Science? Yeah, Right

Jonathan Clements

I HEAR SO MANY compelling investment arguments. That U.S. stocks are destined to generate lackluster returns because valuations are so rich. That there’s no need to own foreign stocks because you get enough international exposure with U.S. multinationals. That interest rates have nowhere to go but up.

And yet U.S. stocks keep clocking gains, U.S. and foreign shares often generate radically different annual results, and interest rates show no signs of heading significantly higher. Year after year, the markets make a mockery of articulate financial experts and their well-reasoned recommendations.

My advice: Whenever you hear a convincing forecast, read about a winning investment strategy or receive financial advice, keep four notions in mind.

First, the language of Wall Street is numbers and numbers suggest precision. But this is not a precise business. If a financial planner says you need to save 12% of your income each year for retirement, the right number could turn out to be 9%—or perhaps 15%. There’s nothing wrong with making financial projections, but you need to revisit them often and fine-tune them along the way.

Second, financial markets deliver an endless stream of misleading short-term feedback. In any given year, a few fortunate fools who bet big will notch huge gains, while those who prudently pursue low-cost, diversified investment strategies might lose money. But over the long run, the prudent investors will likely end up far richer, while the fools are relieved of their wealth with the same startling speed it was acquired.

Third, managing money is not a science, but a social science. There are people involved, and that makes matters messy. Sometimes, investors behave like a crazed mob. Witness 1999, when they drove tech stocks to ridiculous heights, and 2006, when they did the same for home prices.

Fortunately, people also learn from the past. There are clear-cut examples, like the widespread adoption of indexing and broad diversification, and the much stronger focus on holding down costs. Eventually, the list of clear-cut examples may also include smart beta factors like the momentum effect, the small-stock effect and the value effect. These factors might continue to outperform over the long haul—and I’m hoping they will, because my own portfolio is tilted toward small and value. But now that these factor have been so well-publicized and so widely adopted, the performance edge will likely be smaller, and perhaps so small that it’s largely or entirely devoured by the extra investment costs involved.

Fourth, markets are driven by news—and news, by definition, isn’t known ahead of time. Maybe the news that’s still to come will prompt us to collectively decide that the world is a safer place, justifying higher valuations, or maybe we’ll grow more fearful and valuations will come crashing down. Who knows? I sure don’t—and I don’t think anybody else does, either.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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