Ignoring the Noise of Financial Markets

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award.

Some headlines declare that the economy and stock prices are going to hell in a hand basket. But experiencing the latest downturn in the stock market is just another example of an entirely normal adjustment in our dynamic capitalistic economy. The constantly changing nature of the U.S. economy (and world economy) often masks this cyclical behavior, making it difficult for many people to see. In reality, what we're currently experiencing are only (temporary, by definition) cyclical declines within the vast permanent advance of our economy and financial markets the world over.

None of this is to downplay events in the stock market and the overall economy. It's important, however, to have a good historical perspective to better understand what's happening now or at any time, for that matter. For example, there have been 12 bear markets with a decline of 25% in the S&P 500 Index since World War II. That's an average of one bear market every five to six years. Our last bear market ended in 2009, so it may be, six or so years later, that we're just about on schedule.

The media, of course, exacerbate investors' fears by making it appear that the world is coming to an end. Bad news always sells, which is why investors are fed a steady diet of doom and gloom. In selling this narrative, the media would have us believe that "this time is different." That is, the world really will end this time. Yet the inconvenient truth of financial markets intrudes every time: in fact, this time is never different.

Not only is it not different, but the similarity between downturns from the past and those of the present is almost uncanny. The fundamental, underlying fact is that for every downturn (even during the Great Depression), the stock market has recovered--sooner or later--and gone on to surpass its old high. Although the details of each bear market might be different, the general cyclical up and down movements in financial markets continue unabated. The economy expands and contracts over time with various short-term interruptions followed by longer periods of expansion. Capitalism continues to extend into more and more countries around the world making ever brighter the long-term outlook for stock ownership. And yet, there will always be times when this entire system is called into question, when "this time is different."

Amidst all this, some investment advisors continue to provide the same steady and disciplined approach to creating and preserving wealth. They remain grounded in Modern Portfolio Theory and its progeny, which have been developed and utilized over about a half-century now. Their focus is on providing prudent portfolios that are low cost, and broadly and deeply diversified, both of which enhance return compared with other portfolios that are more costly and riskier and on an absolute basis. These prudent portfolios are consciously designed to weather the kind of entirely normal market permutations that we are now experiencing, while allowing investors to harness the positive long-term results of capitalism on a global basis to help meet their financial objectives.

In times such as this, investors may wish to think twice before making any adjustments to their portfolio such as timing the market and/or picking asset classes or stocks based on their current outlook on the economy. An especially useless (and harmful) exercise is what I refer to as track-record investing. This involves identifying the best-performing individual stocks and bonds, mutual funds, asset classes, or whatever, from some recent past time period--e.g., one, three, or five years--and based on that, assuming that their past superiority will continue into the future.

But the law of modern prudent fiduciary investing does not countenance 20/20 hindsight investing. For example, section 8 of the Uniform Prudent Investor Act (UPIA) mandates: "Compliance with the [standard of prudence] is determined in light of the facts and circumstances existing at the time of a [fiduciary's] decision or action and not by hindsight." Commentary to section 8 explains that "[h]indsight is not the relevant standard … [i]n the language of law and economics, the standard is ex ante [i.e., only what we have the ability to know now before we can see, say, lousy returns show up in a track record later], not ex post [i.e., what we now know but only because those lousy returns have now actually shown up in a track record]…" (See also Tussey v. ABB for a condemnation of hindsight investing.)

The language of section 8 of the UPIA as well as commentary thereto requires fiduciaries to adopt a view of risk that's prospective, not retrospective. A retrospective view of risk focuses on the outcomes of investment performances. Those who view risk this way rather simplistically assign no risk to track records that, in retrospect, have succeeded and assign all risk to track records that, in retrospect, are seen to have failed.

A prospective view of risk requires fiduciaries to recognize consciously--before the selection of any investment strategies--the essential problem identified by the father of modern portfolio theory, Nobel laureate Harry Markowitz: "Portfolio selection involves making a decision under uncertainty." Since uncertainty implies risk, the best way of managing the problem described by Dr. Markowitz and encountered by all investors ordinarily is to diversify portfolios.

Investors (including fiduciaries) should diversify broadly and deeply because they cannot know what's going to happen to a particular stock or bond (or a small group of stocks or bonds, or an asset class or even an entire financial market) in the future. That's part of what makes the phrase used previously--"sooner or later"--to characterize eventual stock market recoveries so maddeningly nebulous.

Nonetheless, the fact remains--however much investors may pretend otherwise--that the return on any investment is a random variable subject to inherent uncertainty, so it's just as likely that recent past winners will turn out to be future losers--perhaps even of a greater magnitude. There even seems to be a perverse tendency for recent past winners to turn into future nightmarish losers. We all have our favorite stories about such experiences: just as Apple is heading toward stratospheric heights, it turns south.

Unless an investor's own personal circumstances change significantly, he or she may want to simply sit tight with their current portfolio that, in less frenetic times, was judged after much thought to be a prudent portfolio--just as it continues to be now--even though it may not appear that way in these times.

All too many investment advisors flap their wings in reaction to downturns in market values so their clients can see them "doing lots of stuff" to justify their fees. Wholly apart from this, however, financial markets continue to function rationally--or at least rationally enough so that there's no sure way to know before the fact the identity of those relatively few winners (or losers) that will outperform (or underperform) the market after costs, taxes, and risk--as they go up and down in value through time, which is a reflection of the inherent risk they carry at all times. What may not be so rational is what's between our ears and how we react to perceived investment risk. That is the wildest ace in the deck of investing and is, by far in my view, the biggest risk that investors face: We have met the enemy and it is us. Viewed that way, perhaps 99% of investing is emotional.

Instead of incurring the perils of chasing past returns, then, it is far better to hold a low-cost, and broadly and deeply diversified portfolio. Being invested in this kind of portfolio means that each and every year an investor will hold the best-performing asset class as well as the worst-performing asset class. That's why the performance of this portfolio will always be less than the performance of the best-performing asset class in it. It also means that its performance will be more than the performance of the worst-performing asset class in it.

I might add a personal note here. A family friend practiced medicine for over 50 years. I was shocked to find out recently that his portfolio is much smaller than I thought it would be. He and his wife are struggling in old age to maintain their standard of living. Over the years, he always reacted to any downturns in financial markets by yanking his money out and going to cash. Then he would take forever jumping back into the market and, as a result, missed out on any inevitable ensuing market upturns. He therefore consistently sold low and bought high. Not a good way to invest and sustain a portfolio. I warned him of this destructive behavior over the years, but he never listened to me. That's why, even after many years of hard work, he wound up with far less than he could have had if he had merely remained fully invested in his portfolio at all times.

Perhaps the best advice to investors is to keep their heads low, stuff as many dollars as they can into their retirement plan portfolio (as well as any individual non-plan accounts) for as long as they can, and ignore all the extraneous noise that surrounds them on a daily basis. Investors should not be investing in the latest seemingly attractive asset play or individual stocks, which can, literally, be off-the-charts risky. Instead, invest in a low-cost, and broadly and deeply diversified portfolio calibrated to an investor's own risk tolerance. That should stand any investor in good stead throughout his or her life, even in retirement.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.