful idea when U.S. stocks struggle and foreign markets roar ahead. It seems less wonderful when U.S. stocks are riding high, as they have in the current decade. What about the previous eight decades? Foreign stocks outpaced the U.S. in five out of the eight.

5. Investors quickly buy and sell securities based on the latest news, so the information is almost immediately reflected in market prices. Donald Trump’s election? At this point, that’s old news. There will, no doubt, be policy announcements that affect global markets in the months ahead. But we can be confident that the markets have already incorporated current hopes and concerns about a Trump presidency.

6. It would be great if we could accurately forecast the direction of markets and thereby avoid all uncertainty. But the only thing certain about market-timing is its eventual failure. None of us, alas, is smarter than the collective wisdom of all investors, as reflected in today’s securities prices.

Not so sure? For a reality check, cast your mind back to year-end 2008, during the midst of the financial crisis. Everyone hated stocks—especially the large-cap stocks in the S&P 500. Over the prior 10 years, the S&P 500 had lost 1.4% a year, while small-cap stocks were up 5.2%, developed foreign markets 1.3%, emerging markets 9.2% and high-quality bonds 6.2%. Those who bought based on that past performance would have suffered disappointing returns over the eight years that followed.

Tempted to buy based on today’s recent performance? I wouldn’t bet on a happier outcome.

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