4th Quarter Review: Tough Equity Markets
Global equity markets suffered significant losses during the 4th quarter, which dragged down stock returns across the board for the full year. Our clients’ portfolios, most of which include an allocation to bonds, declined somewhat less. Still, 2018 was unusual in that almost every major investment category experienced a negative total return. The exceptions were cash, US Fixed Income, and TIPs (note: your portfolio’s allocation and results may differ—please refer to your Quarterly Portfolio Review Report).
For the US market, the year started rather well: at its all-time high on September 20th, the S&P 500 index was up 11% year-to-date. Over the ensuing 3 months, it gave back all those gains and more, with a peak-to-trough decline of over 20%:
This may have shocked a new generation of investors, as 2018 represented the first negative return for the S&P 500 index since 2008. Still, it’s important to keep perspective: the same index returned about 50% over the past five years, and 240% since 2008, including dividends.
The FAANG stocks (Facebook, Amazon, Apple, Netflix & Google) which powered the S&P 500 return through September were among the biggest casualties during the selloff: they suffered declines twice as large as the broader market. Again, some perspective is in order: growth stocks crushed value stocks (the kind we tend to favor) over the past decade. The Morningstar US Growth Index had a 10-year average annual return of 12.4% through August 2018, compared with 9.3% for the Value Index. The difference widened further over the 12 months leading to the end of August: 30.5% versus 14.7%. This was an unusually wide disparity and history suggests that value stocks will eventually make a comeback.
Amidst the December selloff, market pundits dutifully offered explanations: increased fear of recession, trade disputes, etc. How much should you pay attention? Very little in our opinion. The reality is that such dramatic moves (up or down) mostly reflect changes in investors’ sentiment, rather than changes in the underlying business fundamentals driving stock returns. The profitability for companies in the S&P 500 reached a record high in 2018 and their after-tax earnings soared more than 20% over 2017, thanks mainly to a lower corporate tax rate. Investor sentiment may have turned apprehensive, but corporate profits remain robust.
As much as we’d like to pretend that seeing our portfolios’ value drop does not affect us, the reality is different. With apologies to Bertrand Russell, in a world filled with confident experts, we hope that being full of doubt is a sign of intelligence. We don’t know what 2019 will bring. But 30 years of experience have taught us not to succumb to our emotions and to trust our process. As your advisor, our first priority is to help you do the same.
“You’ll Never Walk Alone”
If you’ve been reading our posts over the years, you know that we regularly discuss diversification, asset allocation, re-balancing, etc. These concepts are at the core of the services we provide. Educating you about our investment process improves your chances of achieving your goals.
Once we’ve identified those, and selected the appropriate allocation and investments, our work has barely started. Next come monitoring, rebalancing, staying informed about financial changes in your life, and tracking your portfolio’s progress. We stand by your side during your journey towards your goals, help you deal with obstacles, hence our wink to Roger Hammerstein’s famous song.
Tracking your portfolio’s progress is the focus of this post. There are two numbers that all investors need to know: 1) what return does my portfolio need to achieve for me to reach my investment goals? And 2) What is my portfolio’s return and how does it compare to 1)? Answering these questions comes with potential pitfalls, so we need to create a framework that will further your chances of success. Core to this framework is tuning out short-term market “noise”, resisting the urge to compare your returns to irrelevant benchmarks, and staying the course.
Ignoring the Short-Term
The human brain evolved shortcuts to make sense of an uncertain future. One of these is to give more weight to the recent past when making a prediction or forecast (a cognitive bias known to psychologists as “anchoring”). This shortcut served our ancestors well in various contexts but is ill-suited to financial markets and fraught with danger.
At Bristlecone, when assessing an investment’s short-term performance, we compare returns relative to our expectations for that specific strategy. For example, in evaluating a fund which invests primarily in stocks from developing countries, we would ask ourselves how that fund’s return compared to a similar peer group, or an index of emerging market stocks. We would not be asking ourselves why the fund’s return lagged or exceeded the U.S. market. In doing so, we push back against our behavioral shortcomings: near-term performance might well be within the range of reasonable expectations. From this perspective, we frequently conclude that we are better off doing nothing much of the time and remain patient.
The Most Important Benchmark: Your Own
Today, it is very easy to track performance against a wide range of benchmarks because technology is widely available. However, just because investors can do it, it doesn’t mean that they do it properly or that they should do it often. How do we do it at Bristlecone in order to add value to our clients?
A single market index is not a relevant bogie for your overall portfolio. It does not help in assessing your ability to reach your goals. What matters is whether your portfolio is delivering the return necessary to retire securely or pay for your kids’ education, for example. We call this personal benchmark your Required Rate of Return (RRR). We approximate it by looking at your current assets alongside realistic estimates of different variables including future cash flows in and out of your portfolio and time horizon. As these inputs change over time, we re-assess your RRR regularly. We typically reference it relative to inflation (Consumer Price Index or CPI plus a margin). If your portfolio does not hit this personal return number over the assumed time horizon, you will fall short of your goals.
Market benchmarks have their role. First, we use them to build a diversified portfolio that, based on solid historical data, truly can deliver the RRR we just discussed. Second, we also use market benchmarks to estimate the range of returns that can be expected from the portfolio’s mix of assets, relative to a similarly weighted balanced benchmark. Finally, within each segment, we use relevant market benchmarks to review individual investment selections.
Encouraging You to Stay The Course
For us to successfully deliver on our mission to you, not only must we design strategies with robust data to support them, and implement them in a cost-effective manner, but we also need your understanding of why sticking with your plan, including prior investment choices that might be currently underperforming, is your best course of action.
Admittedly, this is easier said than done: during bear markets, clients can feel queasy about seeing us add to investments that have dropped the most—even though this is precisely the rebalancing discipline which we discussed at the outset of our management! During both bull and bear markets, looking in the rear-view mirror creates an illusion that is all too easy to extrapolate into the future. The path of least resistance for investors is to favor recent winners (bitcoin anyone?) and de-emphasize recent losers. Old habits, especially those that are hardwired, die hard.
Unfortunately, the history of capital markets shows that returns within asset classes almost always revert to their long-term averages. Although the timing is painfully uncertain, this pattern of mean reversion means that chasing trends is self-defeating as a long-term strategy.
Sadly, many news outlets, investment professionals, and market “experts” profit from selling trend-chasing advice. At Bristlecone, we have always taken a different path: we hope that by focusing on the metrics that matter during your journey and helping you through the inevitable bumps along the way, you are more likely to arrive where you want to financially.
Two roads diverged in a wood, and I,
I took the one less traveled by,
And that has made all the difference.
Robert Frost
Thank you for your trust in our services.
One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.
Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.