Now that the summer season has ended, I have returned to my weekly musings about the market and investors’ behaviors. I have had several discussions with both clients and referrals concerning how their accounts are doing against market returns. When someone tries to benchmark his returns relative to a broad index, two things can happen: they beat the benchmark or they underperform. However, there is a flaw with this analogy. What is the proper benchmark? And is your portfolio holding the same investments as the benchmark or average (i.e. the Dow Jones)? Since we are hyper-asset allocators and the majority of our portfolios are based on 60% equities and 40% fixed income, the above-referenced benchmark would not be applicable. Our main goal is to reach market returns with less risk or, to say it another way, not fully exposing ourselves to the volatility of the equity market.
When you embark on a trip toward a desired destination, it is important to know your starting point in the path you take. For every investor, the destination is financial success. Wouldn’t it be helpful to have a financial GPS, especially one with updates about market corrections to help you detour around the snarl? The reality, however, is that no such magic device exists and investment success requires old-fashioned discipline and judgment.
Discipline starts with an assessment of the environment and a map of the journey. Ptolemy, a famous cartographer and astronomer almost 2000 years ago, drew horizontal and vertical lines around the globe to enable seafarers to navigate unknown waters using tools of the time. He created the parameters and framework that enabled ship captains to see their futures on the horizon. They no longer were destined to follow a path of hope; they could have strategies that empower direction with insight.
Conventional wisdom holds that long-term forecasting of the stock market must be impossible because “even its short-term predictability is challenging.” If you can’t reasonably know what will happen next week or next year, how on earth are you to know what will happen next decade? Well there is a simple lesson from the forest. There are many factors that impact the growth of the trees each year: rain, sun, temperature, and a host of other conditions. Ask any forester; all of those conditions make it impossible to accurately predict regrowth for any given year. Ask the same forester about the next decade and he will reach for the historical tables. They provide standards for tree growth over long-term decades; when a tree is ultimately cut and its rings are measured, the year-to-year variances average out to prove the reliability of the historical tables.
But, every tree does not grow at the same rate under all conditions. The universal “average” is a fallacy. For example, trees of the same species grow at slower rates when confronted with the altitude, colder temperatures, and reduced rainfall. Likewise for the stock market, it does not generate the mythical 10% average return under all conditions. There are fundamental principles and factors that cause stock market returns.
Stocks are issuance of ownership in companies that generate profits over time. Stocks are financial assets that have value because of future cash flows in the form of dividends and earnings. Today’s value for a stock, and the stock market overall, is driven by future earnings growth and market rates return.
It is almost that simple: if you can assess the likely growth rate for earnings and have an estimate for the market rates of return, then forecasting the future stock market returns is clearly on the horizon. The challenge here is that most individual investors have little concept about PE ratios, projected cash flow, and capitalized annual growth rates. In fact, many professionals will tell you that predicting markets is a failed strategy. In reality, stocks should be chosen based on their future value not entirely on their price today. No one can accurately predict what return markets are going to have. But by back-testing investment models against real-market historical conditions we can produce a somewhat accurate judgment of how they will perform in the future.
Returning to my opening comment, investors must not try to duplicate market returns. What they need to focus on is what they need in percentage returns to meet their goals. After formulating your plan for financial security, don’t be concerned what the market is returning, but watch what your portfolio is returning and the amount of risk it is taking to get there.