Before we all give up on foreign, value and small stocks, to buy the S&P 500 and tech stocks, let’s take a look at what we might have learned from our trip down memory lane.

Diversification

Unless you are deluded enough to believe that you can predict the future, diversification is a great investment tactic. You will notice, that in every ten year period, an equally weighted diversified equity portfolio held up pretty well. You didn’t have to guess the top performing asset classes in order to have good results. Of course, we always had reasons to regret. Something we owned was always in the dog house. 

But, look at the results we would have had over the entire 30 year period! All of our equity asset classes performed well, and just about in the order that we might have expected.

Long Term

While ten years may seem like many, many lifetimes in Internet time, it’s really a pretty short time in financial economics. Many of the relationships that we expect from both practical experience and financial economics take a long time to work themselves out.

For instance, we expect that stocks will outperform bonds. Yet, there was a 19 year period during the 70’s and 80’s where Treasury Bills outperformed the S&P 500. After nineteen years of dismal performance, you might have been tempted to give up on stocks forever, and many folks did. Of course, they missed out on the greatest bull run in history.

Our expectations are based on long-term data. That’s the most rational approach to financial modeling. But, the long-term data hides lots of short-term aberrations. And these can run for what seems like a very long time indeed until they self correct. Economists call these aberrations noise, and have learned to expect them as a matter of course. They try to filter them out by referring to the longest-term data available. Investors should too.

Reversion to the mean

Think about it. If one company, industry, country, or market segment grew faster than the rest of the economy forever, eventually they would own all the assets in the world! Now, that’s never happened before. And, when something has never happened before, you ignore it at your peril.

Economists expect that there will be reversion to the mean because when a company or industry seems to be making excess profits, others will enter the industry. As more and more resources flow to the industry, prices will rise while competition will force profit margins down and equilibrium will be restored.

Of course, when a segment does poorly, resources will flee to more profitable ventures, asset prices fall until the remaining investors can expect market returns on their capital. Markets could not work without this self-adjusting mechanism.

Stock markets show very strong reversion to the mean. Even the strongest runs eventually end. Unfortunately, we don’t know when a run will end, just that it must. But, any strategy that fails to anticipate reversals is doomed to fail.

Projecting recent past experience

One of the biggest mistakes that investors make is to project recent experience forward. Unfortunately, it’s just human nature to feel that when the market is going well, it will continue up forever. If it is doing poorly, recovery seems impossible. Investors know in their heads that markets are cyclical, but emotions drive them to act as if it weren’t true. Unable to see the future, many investors plot their strategy through the rear view mirror. In the process, closer, more recent experiences appear larger; so, the view of reality gets distorted.

Summary

Investing takes discipline. A good strategy may take time to pay off. Noise, temporary aberrations, market reversals, fits of irrational exuberance followed by deep despair, and constant but irregular reversion to the mean are the norm. That’s life on Wall Street. Because we cannot force the market to meet our expectations, out guess it, or predict it, we must take the market on its terms and adjust to its cadence. Over time each market should earn the appropriate returns according its risks. Meanwhile, while nothing is ever guaranteed in the world’s equity markets, a well-diversified portfolio has the highest chance of a satisfactory result over both the long and shorter terms.

Frank Armstrong, CFP, is the author of Investment Strategies for the 21st Century, published here, President of Investor Solutions, Inc., a fee-only Registered Investment Advisor, and Chief Investment Strategist of DirectAdvice.com.

Note: The featured writer is solely responsible for the content of this article. The opinions expressed herein are not necessarily those of MFI or BES, Inc.

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