If I Had a Time Machine, What an Investor I Would Be!
There is a common mistake that investors make when managing their portfolios and I will try to help you avoid it.
Let’s start with a simple question. Would you rather choose an investment that promises a 10% return or one that offers a 5% return?
On the surface the answer would seem to be obvious: take the 10%!
But knowing the promised returns or what has been earned in the past, is not enough information to make an informed decision. To make that decision, you need to understand the risks you’ll be taking with each investment.
To their detriment, investors are often too focused on the historic performance of their investment options and they ignore the risks.
Major inflection points in market history are generally moments in time where one investment type has persistently dominated the returns of all others. Typically, this leads investors to believe the markets have changed; that a new paradigm has emerged, and it requires they change how they invest.
There are three such inflection points I’d like to highlight…
The first occurred in the late 1970’s when inflation was out of control and interest rates were at historic highs. Because of this, stocks experienced an extended period of poor returns.
In fact, stocks had performed so poorly that Business Week ran a cover story titled: “The Death of Equities”.
With interest rates on bonds at 16% or higher, it was hard for stocks to compete. And with yields so high, it’s not hard to see why investors shunned equities in favor of bonds.
Why risk money in stocks? Not only have they underperformed, but bonds are paying very acceptable returns with less risk.
Seems to make sense, doesn’t it?
There’s more.
According to Macrotrends, 30-year Treasury bonds were paying 15.08% in September of 1981. At the same time in August 1981, 6-month bank CDs were offering 18% according to Forecast Chart.
So there you are, an investor looking at your options in the early 1980’s, what do you do?
Had you looked at the macro environment, you would have noted there was a new Administration and a Federal Reserve Chairman both determined to end the spiral of inflation. If they were successful, it would completely change the markets.
So again, I ask, how would you have invested your money?
It’s not an easy question to answer.
So, let’s change the question, what did investors do?
Many bought 6-month CDs. Since they paid interest rates much higher than Treasury’s, why not? By the early 1980’s, a common “strategy” for investors was rolling their money in 6-month CDs. That was touted as the “smart” investment strategy, and a lot of people were doing it.
By the early 1980’s, stock ownership in America was at its lowest point in history.
But soon thereafter, the fight against inflation began to show success and conditions in the markets changed quickly. Interest rates started to fall, and they fell fast.
Investors who employed the “roll CD” strategy now lamented their “smart” strategy. They could have locked in 15% buying 30-year Treasury bonds. They were now seeing their “reinvestment rate” (rates on new 6-month CDs) plunge.
Later they would wonder why they hadn’t bought stocks, as the early 1980’s marked the beginning of the greatest bull market runs in history.
Fast forward to the 1990’s. Interest rates fell significantly once inflation was beaten. Stocks performed very well for over 12-years but now started to go up at an even faster rate. Investors seized on this new technology: the internet.
What were investors doing by the late-1990’s? Yep, most were realigning their portfolio allocations again.
The new mantra was: why buy a low-yielding fixed-income security when certain stocks double every few months?
By the time the bubble burst at the turn of the millennium, those that fared best stuck to their portfolio mix that included fixed-income securities. Those willing to make less in the short term ultimately won the race.
But did investors learn a lesson?
Not yet!
The dot.com crash ushered in the next bubble: real estate. As it gained momentum, the new cry became “no one ever loses money in real estate!”
Year after year, real estate consistently outperformed other investment markets as investors flocked to real estate. Portfolio allocations changed once again: sell stocks and bonds; own more real estate.
I think you get the idea.
Am I arguing that the risk you face is in chasing markets that are doing well? Actually, no. The risk I want you to avoid is changing the mix of your investments because one is doing better than another.
The mix of fixed income and equities you own should be specific to your own circumstances. It should not change simply because something is doing exceptionally well (or poorly) over a period of time. Your mix of equities and bonds should persist because it’s based on what you need.
It may not be sexy to make less when things are moving and there are seemingly more attractive options, but you must remember that there are two components to measuring performance - returns and risk.
As difficult as it may be, when others are making more, sticking to your investment allocations as dictated by your specific circumstances and planning will help you avoid this common mistake.
Today we are at another inflection point for investors and I am seeing the same mistake being made. Historically low interest rates are enticing investors to chase yields in equity investments. Allocations to fixed income are being reduced for alternatives that most definitely include greater risk.
Avoid this mistake.
If you would like to better understand how to navigate current markets give me a call.