With everything going on in the world right now — protests, war, and floundering economic systems — it’s natural for even the most confident investors to have doubts. Our best plans are still based on certain rules and assumptions, and our own lived experience shades our perspective more than we probably realize. So when the world suddenly seems out of control and beyond our comfort zone, things we formerly took for granted feel a lot less stable. Like walking a lonely road with no idea what is over the horizon, it can be a unsettling experience.
Now I certainly don’t have the answers to every problem in the world. But when it comes to investing, the good news is that you actually don’t need those answers to protect yourself. The cool thing about studying financial history is that no matter how crazy things feel today it probably pales in comparison to events that your parents and grandparents dealt with. And by understanding how certain portfolios handled those stress tests, we can choose one more likely to stand the test of time.
So if you’re watching the news and worried about what it means to your important financial goals, here are a few tips for setting your portfolio up for success no matter what happens.
Focus on the big picture
Any time some big new world event happens, it’s common for people to speculate on how it affects particular markets. How will a war affect regional stocks? How will inflation affect bonds? And once you feel like you understand cause and effect, it’s human nature to want to act on the information to preserve your best interests.
Everyone expects active traders to attempt moving in and out of certain positions to make a profit, but in the right conditions even passive index investors are not immune to the temptation to tinker. Why should I hold stocks in a risky market like this? Why own bonds at all at these rates? People like to talk about asset allocation as a neutral balance of risk and return, but personal tipping points are surprisingly malleable based on one’s current state of mind. And when times get tough, portfolios often change along with attitudes.
Now there’s nothing wrong with learning something new about yourself and changing your portfolio as a result. Personal growth is a healthy thing and a sign that you’re open to new information and not a pure investing ideologue. But the thing that often trips up even the most thoughtful asset allocator is how their perfectly rational tweaks may not always turn out the way they hoped. And it’s not necessarily because they were wrong about the asset, but because portfolios behave very differently than they assume. Like removing the flour from a cake because you think it’s overpriced, by tweaking the ingredients too far you ruin the recipe.
This is a complex topic on its own, and I encourage everyone to read this article that tackles it in depth:
But for a high-level summary, check out this chart showing the risk and return of more than 40,000 different portfolios.
Note the positions of SCV, long-term bonds, and gold, and think about where you’d expect combinations of those three assets to fall on the same chart. Now look at where they measurably landed. That disconnect between expectations and reality is hard to understand without digging into the data, and it is a good illustration of the problem with reactionary tweaks to individual asset percentages without looking at the portfolio as a whole. Even if you’re right about the asset in isolation, portfolio performance may not react to your change the way you expect.
So the next time world events cause you to stress about the prospects of a particular asset, step back and think bigger. Rather than purely seeing it as a drag on an impossible-to-achieve “ideal” performance, consider the possibility that it:
1. Is an important ingredient in the recipe, which…
2. Will soon have its own time to shine, and…
3. May be more important to total portfolio performance than you understand.
Individual assets wax and wane over time, but in the grand scheme of things they’re not what really matters. Focus on the portfolio, and everything else is just noise.
Know your history
The thing about news in the age of social media is that not only do people have short memories but they often have zero historical context at all. Breaking events have a way of being amplified in an echo chamber with no release valve until it sounds like the world is coming to an end. And in terms of investing, cries of “This time is different!” are regular features of everyday financial life.
Even offline, individual investors of all ages tend to suffer from a form of cognitive bias where they assume their own investing experience is the universal reality that has always existed. Older investors who made hay in the 80’s and 90’s during the greatest stock run in history often advise their kids to load up heavily on US equities because it worked out so well for them. Younger investors who started investing after 2009 may have a similar mindset simply because they’ve never experienced a meaningful recession in their lifetime. And late Gen-Xers who came of investing age in the 2000s may have a very different idea of investing risk altogether, with memories of war, recession, and complete a lost decade for stocks. You get the idea — we are what we see. And what we see isn’t always the full picture.
Of course, all of those generations probably thought grandpa was crazy with his unbelievable stories of gas shortages and double-digit inflation in the 1970’s. Well… until now! Maybe his gold stash isn’t so strange after all. By listening to experiences beyond our own, we can not only put our own biases and fears in the proper perspective but also learn a few things about how to prepare ourselves for similar events in the future. After all, history never repeats but it often rhymes.
So as you watch current events unfold and start to feel that it sounds overwhelming, consider these big market-shaking events of decades past:
- The Nixon Shock upends the entire global financial system.
- Stagflation with skyrocketing inflation, interest rates, and unemployment.
- An international oil crisis and massive gas shortages.
- Inflation hits 14%.
- Ronald Reagan assassination attempt.
- Black Monday wipes 22% off of the stock market in a single day.
- The Gulf War in Iraq.
- Collapse of the Soviet Union.
- Increasing domestic violence, from the first WTC attack to the OKC bombing.
- The September 11th attack kills 3000 and wrecks Wall Street.
- A decade of a global war on terror.
- Sub-prime mortgages instigate a severe financial crisis.
- The Greek debt crisis rocks global markets.
- The Brexit referendum shakes up the European Union.
- Flatlining interest rates worldwide.
Here we sit early in the 2020’s. It has already been rough and we’re just getting started. But looking at that list, we can at least take solace in the knowledge that we’re not the first people to deal with major adversity. And when it comes to investing, lots of people did just fine.
Analyzing the strengths and weaknesses of each portfolio through all of those historical events would require a blog of its own, but the nice thing about the Heat Map is that you can get a pretty good feel at a glance. Lots of portfolios struggled in the 1970s, and some options were much weaker in the 2000’s than people realize. But importantly, some portfolios were clearly more resilient than others during crazy world events.
While the classic comparison would be to look at very different approaches like the Total Stock Market versus the Permanent Portfolio, there are even clear differences between what I would consider close portfolio peers. For example, the All Seasons Portfolio and Golden Butterfly both share a common investing philosophy based on balancing different economic conditions. But when it comes to 1970’s-style stagflation, the charts speak for themselves.
Now that’s not to say that the All Seasons Portfolio isn’t a superior choice for a lot of people. The point of the exercise is simply to illustrate that it’s possible to evaluate sound portfolio ideas against history to see how they held up against events that also concern us today. And by choosing a portfolio with that knowledge (or perhaps even tweaking them to our own taste using good data), we can sleep well knowing that our investments are not fragile flowers to be constantly protected from the elements but are tough as nails through the freezing cold and blistering heat.
As an aside, it’s no accident that the Heat Map is a particularly good tool for this historical evaluation process. The original inspiration for the Heat Map was a phenomenal chart by Crestmont Research that also includes a crazy amount of historical context going back to 1901. So if you really want to learn about how the US stock market performed relative to world events, be sure to add that to your bookmarks.
Plan beyond the average
Even when one has a pretty good handle on the potential ups and downs of a portfolio, it can still be a challenge to know how to put that information to productive use. Averages are easy to understand, but the natural uncertainty that simple averages hide is a lot more complex.
But that’s not to say that people don’t spend a whole lot of energy reacting to that uncertainty. How much do you see written about stock valuations and the effect of current interest rates on future bond returns? If you spend any amount of time at all reading about investing, I imagine it’s a LOT. At it’s core, these discussions are founded on the idea that the averages people talk about are unreliable and that we have to adjust our expectations when planning for our own futures.
I totally agree! But I have a very different approach to solving that problem. Rather than tracking complicated and ever-shifting signals to dictate new expected returns every time we receive new market news, I personally believe the average investor would be far better off tuning all of that out and using history to plan conservatively.
The most common example of this that people widely accept is the idea of safe withdrawal rates. For a long time, the state of the art advice in financial planning was to use the average return of a portfolio to determine retirement expenses. After watching too many retirees go bankrupt following that advice, William Bengen wrote a famous paper that found that in the worst historical case, the safe withdrawal rate for a 30-year retirement (for the assets he studied) was about 4%. That study was a true landmark in financial circles, and his methodology of looking not at the average but at the worst case is now the gold standard* in responsible retirement planning.
(*) Of course, the modern popularity of expected returns discussions is so widespread that even big institutions like Vanguard don’t always understand how SWRs work. But that’s a topic for another article.
Interestingly, the usefulness of Bengen’s insight can be extended far beyond retirement calculations. Let’s say you’re in the early stages of saving towards that retirement and are planning how much you need to save to meet that goal. Using the assumption of an average investing return can be a dangerous proposition, as there’s a very good chance that you’ll personally experience less than that average. You could perhaps seek out the current expected returns for your portfolio over your needed timeframe, although they are also anything but certain and change all the time.
What if you instead used Bengen’s thought process and found the savings rates that always succeeded even in the worst case? While there are no guarantees in investing, that conservative number which worked out even when inflation skyrocketed in the 1970’s and the financial system nearly collapsed in the 2000’s would most likely allow you to tune out the pundits and get on with your life.
Another example I’m personally fond of is the idea of the baseline return. Instead of anchoring on the long-term average and adjusting from there as the financial winds blow, the baseline return is the 15th percentile real return over your desired timeframe looking at every start date on record. That represents a conservative, data-driven return that you can plan around with a reasonable amount of confidence even in shaky times.
The basic idea of either planning for the worst case or the baseline is to stop playing prediction games and embrace not knowing. Rather than trying to establish real-time cause and effect to estimate market reactions, use history to account for uncertainty and study portfolios in tough times. Create a plan that worked even when markets were unfavorable, and your odds of future success skyrocket with no market predictions required.
Safe investing is all about wisdom
From a big-picture perspective to knowledge of history and the ability to think beyond averages, a common theme in safe investing is that it’s about more than just being smart. In fact, the most brilliant people are often the most susceptible to complex investing ideas that inevitably fall apart under the weight of chaotic reality. So you need more than just knowledge to succeed.
It takes wisdom.
The wisdom to recognize when the news that worries you is nothing compared to events of the past. The wisdom to see through volatile returns to find a dependable baseline that is more than enough to meet your own needs without worry. And the wisdom to let go of perpetual financial optimizations and choose a portfolio that is truly good enough so that you can focus your attention on the things in life that truly matter. Smart investors chase unattainable perfection, but wise investors choose measurable happiness.
Are you a smart investor or a wise investor?
Learn how to think like the latter, and I wager that not only will your anxiety levels drop in the near term but your financial prosperity will also rise in the long term.
Do you feel a little wiser after reading this?