Miles on money: Driving by the rearview mirror
Friday, March 29, 2013 7:00 AM
Close your books. We’re having a pop quiz.
Question one: How much is the U.S. stock market up so far this year?
Question two: What has been the best performing asset class over the last five years?
Question three: What will be the best performing asset class over the next seven years?
The answers: 9.16 percent (as measured by the Standard & Poor’s 500 as of March 22), high-yield bonds (five-year annualized return of 10.3 percent through Dec. 31), and emerging market stocks (according to GMO LLC’s Feb. 28, 2013, 7-Year Asset Class Return Forecast; I excluded timber as it’s difficult for most investors to access).
How did you do? Don’t worry if you missed a few, because there’s one additional, far more important question: As an investor, which of the first three answers is most important?
Don’t get me wrong. All are pertinent, particularly when taken in context. It is useful to know, for example, that the U.S. stock market is very near all-time record highs, that it has gained nearly as much in the first quarter of 2013 as in a typical year (annual returns for the S&P 500 have averaged 9.84 percent from January 1926 through December 2012), and that the market currently trades at 18.04 times trailing 12-month earnings (compared with a long-term median of about 14.5).
High-yield bonds outperforming other asset classes over the last five years is also interesting.
But the value of this fact is diminished when you consider the artificiality of choosing five years versus, to be frank, any other period. Further, this particular comparison would look very different if one examined a more granular set of asset types rather than the nine broad asset classes I used.
What’s more revealing is that over the last five years, there were four different best-performers on an annual basis, and, measured year-by-year, high yield bonds didn’t finish first even once. That little reminder of the value of diversification is worth the exercise in and of itself.
No, the most valuable information to an investor – if one had confidence in the forecast – is which asset class will perform best going forward. Think about it. If you could know with certainty which asset class (or individual investment for that matter) would perform best over your investment horizon, it would be logical to invest all of your money there.
Of course, certainty is impossible to come by as to future events (with the possible exception of death and taxes). Still, I applaud GMO for asking the right question and doing serious analysis to attempt an answer. Far too much of what passes for investment analysis these days is little more than extrapolating recent trends. The shifting tides of performance from one asset class to another, and the frightening lack of persistence in active management, should cause us all to question this obsession with recent performance.
Far more attention should be paid to where we are going than where we have been. After all, financial markets operate to discount expectations for future returns into present values, not to honor past performance.
Within highly regarded Oaktree Capital Management, they have a saying: “Well bought is half sold.” That is, no matter the quality of any investment, the price you pay is critical. But investor behavior often runs counter. We have noted before that investing is often a tug of war between fear and greed. And it is the latter that causes otherwise rational human beings to invest more when stock prices are rising and less when they are falling. As a result, actual returns to investors typically lag market returns.
With the stock market setting new highs, investors have poured more than $59 billion into equity mutual funds since the first of the year. Although a move back to stocks is overdue for many investors, we worry that too many are chasing last quarter’s performance. The dispassionate investor improves his or her odds of success by asking what happens from here forward, not through a doomed effort to capture gains that are already baked into current prices.
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