Homers
Back in September, I took my eldest son to his first Dodgers game. As you can imagine, the traffic alone built up a lot of anticipation.
Everything was new to him – the stadium, the city, the concessions, the parking lot, etc. With a limited knowledge of the Dodger’s roster, he just knew he wanted to see Shohei Ohtani at bat.
His wish quickly came true as the first batter, Ohtani, stepped up to the plate.
Then…
BOOM!
The crowd went wild, and my son went absolutely bananas as Shohei knocked it right out of the park. The fun wasn’t done, though. Over the next five or six batters, the Dodgers had THREE MORE home runs. That’s right, four home runs IN THE FIRST INNING!
You can imagine how disappointing that second inning would be for a hyped-up 5-year-old expecting four or five more home runs.
Great Expectations
Let’s be clear: I think my son would’ve been ecstatic with seeing four home runs for the entire game, but that atypical first inning recalibrated his expectations.
This is the harsh reality behind small sample sizes. Our brains like to take shortcuts, so recent results are projected and expected soon.
In finance, we have this well-known and often-stated legal tagline, “past performance is not indicative of future results.” Yet, what’s the first question every investor leads off with: what are the past results?
Bad Behavior
Most importantly, though, why does any of this matter? Well, our emotions are highly determined by whether our experience missed, met, or exceeded our expectations. High expectations leave more room for disappointment, creating an emotional state of mind, often leading to irrational and potentially damaging financial decisions.
As an advisor, I know that a good financial plan and a solid investment strategy are crucial, but I also know that all goes out the window if an emotionally charged investor can’t stick to the plan.
Getting to Average
So, inflated short-term results can amplify our near-term expectations.
High expectations leave us more prone to disappointment.
Disappointment can place us in an emotional statement of instability – not ideal for decision making.
That’s the framework. Now, let’s make it relevant to 2024. The stock market this year is poised to deliver one of its best years of all time. Not THE best year, but a historical and memorable performance nonetheless.
So, riddle me this? If your financial plan is built based on an “average return,” and you are getting an above-average result this year, what do you expect for next year? Shouldn’t you expect that you would have a below-average year sometime in the near future? A negative year?
Just for fun… let’s imagine that your financial plan has you expecting/needing a 7% return, and let’s imagine that you are up 14% this year. Using rough math, you’d be on trend with a 0% return this next year. That’d be on target with the plan, but I’m guessing you may be disappointed with the result. Yet, that’s how averages work.
Misplaced Enthusiasm
Now, I want to share a simple truth that, if understood, would greatly benefit investors.
Investors get excited/enthusiastic about stock prices going up. I get it; it has a positive emotional impact on me, too, BUT I want to teach you how to throttle that enthusiasm a bit.
In the long run, what does and should drive stock prices up? Growing profits. Prices go as earnings go.
But that’s in the long run. In the short run, enthusiasm can muddy the waters a bit. Prices can, and do at times, grow at a faster pace than earnings. We call this multiple expansion.
Here’s the conclusion on this particular point. Stock prices and corporate earnings should grow at the same rate. Yet, they don’t always do. When that relationship is disconnected, stocks either become relatively expensive or cheap as those multiples – the relationship between prices and profits – expand and contract. If prices grow faster than profits, an investor is just borrowing returns from tomorrow to be experienced today. One should focus their enthusiasm on year-over-year profit growth instead of year-to-date stock price appreciation.
Easier said than done, but understanding what to attribute returns to (earnings growth or multiple expansion) should help to frame your expectations of the future better. Multiple expansion is fleeting, as multiples mean reverting, and expansion is simply followed by contraction.
They Can’t All be Home Runs
Home runs are exciting because they are rare. Dessert is tasty because it’s a treat. Vacations are fun because they are a retreat from the norm.
Stock prices go up, and stock prices go down. Returns are not linear, and the dispersion of potential outcomes is wide.
We are experiencing an atypical year when it comes to stock market returns. Yes, the presidential election and the potential for lower for longer tax rates and deregulation would be accretive to future earnings. Still, regardless of how you slice it or explain it, prices are inflating faster than profits. Again, the market is simply pulling future returns into the present, and it’s important to understand those details to help set the right expectations for your future self.
The only way to achieve average returns, which your financial plan expects, is to achieve both above-average and below-average results along the way. Interestingly enough, neither 2023 nor 2024 have seen a normal or average intra-year drawdown. This recent unfamiliarity with risk breeds complacency, drives up prices, and creates a sort of pent-up volatility to be endured by your future self.
You know me, I’m not a pessimist. I simply need you to have the right framing for what the future will most likely have in store. Your willingness to endure the nausea of markets is exactly why you receive the return premium you are experiencing in 2024. Enjoy the reward; embrace it, and don’t be surprised when the tides turn, as they always do. You’re a long term investor, you are built for all-weather, your portfolio needs to be an all-terrain vehicle of sorts.
I’ll simply conclude with what I told my son, “Sorry, my boy, four home runs in the first inning just isn’t the norm. Be glad you experienced it, but don’t expect to see it again.”
Trevor Cummings
PWA Group Director, Partner
tcummings@thebahnsengroup.com
Blaine Carver
Private Wealth Advisor
bcarver@thebahnsengroup.com
