What RIAs & Investors Can't Know

July 16, 2021

As a financial planner, I get asked a lot of questions about the market. My answer to many of these questions is, “I don’t know.” In fact, I charge clients $450 an hour to tell them I don’t know the future, and it’s the single most important advice I give them about investing.

Here are five things it’s critical for you to know you don’t know, followed by why it will lead to better investment returns.

 

1. How will stocks perform in the next year? 

Sure the market is elevated, and my gut tells me we are in for a bear that will make the last three we’ve had since the turn of this century look like teddy bears. But I’m a pessimist by nature, and I’ve long learned the lesson of behavioral finance: that gut instinct is one of the enemies in investing. I try my hardest not to react based on gut or any other type of instincts.

In fact, I tell people that, not only can I not predict how stocks will perform in the future, I can’t explain how they performed in the past. 2020 was a horrific year—the pandemic, surging unemployment, plunging GDP, racial unrest and political dysfunction. Yet inexplicably, the U.S. stock market clocked in great total returns with the Vanguard Total Stock Market ETF (VTI) recording a 21.03% return and the iShares Core S&P Total U.S. Stock Market ETF (ITOT) returning 20.71%.

If we can’t even understand past performance with the benefit of 20/20 hindsight, just think how futile an attempt it is to predict the future.

2. Will international stocks finally outpace U.S. stocks? 

International stocks have badly lagged the U.S. over the past decade and longer. VTI has had an annualized 14.50% return over the past 10 years ending July 7, 2021, while the Vanguard Total International Stock ETF (VXUS) returned only 5.54% annually.

Will there be reversion to the mean, or will the late Vanguard founder John Bogle continue to be right on avoiding international? Vanguard’s long-run prediction is that international will best the U.S. handsomely with less risk. I personally don’t buy that, and thus am not increasing or decreasing international stock allocation.

3. What styles or sectors of the market will outperform?

Will small cap value and other smart beta strategies finally have their day? Over the last 10 years, the iShares S&P Small-Cap 600 Value ETF (IJS) returned 11.93% annually, while the large cap growth Invesco QQQ Trust (QQQ) earned a much greater 21.03% annually. Cathie Wood’s relatively new ARK Innovation ETF (ARKK) returned a spectacular 46.64% annually over the past five years. 

Which styles and sectors will I overweight? None!

4. Which stocks will outperform and be dominant in the long run? 

I haven’t a clue as to which stocks will outperform. However, I know it is very unlikely to be today’s most valuable companies. I know that things change, and once-dominant industries such as energy and railroads have been overshadowed by tech. If I knew what was going to change or who the winners were going to be over the next decade, I’d be a billionaire. But I don’t. And though I know a handful of stocks will drive the market returns, I don’t know which ones they will be. I do know my total stock index fund will own all of them.

 

1980 2020
1 IBM 1 Apple
2 AT&T 2 Microsoft
3 Exxon 3 Amazon
4 Standard Oil of Ind. 4 Alphabet
5 Schlumberger 5 Facebook
6 Shell Oil 6 Berkshire Hathaway
7 Mobil Oil 7 Walmart
8 Standard Oil of Cal 8 Tesla
9 Atlantic Richfield 9 Visa, Inc.
10 GE 10 Johnson & Johnson
Sources: ETFDB.com & Assetdash.com Source: Standard & Poor's

 

5. Will interest rates rise? 

Actually this one tends to come in a statement rather than a question. A typical comment is that interest rates have to rise with all of the money we are printing and inflation starting to take off.

Well, the Fed only controls the overnight interest rate, and markets control intermediate and long-term rates. Interest rates constantly fool us, with the nation’s top economists calling the direction of the 10-year Treasury bond correctly well under the 50% expected by a coin flip. Will we have the hyperinflation some predict, which will lead to higher rates and poor bond performance, or will we follow the path of Japan, which printed money yet is fighting deflation?

Again, I don’t know, so I’m sticking with high quality intermediate-term ETFs like the iShares Core U.S. Aggregate Bond ETF (AGG) or the Vanguard Total Bond Market ETF (BND). I also use direct CDs with small early withdrawal penalties to hedge against the possibility of rising rates.

Why Thinking We Know Is So Costly

It’s human nature to want to know the future, and accepting that we don’t know it is a hard pill to swallow. But thinking we know is very costly to our returns. It causes us to invest in what’s hot, only to dump the investment when it cools off or turns downright cold.

Yet even more than this, it goes against mathematics. Although I won’t go into the details of the math, at a high level, moving into and out of markets and picking parts of the market increases the average volatility of a portfolio. Even being right half of the time leads to the same arithmetic mean but a lower total return (geometric mean). And most portfolios I review aren’t even close to right half of the time.

While financial gurus brag about what they think they know, I’ll brag about what I know I don’t know.

So my advice is to know we don’t know these things and own the entire global market and rebalance to your target allocation. And when you get that irresistible urge to deviate from your plan because you think you know something, let it pass.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at a[email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.

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