More Questions than Answers
When it comes to investing or financial planning, it is very hard to provide helpful answers without having a great deal of context first. The initial answer to so many questions is, “it depends.” This means that a good conversation about finances should start off with a lot more questions than answers. This is why I’ve always found those Dear-Abby-type personal finance articles more harmful than helpful. Each situation is unique based on goals, preferences, resources, etc. and deserves tailored advice, not blanket answers.
I can’t help but be reminded of the conversation between Alice and the Cheshire Cat:
“Alice: Would you tell me, please, which way I ought to go from here?
The Cheshire Cat: That depends a good deal on where you want to get to.
Alice: I don’t much care where.
The Cheshire Cat: Then it doesn’t much matter which way you go.
Alice: …So long as I get somewhere.
The Cheshire Cat: Oh, you’re sure to do that, if only you walk long enough.”
– Lewis Carroll, Alice in Wonderland
Purpose & Expectations
This week, I had the pleasure of speaking to a not-for-profit board of directors regarding the organization’s investment funds. The board simply wanted some feedback on their current strategy, and of course, I had a lot of questions but a limited amount of time. Again, context is key. I wanted to respect the board’s time, so to be succinct, we covered two primary topics: what is the purpose of these monies and what their expectations should be based on how the portfolio was/is currently designed.
In most investing conversations, you should start with this question: What is the purpose of this money? You want to know when the money will be used and what it will be used for. Monies earmarked to be used in the near term need to be accessible, and the value needs to be stable. Monies earmarked for the long term need to grow and retain buying power, which often means that those funds won’t be as accessible (liquid) or stable (volatile). An oversimplified example might be that stocks aren’t appropriate for an upcoming down payment on a home, and a CD probably isn’t suitable inside a retirement account that won’t be accessed in the next decade. Understanding the purpose is the context one needs to deliver meaningful advice.
Once you’ve defined purpose, you then simply want to see if the current structure and design help to best support that purpose. An investing conversation shouldn’t lead off with, “Are these good investments?” Because the appropriate response really is what the Cheshire Cat said, “That depends a good deal on where you want to get to.”
In my discussion with the board, they shared that they had designed a very simple and cost-efficient portfolio, which had roughly half the funds in stocks and half the funds in bonds. After discussing the purpose, I wanted to explain what the appropriate expectations would be for this type of portfolio. I simply cannot express enough how important appropriate expectations are, as misplaced expectations are usually the impetus of most bad financial decisions. Misplaced expectations lead to disappointment, and the emotions that come with disappointment lead to poor judgment.
Two Charts
Regarding expectations, I just wanted to outline what a reasonable expectation would be for the return on the bond portion of the portfolio and the stock portion of the portfolio. The goal here is to just assure that their current expectations match what I would describe as “reasonable expectations.”
I always start with the bonds, because bonds are easier to explain. When it comes to high-quality bonds, there is a very simple equation called “twice duration minus one.” Here’s how this quick and easy back-of-the-napkin calculation works: let’s say the yield-to-worst on your bond portfolio is 4.5% and the duration is 6. You can safely ‘guestimate’ that over the next 11 years (twice duration minus one), your return will be 4.5% (yield-to-worst). Making a basic assumption that duration/maturity is constant, you place a reasonable expectation that the annualized return will be around that 4.5% figure. Yes, returns will fluctuate year-over-year (standard deviation) based on movement in rates, but still, you are left with a reasonable expectation of what returns will be over the next decade.
Stocks are a bit more complicated, but in the long run, there is a strong correlation between the starting price you pay and your future returns. When we talk about “starting price,” we are really looking at how many dollars you have to pay for a stock relative to the dollars that stock is generating in profits (earnings). Next, I shared two charts to help illustrate this point, but I need to provide a quick disclaimer: no investment decision should be determined by a single chart or even a few charts; these are simply meant to provide context to help anchor our expectations.
With that said, here is what prices compared to profits look like today, along with what this ratio has looked like over the last handful of decades:
Source: J.P. Morgan
A simple reading of this chart would be that stock prices, on average, are expensive relative to what the cost has been historically. As I mentioned, there is a high correlation between where that ratio sits (expensive or cheap) and what your future returns are (above-average or below-average). Said another way, expensive prices today (high P/E Ratio) lead to below-average returns in the future. The next chart I am sharing will help to define what I mean by “the future,” as this ratio is not a good predictor of what results will be next year, but a very strong predictor for what average returns will look like over the next five years.
Source: J.P. Morgan
The chart on the left (one-year forward returns) shows no trendline or correlation between prices (P/E Ratios) and returns, while the chart on the right (five-year forward returns) shows a strong relationship and trendline between prices and returns. Again, a simple way of expressing that high prices lead to below-average returns.
The point I wanted to make here was just that expectations should be that returns will probably be below average, but an investor will still need to endure the traditional volatility associated with owning stocks. So, one has to ask themselves if that risk/reward is appropriate for their portfolio or the portfolio they are responsible for. We won’t dive too deep into it here, but these charts are descriptive of the broad market, which is where I segue to my advocacy for a Dividend Growth strategy as a solution to the potential problem presented above (another conversation for another day).
Again, my focus here is less a critique of an investment strategy and more around the importance of what one’s expectations are and how they landed on those expectations. We should always ask ourselves, “Are my expectations reasonable?”
The Late 90’s
Even though I stated it above, it is important to reiterate that current valuations (e.g., P/E Ratios) aren’t a great signal for timing the market. Expensive things can and do get more expensive. The term “bubble” helps to describe this phenomenon well. A bubble – whether gum or balloon – will continue to expand until it eventually pops. The timing around that pop is hard to predict, but when it happens, it is swift and violent.
I regularly think about this quote from Alan Greenspan in December 1996. Greenspan was speaking at the American Enterprise Institute, and he posed this question: “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?” The whole quote isn’t often remembered, but that descriptor of “irrational exuberance” has echoed through financial history. My favorite part is that Greenspan made this claim in late ’96, and here are the returns for the S&P 500 over the following three years:
1997 +33.36%
1998 +28.58%
1999 +21.04
Perhaps the greatest three-year run in market history. A three-year run that was followed by the worst three-year run in history, which led to what we now call the “Lost Decade.” So was Greenspan, right? Yes, but I am sure some laughed off his comments for about three years or so.
Moral of the story, price matters and sometimes it takes thick skin and strong convictions to not be lured off course by a bubble.
In Closing…
What I would like you to walk away with today is simple: (1) know the purpose(s) for your money and (2) set reasonable expectations on your portfolio.
I want to emphasize that word, “reasonable,” and encourage you to ground your beliefs in truths portrayed throughout market history and supported by empirical data. Many philosophers throughout history, along with the economist John Maynard Keynes, have referred to these “animal spirits” that drive us to make decisions grounded more in emotion and gut feeling than logic or probabilities.
Buffett goes as far as saying that “The most important quality for an investor is temperament, not intellect,” an elevation of EQ over IQ. For me, the word “groundedness” comes to mind, which Google describes as “self-awareness, emotional stability, and a balanced perspective, allowing individuals to navigate life’s challenges with resilience and purpose.”
That’s it, just strive for groundedness.
