Swedroe: 7 Investing Rules

November 16, 2018

Here’s an example of a test you should take before investing in the emerging markets. In 2008, the MSCI Emerging Markets Index lost 54%. Would you have been able to not only stay the course (avoid panic-selling) but buy more to rebalance your portfolio, as emerging markets were the worst performing asset class? If the answer is no, you should not invest in them. I would note that, in 2009, the MSCI Emerging Market Index returned 75%, but only for those investors who stayed disciplined.

There’s one other important point we need to cover regarding knowing your investment history. When recent returns have been well above averages, historical results can be misleading and should not be blindly projected into the future.

Consider the following: From 1928 through 2017, a portfolio that was 60% S&P 500/40% five-year Treasuries returned 8.5%. However, from 1982 through 2017, it returned 10.4%. This “Golden Era” is not likely to be repeated, because three favorable tail winds are not likely to recur:

  • Equity valuations rose sharply—CAPE 10 increased from 7 to 30 (as of Oct. 24, 2018).
  • Yield on 10-year Treasury fell from about 14% to about 3%.
  • Corporate after-tax profits as a percent of GNP about doubled, from 5% to 9%.

The result of the favorable tail winds is that current valuations (our best estimate of expected returns) result in the expected returns for that 60/40 portfolio of around just 5%, about half the return of the prior 36 years. Investors need to understand not only the historical returns, but that current valuations matter in projecting future returns.

3. Ignore All Guru Forecasts

Benjamin Graham, legendary investor and co-author with David Dodd of “Security Analysis,” offered this observation: “If I have noticed anything over these sixty years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.”

William Sherden came to the same conclusion in his excellent book “The Fortune Sellers.”

He noted: “Despite recent innovations in information technology and decades of academic research, successful stock market prediction has remained an elusive goal. In fact, the market is getting more complex and unpredictable as global trading brings in many new investors from numerous countries, computerized exchanges speed up transactions, and investors think up clever schemes to try to beat the market. Overall, we have not made progress in predicting the stock market, but this has not stopped the investment business from continuing the quest, and making $100 billion annually doing so.”

The evidence on the lack of economic and market forecasting ability led Graham and Sherden to draw their conclusions.

It’s also what led Jonathan Clements, writing at the time for the Wall Street Journal, to offer this advice: “What to do when the market goes down? Read the opinions of the investment gurus who are quoted in the WSJ. And, as you read, laugh. We all know that the pundits can’t predict short-term market movements. Yet there they are, desperately trying to sound intelligent when they really haven’t got a clue.”

The problem with listening to forecasts is that not only is there no evidence of the ability to accurately forecast markets, listening to them can lead to the abandonment of well-thought-out plans.

One reason is confirmation bias. If you are concerned about an issue’s impact on the economy and the market, and a guru predicts that issue will lead to a bear market, you become much more likely to sell.

On the other hand, if another guru predicts that the same issue will be good for the market, you are likely to experience cognitive dissonance and ignore the advice. It’s hard for humans to ignore their biases. Yet successful investing requires us to do so. Remember, you are best served by following Buffett’s counsel: “Inactivity strikes us as intelligent behavior.”

4. Do Not Take More Risk Than You Have The Ability, Willingness Or Need To Take

Most battles are won in the preparation stage, not on the battlefield. If you take more risk than you have either the ability (in terms of job stability and investment horizon), willingness (ability to absorb the stomach acid and sleepless nights that bear markets can cause) and need to take, you increase the odds that the inevitable next bear market will cause you to lose your head while more disciplined investors are keeping theirs.

Losing your head leads to the stomach taking over decision-making. And I’ve yet to meet a stomach that makes good decisions. The result will likely be that your well-developed plan will end up in the trash heap of emotions.

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