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What We’ve Learned

Adam M. Grossman

WHEN I THINK BACK on 2020—and I know we aren’t quite done with it yet—I’m reminded of the movie Alexander and the Terrible, Horrible, No Good, Very Bad Day. But to paraphrase Nietzsche, chaos isn’t all bad—if something positive ultimately emerges from it.

Below are five financial lessons that, in my mind, are worth carrying beyond this year:

1. Stock prices respond to news—but never in a predictable way. Leading up to the election, anxiety levels were running high. But in the end, even though there was a lot of noise in the political arena, the market reacted with equanimity. In fact, since election day, the S&P 500 is up about 10%. The lesson: In the ordinary course of events—even in a year with above-average political heat—stock prices care less about Washington and more about the economic fortunes of the underlying companies.

Consider this: Over the past 20 years, there have been six presidential elections. How has the market reacted to them? In the month following the election, the market has risen half the time and fallen the other half. On average, across those six elections, the reaction has been essentially a nonreaction: up 0.08%. You could have flipped a coin and gotten the same result.

Just before the 2020 election, one observer suggested this thought experiment: Suppose you’re considering buying a new phone or a new car. Will it make any difference to that decision whether a Democrat or Republican is sitting in the Oval Office? I think that sums it up well. As much power as presidents have, and as much emotion as they elicit, ultimately it’s corporate profits that drive share prices.

2. Market bubbles are tricky for lots of reasons—but mostly because no two look the same. We’re all familiar with the Dutch tulip bubble of the 1600s, the stock market mania of the Roaring 20s and the dot-com bubble of the 1990s. With the benefit of hindsight, we recognize these episodes as collective madness. But the problem for investors is that no two bubbles look exactly the same. We’d like to think we can spot a wolf in sheep’s clothing, but wolves are very good at disguise.

If someone tried today to sell you an overpriced tulip bulb or shares in an unprofitable company like Webvan, you’d spot it a mile away. But when the price of an electric car company rises 690% inside of a year, we’re less likely to see it for what it is. That’s because it’s so easy to paint a picture about the future: Elon Musk is a genius, the narrative goes. It’s more than a car company, they’re making trucks, too, and batteries and drivetrains and who knows what else. From that perspective, you’d be crazy not to invest in Tesla.

It’s the same with bitcoin: If you really believe that it will replace traditional currencies, it doesn’t matter that the price has tripled this year. I don’t know when or how these bubbles will burst, but history suggests they will. The lesson: If it looks like a bubble—if the price chart looks dangerously close to vertical—then, more often than not, it probably is. If you’re interested in this topic, I recommend Charles Kindleberger’s classic Manias, Panics, and Crashes: A History of Financial Crises.

3. The S&P 500 is a reasonable proxy for the market—but it isn’t perfect. When most people talk about the market, they’re usually referring to the Dow Jones Industrial Average or the S&P 500. Most of the time, that’s reasonable. The correlation between the Dow or the S&P and the overall market is close to 1.0. In other words, they move in almost perfect unison.

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But they aren’t exactly the same. The Dow has just 30 stocks. While the S&P 500 is more diversified, it still—of course—includes just 500 companies. Meanwhile, the U.S. stock market consists of thousands of publicly traded companies. As research has shown, and as we’ve seen this year, just a small number of stocks account for a large part of the market’s gains over time, so you don’t want to miss one. The lesson: If you’re building a portfolio, be sure to cast a net that’s wider than these two well-known market benchmarks.

4. Wall Street people know a lot—but never enough to be useful. The financial business is full of analysts and fund managers whose job it is to generate opinions. While they’re incredibly well-informed, the events of this year highlight the reality that no one can truly know everything. This is true at a macro level, as we saw when a virus came out of nowhere and wreaked havoc on the economy.

It’s also true on a micro level, as we witnessed recently when an obscure technology company called SolarWinds (symbol: SWI) turned out to be the weak link in enabling a massive hack against U.S. government systems. Prior to the news, any analyst looking at SWI would have seen a strong, growing business. Revenue had more than doubled over the past five years and the stock had been flying, up 27% this year. But no one—other than the hackers—knew about this risk below the surface. As a result of this unpleasant surprise, when the hack was revealed, the stock fell 40% almost overnight.

I often feel like a broken record when I say no one has a crystal ball. But it bears repeating. Whether it’s a virus or a hack or any other unexpected event, the only thing you can count on is that unexpected things will continue to happen. The lesson: If you want to listen to forecasters, that’s fine. But recognize that it’s just info-tainment and doesn’t contain the information you’d really want to know.

5. Once-in-a-blue-moon events should be rare—but occur pretty frequently. In his book When Genius Failed, Roger Lowenstein chronicles the blow-up of the hedge fund Long-Term Capital Management. How did a group of geniuses, including two Nobel Prize winners, fail so spectacularly? Long-Term Capital had built its trading strategy on a set of carefully researched statistical assumptions. But, Lowenstein writes, “They had forgotten the human factor.” They ignored the reality that market behavior doesn’t fit neatly into standard statistical models.

Extreme price movements occur much more frequently than a normal distribution would predict. The lesson: When constructing a portfolio, you should build in plenty of margin for error. Spreadsheets can only take you so far. But since they can’t predict viruses or hacks or anything else, it’s okay to be—and indeed you probably want to be—more conservative than the numbers suggest.

Adam M. Grossman’s previous articles include Unhelpful AdviceHelp Today’s Self and Split the Difference. Adam is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, Adam advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman.

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Langston Holland
Langston Holland
8 months ago

Here’s a little perspective on the 2020 market c/o Robert Shiller’s data. Zoom in as much as you’d like or download it.

Edit: A little OT, but remember inflation? From about 1965 to 1995 there was no real* return in the market!

* Real means inflation adjusted, thus the “CPI S&P 500” shows the change in purchasing power of the investor in the index.

parkslope
parkslope
8 months ago

John Klement has an informative summary of the distribution of stock returns.

“The data is from Prof. Robert Shiller’s homepage. As you can see, on an annual scale, market returns are essentially random and follow the normal distribution relatively well. Put in this context, the year 2019 was one of the better years in the history of the S&P 500 but not an extreme year.”

“If we look at rolling 3-year returns, we can see that the distribution of market returns become bimodal. There is a first peak for cumulative 3-year returns of about 0% and a second peak for cumulative 3-year returns of about 30%. The first peak corresponds to bear market environments when 3-year market returns become essentially negative. The second peak corresponds to bull market environments where markets rise uninterrupted for three years in a row.”

https://klementoninvesting.substack.com/p/the-distribution-of-stock-market

JDave Foster
JDave Foster
8 months ago

The only thing that is predictable is the past.

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