As wealth managers, we are frequently asked some variation of the question “So, what do you think the market is going to do?” or “What do you think of XYZ stock?” Those are difficult questions to answer, and this month’s post is an attempt to explain our perspective.
The reason that those questions are problematic is because no one knows. Certainly there is no shortage of prognosticators who pretend (or may even believe) they know, but the current price of a security, and by extension the market, generally incorporates all of the information possessed by millions of investors, most of whom are institutions. These market participants are intelligent, informed, and motivated. Thus the odds that any individual will consistently be able to find mispriced investment opportunities are extremely small. (Many excellent books have been written on this topic. I heartily recommend Winning the Loser’s Game by Charles Ellis as an excellent introduction.)
In light of that, the answer I want to give to the first question is, “It will fluctuate.” (Credit to J.P. Morgan, possibly, for that bon mot.) and to the second, “It is probably correctly priced.”
This doesn’t mean that there is nothing that can be done to try to increase our client’s odds of success, but rather than the futile exercise of stock picking, here are the main things we focus on:
Risk Management. There are two aspects to this. First, the portfolio should be positioned so that the amount of risk is not greater than the client can bear. In a bad market we expect the value of risky assets (e.g., stocks) to decline by approximately half. Thus, most clients should not have all of their investments in risky assets. Second, the portfolio should be diversified among a variety of risky assets, not all of which will go up at the same time or by equivalent amounts. (Risky assets do have the unsettling tendency to all decline together however.)
Behavior Management. Keeping clients invested in an appropriate asset allocation during times of euphoria (the late 1990’s) or panic (early 2020) is probably the most important function of a good wealth manager. One of the differences between a salesperson and a quality investment manager is their willingness to go along with (or even encourage) client’s emotional investing impulses.
Even worse, some advisors are themselves not temperamentally suited to investing and get caught up in the emotion of the market. When I say behavior management is important, I don’t just mean the client’s behavior. I mean the advisor’s too.
Asset Class Opportunities. While individual securities tend to be correctly priced relative to similar securities, occasionally entire areas may be mispriced because of widespread emotion. This is one of the most difficult areas to exploit because while the mispricings are blindingly obvious in hindsight, they are almost impossible to see in real time. They also don’t exist all the time, so as an investment strategy this has low “breadth.” If a mispricing seems to be occurring, a small adjustment to a portfolio rather than a large adjustment is generally appropriate because of the level of uncertainty.
Costs. The outperformance of asset classes and active investment managers may come and go, but expenses are permanent. Controlling costs (both explicit and implicit) is crucial over time.
Factor Tilts. There is substantial evidence that some factor tilts can be advantageous. For example, value stocks are likely to outperform growth stocks over time (particularly in small companies and at current valuations).
To recap, “Is my porfolio constructed soundly to meet my long-term financial goals?” is a much more pertinent question than, “What’s the market going to do?”