My first client email of the day on October 6th came with the following subject line statement: “I know what you will say, but this kind of makes sense..for 5.5% in a bank account it’s a NO-BRAINER.”
He attached a CNBC article titled: JP Morgan’s Marko Kolanovic braces for 20% market plunge, delivers recession warning. The first paragraph claims: “According to the Institutional Investor hall-of-famer, high interest rates are creating a breaking point for stocks – and choosing cash at a 5.5% return in money market and short-term Treasuries is a key protection strategy right now.”
There are several behavioral biases that activated my client’s worst human nature instincts to engage in exactly the opposite behaviors needed to maximize the probability of long-term investing success. Worse, without my counsel, he might have acted on his behavioral impulse and at exactly the worst time.
Further, the S & P 500 came into October 6th at about 4,200 and just 40 trading days later, as I type, the S & P 500 stands at about 4,600 -- plus 10%, arguably coming off of one of the best 40-day periods in history. In fact, the market just reached new highs for 2023, experienced it’s second-best November in over 4 decades and stands a few small percentage points from making ALL-TIME record highs, but I digress!
Loss-aversion bias refers to the fact that we feel the pain of a loss much more strongly than the pleasure of a gain. This causes us to focus on avoiding short-term losses rather than maximizing long-term gains.
We tend to prioritize short-term losses over long-term gains, which is called myopic-loss-aversion. As a result, we are attracted far more to strategies that may reduce short-term losses even though those same strategies will minimize long-term wealth. We are also more sensitive to changes in the value of what we own than in the overall value itself. We get used to having money, but we get excited about making more of it and are fearful of having to replace it.
The second bias at play here is known as authority bias whereby we pursue a course of action based on someone’s title, perceived authority, or expertise, rather than making informed judgements based on evidence and critical thinking. Succumbing to our need to believe in a predictable, controllable world, we turn to authoritative people who promise to satisfy the need.
A third is confirmation bias. This investor (as many others) is generally concerned about market declines so they seek out only articles and news items that confirm their fear, using search terms like: “reasons market will decline,” rather than “reasons market will hit new highs.”
Finally, ambiguity bias -- whereby we prefer options where the potential outcomes are more certain, even if the probable outcome is far less favorable -- leads to selecting the inferior option (bonds).
“The illusion of control is more persuasive than the reality of uncertainty.”
- Daniel Kahneman
THE LONG-TERM INVESTOR’S NO-BRAINER BOND DECISION IS TO ALMOST ALWAYS MINIMIZE A PORTFOLIO’S EXPOSURE TO THEM
We are taught to believe that the biggest risk to our wealth is the frequent, sometimes steep, but historically, always temporary declines in the number of dollars in our portfolios (volatility). To minimize this illusory risk, we are taught to own more bonds. The problem: the real risk to our wealth is the gradual disappearance of the value of each of our dollars (the erosion of purchasing power due to inflation). The main enemy of the investor has never been the temporary fluctuations in the NUMBER of our portfolio dollars (volatility) but ALWAYS, the diminution and destruction of the value of EACH of those dollars.
The average couple retires at 62 with a joint life expectancy of 30 years. At 3% inflation, in 30 years, they will need $2.5 to buy what $1 buys today. Every dollar in bonds will still be only a dollar in 30 years, so that the investor is only able to buy less than half of what they used to. Stock values grew at 7% annually over the past 30 years, leaving an investor with $8 for each dollar invested. The stock investor can buy over 3 times what they were able to buy 30 years ago – the bond investor can buy less than half.
Investments that preserve and grow purchasing power are safe and those which freeze and destroy purchasing power are risky. What we counsel at Fusion is not different than what the broad industry counsels. It is the opposite. When risk and safety are properly measured in terms of purchasing power protection, STOCKS ARE SAFE AND BONDS ARE RISKY.
If inflation is the disease of money, stocks cure the disease while bonds are a carrier of it.
WHAT ROLE SHOULD BONDS/CASH PLAY?
The market experiences an average decline of 33% about every 5 years. The full cycle, from a market top to a bottom and back, historically has taken an average of about 3 years. Investors should therefore hold bonds or cash equal to 2 to 3 years living expenses. This allows them to have most of their investments (stocks) always fighting off purchasing power erosion (inflation) while bonds and cash will save them from having to liquidate stocks (and from interrupting compounding) during their many temporary declines.
Investors should not own any bonds for the purpose of reducing volatility as each marginal dollar in bonds will destroy its long-term purchasing power. We can invest to satisfy our emotional wants or our financial needs, but we can seldom do both.
We must decide on which side of our financial lives we are willing to accept insecurity so that we may have security on the other end.
Gentleman who prefer bonds don't know what they're missing.”
- Peter Lynch
A bond that pays you 5% is selling for 20X earnings and the earnings can’t go up. It is absurd to own something like that."
- Warren Buffet
Given the fragile state of the world as it relates to geopolitics, economic challenges, and the anticipation of an upcoming bitterly partisan election, I am sensitive to the fact that many may feel a sense of vulnerability relating to their investments. Some may even consider abandoning critical disciplines like continually saving into their portfolio as soon as they have the funds available or maintaining the critical level of exposure to stocks in the face of current fears. In this light, I share the concept of the investor needing to become unbreakable.
The world breaks about every 5-10 years:
- In 2020, we had a one-in-a-100 year global health pandemic.
- The global financial system nearly collapsed in 2008.
- We experienced the first major US terror attacks on 9/11/2001 and the markets closed for a week.
- In 1991 we saw the fall of the Soviet Union.
- The stock market lost about a quarter of its value on one day in 1987.
- Inflation, interest rates and unemployment all approached 20% in the ‘70s.
- We had the Cuban Missile Crisis and assassination of JFK in the early 60s and of Martin Luther King in 1968.
I can go on like this for pages.
“The correct lesson to learn from surprises: the world is surprising.”
~Daniel Kahneman
The S & P 500 came into 1960 at 60 and sits at 4,600 today. A $1 million investment has grown to almost $80 million. Inflation, having grown 10X, means we need only $10 million to buy what we bought for a million then. Those extraordinary returns were not due to experiencing a remarkably benign economic, political and geopolitical environment. Moreover, we experienced 9 recessions and 11 bear markets (3 of which declined by 50% or more)!
What one had to do to experience the miraculous result was to be unbreakable – to have the endurance and longevity to allow the UNINTERRUPTED compounding to do its magic. They had to avoid allowing periodic breakdowns to cause them to abandon the requisite patience, discipline, and faith in the future that every successful investor must maintain.
“The only thing we learn from history is that we learn nothing from history.”
-Georg Hegel
Since there are no facts about the future, attempting to consistently forecast it is futile and will lead to horrible emotional and behavioral-biased mistakes. Instead of basing a plan on PREDICTIONS, we must base them on PREPAREDNESS (both financial and emotional). Having 2-3 year’s living expenses at retirement in cash/bonds, for example.
The market’s annualized price return that got us from $1 million to $80 million since 1960 was only 7%. The secret to long-term success is not finding investments that might return the highest amount, the fastest -- It is finding investments with the best returns you are likely to be able to sustain for the longest period. Earning average returns for above-average periods leads to extraordinary results. Always has and I suspect always will.
“The first rule of compounding is to never interrupt it unnecessarily.”
~Charlie Munger
THOSE FOCUSED ONLY ON TODAY OFTEN RISK MISSING TOMORROW
The 1970s are a vivid example. Then, Americans were most focused on the following “todays:” the cataclysmic terminal phase of one of the worst bear markets which began in 1968. The massive multi-million person Vietnam war protests including the Kent State shootings; the removal of the US from the Gold standard; the VP stealing money in the White House and Presidential resignation; the oil embargo and unprecedented gas lines; runaway inflation and interest rates all culminating in the August 1979 edition of Businessweek’s cover announcing “THE DEATH OF EQUITIES,” STATING THAT US EQUTIES WERE DOOMED TO NEVER MAKE MONEY AGAIN. What followed from the early ‘80s was one of the best two-decade stock market runs in US history.
The market has experienced a remarkable 45-fold increase since then. Why? Because the S & P 500 earnings -- which were about $5 then are forecast to be $245 next year – are also up about 45 times. IN THE LONG RUN, IT IS EARNINGS AND ONLY EARNINGS THAT DRIVE STOCK PRICES.
Meanwhile, somewhere in our great republic today, a middle schooler got on a school bus with a brand new iPhone 15 in their backpack. They are carrying a device that commands more computing power than did all the IBM mainframe computers in operation on the planet in the year 1970. If, when they got to school, they were assigned to write a research paper on any subject in the world -- nuclear physics, penguins, the Louisiana Purchase -- they could use the iPhone to research it at virtually no cost. If the topic was written in a foreign language, the device will translate it.
It wasn’t simply that by being focused on “today,” the investors of the ‘70s didn’t anticipate or predict these capabilities were forthcoming. That would miss the critical point, which is that in 1970, an instrument having those capabilities was inconceivable.
When the genius of equity-driven innovation collides with catastrophic current events, equities always win. Always.
~Nick Murray
Wishing everyone a Holiday Season and New Year marked by health happiness and peace.
All my best,
Jonathan