The last two years have been quite the rollercoaster ride for financial markets. In 2022 the global stock market was down -18% and has rebounded +17% year to date. If you’d gone to sleep on December 31st of 2021 and just woken up you’d think nothing interesting happened during those two years. Of course, if you lived through it in real-time 2022 was pure panic and 2023 has been pure euphoria. But this is how the stock market works. It’s a consistent short-term rollercoaster that tends to take you higher and higher in the long-run. This is one reason why we like to think of the stock market as a 17 year instrument that will pay you about 5-7% per year on average. You won’t get that return consistently on an annualized basis, but over longer periods of time the returns will smooth out to something that looks more stable. But you have to be patient to let the market accrue those returns. Sometimes you have to be very patient.
Warren Buffett says the stock market is a voting machine in the short-term and a weighing machine in the long-term. In other words, it’s a bunch of flawed opinions in the short-term and a precise measuring instrument in the long-term. But most of us don’t have the discipline or patience to ignore the votes. Instead, we get caught up in the panic and euphoria of short-term moves that are irrelevant in the long-run.
So, this seems like as good a time as any to sit back and remind ourselves of some important facts and how to properly navigate a short-term market boom:
1) The financial markets aren’t where you get rich. I specifically refer to people’s “investment” portfolios as their “savings” portfolios because the financial markets are not where we make real investments.1 The financial markets are where we allocate our savings. Our real investments are the skills we build over time to earn an income.2 That’s where you get rich. The financial markets are secondary markets where we allocate some of our saved income. The value of certain instruments reflected in secondary markets is based on how those firms invest in their own means of production. When we buy those instruments we are using some of our saved income to allocate it to certain instruments with the hope of achieving some financial goal over time. Too many people think about this backwards and try to use the stock market and other financial markets as a “get rich quick” scheme. In the vast majority of cases this ends up creating lower returns by creating unnecessary taxes and fees.
Remember – you get rich building skills or products that earn income. You stay rich by allocating your saved income prudently.
2) Set realistic savings return goals. The global stock market generates about 5.5% per year in inflation adjusted terms per year. The bond market has generated about 2.5% per year adjusted for inflation. And cash (T-Bills) has generated about 0.5% per year after inflation. The stock market achieves this return with volatility that is 2.5X the bond market. So, if you want to capture all of that 5.5% stock market return you have to be willing to endure 2.5X the volatility or consistent 20%+ downturns with the occasional 40%+ downturn.
The global financial markets are roughly 50% stocks and 50% bonds which means that the average annual real return for the Global Financial Asset Portfolio is about 4% per year before taxes and fees. We often hear the mainstream media refer to nominal pre-tax and pre-fee returns of 10% or more for the stock market. These numbers are wildly unrealistic because they do not account for taxes, fees, inflation and the fact that these returns are very inconsistent on a year-to-year basis.
When you establish your target returns you need to keep this in perspective because the aggregate financial markets will not generate high real returns in the long-run. This is especially important if you have an short-term liquidity needs as those instruments will necessarily generate lower real returns than longer duration instruments like stocks.
3) Establish a time based allocation. Good financial planning solves for time. We don’t live our lives in one “long-term” or “short-term”. You have daily, monthly, annual and decade long liabilities. Your savings needs to service ALL OF THESE TIME HORIZONS. After all, if you put all of your savings in the stock market you’ll soon realize that the stock market is a long-term instrument and if you need cash when the stock market is down a lot you’ll become a forced seller into a bear market.
A good financial plan needs to allocate assets using a time blocking asset allocation like our All Duration strategy. This means allocating assets so that you increase the certainty of having a certain amount of assets for specific time based goals. This will not only help you better understand your goals, but it will make you more comfortable with your asset allocation by knowing how certain assets are helping you meet certain time based financial goals.
4) Don’t chase the panic and euphoria. The worst thing an investor can do is change their target returns during booms and busts. Our urge will always be to get more aggressive during booms and less aggressive during busts. If you change your risk profile during a boom it’s very likely that you’re chasing more risk, not more return. These urges reflect an imbalance in your asset allocation and a mismatch relative to your financial plan. This increases the risk that you’ll overreact when the stock market inevitably turns down. All along the way you’ll have churned up taxes and fees and lower average returns. It’s far better to establish realistic goals and then ignore the booms and busts of the individual markets over the short-term.
If you have the urge to get more aggressive during booms then it might mean you hold too much cash relative to your liability needs. But you need to be careful because if that’s not the case then you could be creating an asset/liability mismatch or behavioral mismatch that you won’t recognize until your portfolio falls substantially (which it will at some point). Likewise, if you get the urge to sell during busts it likely means you don’t hold enough cash and short-term instruments to keep you comfortable during bear markets. Find that balance is crucial to maintaining a disciplined approach to portfolio management and creating a sustainable financial plan.
NB – I write this article every few years when things are starting to feel a little out of whack. The last edition of this article came in January of 2020 right before the Covid crash. Hilariously, I had to write the opposite article just 3 months later.
1 – See “The Total Portfolio” perspective.
2 – “Investment” is spending for future production. When a company builds a factory they are investing. If they finance that investment by issuing stock the value of the stock will reflect whether their investment spending was productive or not. But our purchases of stocks on a secondary market are not properly referred to as investment. It is an allocation of savings whose value will reflect the investment spending of the firm.