The world is oversupplied with oil, U.S. interest rates are rising and international prospects look dim, with slowing growth in China and persistent troubles in Europe and Japan. How should investors react?
When asset prices decline, people naturally want to take action to alleviate the pain. Yet sometimes no action is the best reaction. Trying to avoid the next market meltdown or identify the next hot market is a siren song for all investors, but even professional investors are collectively unsuccessful when they try to time buying into or selling out of particular investments. For the 15 years ending December 31, 2014, only 19 percent of stock mutual funds and 8 percent of bond mutual funds survived and outperformed their indexes, according to data from Dimensional Fund Advisors and the Center for Research in Security Prices at the University of Chicago.
Knowing a bit more about how the markets work can help you understand why maintaining a consistent, diversified approach to investing is the right philosophy for achieving long-term success, regardless of the crisis du jour.
Understanding Valuation Principles
The basic theory behind investing is easy to understand: Buy low; sell high. However, determining what an investment is worth, and thus which investments are underpriced and which are overpriced, is not as easy as it seems. While Palisades Hudson recommends a diversified approach to investing that is implemented using mutual funds and exchange-traded funds, the principles discussed below also apply to individual stocks, bonds, real estate and other investments.
U.S. Treasury Regulations define “fair market value” for federal tax purposes as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” Essentially, this describes what happens in the stock market every day. Two independent parties reach a mutually agreed-upon price at which to trade an investment.
This definition also encapsulates one of the theories of valuation: An investment is worth only as much as someone else is willing to pay for it. If people are enamored with tulip bulbs, Beanie Babies, tech stocks, real estate or gold, they might pay ever-higher prices that seem to have little rationale. The buyers of a seemingly overpriced asset might just be hoping they find a greater fool who will buy it from them at an even more inflated price. The possibility that they are, in fact, that greater fool scares many investors.
On the other hand, there is another theory of valuation that says each investment has an intrinsic value, which can be determined through due diligence. Most investors consider this intrinsic value when they try to price an investment based on the current value of its future cash flow. However, this second method is not as robust as it sounds, because it still relies on the investor’s assumptions. The future cash flow of most investments is not certain, regardless of how much research an investor performs. As a result of this uncertainty, any valuation can be justified based on a given prediction, though thoughtful analysis should still result in a more accurate assessment of intrinsic value.
Market Efficiency
Each investor makes certain assumptions about the future and has reasons to buy or sell an investment. Every time a trade occurs, it is another affirmation that two parties agreed on an appropriate fair market value for the investment at that time. In this way, the market incorporates the collective wisdom of all investors’ different predictions of the future.
The degree to which a market’s prices are accurate and its mispricings are unpredictable is known as a market’s efficiency. Efficiency varies by markets. Markets with more participants, a freer flow of information, better-informed participants and more trading tend to be more efficient than markets that lack these features. At Palisades Hudson, we believe that markets, and especially large capitalization (large-cap) markets in developed countries, are fairly efficient. For that reason, we choose to index large portions of our portfolios, since we do not believe active mutual fund managers can add value in efficient markets.
But markets are not perfect, and mispricings occur from time to time as a result of many investors either choosing to ignore intrinsic value or incorporating incorrect assumptions in their fundamental analysis. These mispricings tend to be random in efficient markets, and it is hard to know when your viewpoint is smarter than the collective wisdom of the market. You should only attempt to outperform an index if you believe that you, or someone you hire, can secure a sustainable advantage versus other market participants.
Avoiding The Temptation To Time The Market
Many of us think we are smarter than the average investor, so we should be able to outperform the market. We read headlines about the hedge fund manager or other star investor who profited handsomely by accurately predicting the last unexpected event. The next time you hear about these predictions, remember this quotation from Malcolm Gladwell: “If you make a great number of predictions, the ones that were wrong will soon be forgotten, and the ones that turn out to be true will make you famous.”
One investor may get several predictions wrong before getting one right and may be too early with his or her prediction. In hindsight, we will recognize such clairvoyance, but before the unexpected occurs, multiple experts would likely predict wholly different scenarios. The majority of professional investors underperform the market, and those who consistently outperform may do so by chance.
While experts who have a contrarian viewpoint that is ahead of the market might outperform the market as a whole, individual investors will have a much more difficult time succeeding. If you expect a recession based on something you read in The Wall Street Journal or heard on CNN, it is likely pointless to trade on that information, because that possibility is already incorporated into the current market price of investments. Similarly, if you read a story about a company’s breakthrough product, it is also too late to buy that stock. Trading based on your own theories should only result in excess profits if your viewpoints are more accurate than the market’s view as a whole.
If I expect gas prices to go up next week, I will fill my tank today, even if I have plenty of gas. If I expect prices to go down, I’ll roll into the gas station on fumes next week. Markets work the same way to incorporate people’s expectations of the future.
If a region, sector or company is likely to produce higher output in the future, the stock market often takes notice of this and prices the expectation into the current valuation. The stocks go up, even though the good news or growth has not yet arrived. So if investors already anticipate substantial growth in a country, that market’s future returns might not exceed those of a slower-growing economy, since the faster growth was already accounted for in the original market price. An investment is most likely to outperform when its prospects or earnings exceed the market’s expectations.
Under these circumstances, growing a portfolio is not as easy as identifying the market with the highest potential for growth in future output, and investing accordingly. One of the biggest mistakes investors make is trying to trade based on a very accurate prediction for which the market has already accounted.
Investors can get a little more information about how expensive a company or market is by looking beyond recent stock market movements. Just because markets have declined does not mean their value cannot fall further. Nothing in the laws of math or the markets prevents an investment that has fallen 50 percent from declining another 90 percent. For this reason, you should not concentrate your portfolio in an area that has had recent trouble with the hope of it bouncing back.
Experienced investors often look at certain valuation metrics to give them an idea of how expensive an investment is. The most widely known of these measures is a stock’s price-to-earnings ratio, but there are several others, including its price-to-book value, price to cash flow and dividend yield. These measures provide more information than just looking at a market’s recent moves, and they can be compared across time and across markets to determine a market’s relative valuation. However, again investors as a whole might be correct to seemingly over- or underprice a market, and it is hard to know when the market is wrong.
You can find substantial support to prove that almost any valuation is right, and probably just as much to prove that it is wrong. Cheap markets can get cheaper, and frothy markets can get more expensive.
Given how uncertain stock markets are in the short term, we prefer to establish a set mix of investments, known as an asset allocation, for each client based on that individual’s risk tolerance and spending needs. We then encourage clients to stick with that asset allocation unless their financial objectives or situation materially change. Our focus on maintaining asset allocation is also supported by many academic studies that have concluded that asset allocation is the most important determinant of a portfolio’s performance — even more so than security selection or transaction costs.
When rising markets lead to an overconcentration in one area, this is a signal to reduce your stake in that area to its original target percentage. Conversely, when falling markets leave a segment underrepresented, you should increase your investment in that segment to its original target. This is called “rebalancing the portfolio,” and it is an important part of our investment strategy. Our research suggests that rebalancing provides a higher risk-adjusted return than leaving a portfolio to its own devices.
We take a disciplined approach to rebalancing, by buying or selling an asset class when it deviates beyond a predetermined range from its target allocation. This ensures that our clients’ portfolios do not become overexposed to one investment type or asset class, thereby maintaining the desired diversification. It does not include any attempt to time the markets, for all the reasons I have discussed.
Those who invest in the market do so with the aim of maximizing their profits. Unless you think you know something of which others in the market are unaware, think twice before changing your portfolio. Markets quickly incorporate new information into prices, and you are unlikely to be trading ahead of the crowd.