One of the most basic survival traits that humans have developed over the years is pattern recognition. We work exceptionally well when things are structured. Just think about your job, no matter what it is. There is likely some aspect of your work that is broken up into well-organized pieces. The most obvious way to see this is through the explosive use of digital spreadsheets, such as Microsoft Excel, over the last 30 years. When you couple this innate human trait with the development of "on-demand" everything, growing wealth becomes exponentially more difficult. The irony is that it has never been easier or cheaper to build a portfolio. However, wealth is built one day at a time, and it takes a great deal of time. Likewise, markets move in anything but a structured way. There are many investment firms that are trying to use supercomputers to analyze unstructured data (think videos, tweets, hashtag trends, etc.). We shall see over the coming decades if these machines can tame the wild jungle that is the stock and bond markets. However, the purpose of this discussion is to highlight how important it is to think about long periods and how our brains' need for structure can lead us to draw incorrect conclusions.
Arek attended an investment conference recently where one of the speakers, a well-regarded person in the field of finance, pointed out that a psychologist once concluded that even if an investor today would know which asset class (bonds, stocks, commodities, etc.) would produce the best returns over the next 10 years, most investors would not achieve those returns. The reason is that there will likely be a period (which can last for 3-4 of those ten years) where that asset class will have inferior returns relative to other investments. Additionally, a 10-year period will feel like an eternity to most people. The conclusion was that investors have a hard time with the uncertainty around markets. If you look at the data from 1950-2018 (nearly 70 years), some exciting patterns begin to emerge. If you pick one year period (any start and end date) during those almost 70 years, you find that your 100% stock investment would be anywhere from -39% to +47%. That is an 86% swing! If you invest 100% in bonds and do the same analysis, you end up -8% to +43%, better, but still a 51% swing! However, if you do the same report over 20-year periods, 100% stock portfolios have a range of +6% to +17% per year, and 100% bond portfolios have a range of +1% to +12%. Notably, neither choice results in negative returns.
Recently the stock markets have been hitting record highs, and there is a lot in the media around how well markets have done this year. But it's essential to see that our need for structure can cloud our views. You know, we like to evaluate stock returns over the calendar year, which is an entirely arbitrary figure. So many people look at the S&P 500 having returned approximately 26% in 2019 as either a fantastic year or perhaps a bubble that may pop. However, if we change the dates we evaluate from, we can draw very different conclusions. The markets had a high back on January 26, 2018. As of this writing, the market is up just over 8% from that high. So in nearly two years, the markets are up only 8%. Looking at the data from that viewpoint, the return in the markets feels completely normal. Now, over the last decade, the US markets have had strong returns, averaging over 13% per year. Globally, US included, markets have averaged just over 8%. So clearly, the US has led the way. However, it is crucial to understand that in the short-term, returns are arbitrary, and information that affects the market is anything but structured. Building wealth is a process that takes many years and requires many points of optimization: budgeting, so you have money to invest, portfolio design, so you don't panic at the wrong time, and tax planning so that all of that hard work doesn't go unnecessarily into the hands of others. These three pillars: budget, portfolio design, and tax optimization are vital for long-term success. So if you get caught up in the market's move up (or down), remember that your emotions are mainly driving things, and in today's instant information world, it's important to see the forest for the trees.