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There is no shortage of investment lessons to draw from the securities markets in 2017.
But in this column, one of my last in 2017, I want to highlight three that I think are among the most important to take with us into 2018.
Humility is a virtue
Humility is always a virtue in investing, but especially so today. That’s because there have been an unusually large number of spectacularly wrong forecasts over the past year, and there’s no reason to expect 2018 to be any different.
You’d think the gurus issuing those bad forecasts would show some contrition. But, instead, they are just as confidently issuing their 2018 forecasts. They are banking on our memories being too short to remember what they were saying a year ago, along with our all-too-human tendency to be attracted to the carnival barker than to someone who reasonably and soberly concedes that no one knows for sure.
If you doubt that latter point, just ask yourself which of two stories you’re likely to turn to first. The headline of the first is: “Why the Dow will skyrocket to 36,000 by the end of 2018,” while the headline of the second is “Gradual improvement in economic data warrants a slight increase in equity exposure.”
This second headline alerts you to a responsibly reasoned and well-balanced article. Incredibly boring, in other words. In contrast, the first headline alerts you to something outlandish and provocative — and almost certainly wrong. Yet the vast majority of viewers will click on it first.
Consider some of the predictions that were commonplace one year ago — and wrong:
–Donald Trump’s presidency would be a disaster for the stock market. With little more than a week left in 2017, the Dow Jones Industrial Average (DJIA) is up 25.3%, the S&P 500 (SPX) is up 19.8%, and the Nasdaq Composite (COMP) is up 29.3%. Some disaster.
–A bond bear market was about to begin, if it hadn’t already. As we near the end of 2017, however, the Vanguard Long-Term Bond Index Fund (VBLTX) is up 8.7% for year-to-date performance, and the Vanguard Intermediate-Term Bond Index Fund (VBILX) is up 3.5%.
–This would be a blockbuster year for gold. And it did shoot out of the starting gate at the beginning of the year. But since then, gold has languished, climbing only 9.5% in 2017, less than half the gain of the broader stock market. Notice the ultimate insult to gold’s devotees: Bullion is barely ahead of long-term bonds for 2017 performance.
An older example that cries out for mention is Warren Buffett’s spectacular bet 10 years ago against the hedge fund industry. As you may recall, at the beginning of 2008, he bet that the S&P 500 would outperform hedge funds over the subsequent 10 years — through the end of 2017, in other words. The contest hasn’t even been close; the package of hedge funds picked by the hedge fund manager who took the bet fell so far behind the S&P 500 that the manager threw in the towel last May, seven months before the formal end of the bet.
The reason Buffett’s bet is such an instructive anecdote: Hedge funds for the most part are run by some of the smartest people in the business — Wall Street’s best and brightest. If they fall so short of the S&P 500, perhaps even they should be a bit more humble.
(To head off the inevitable counterarguments from hedge fund devotees, let me acknowledge that it’s not necessarily an apples-to-apples comparison to judge hedge funds against the S&P 500, and that in an equity bear market, hedge funds are likely to do better. But the hedge fund manager didn’t have to take Buffett’s bet. By nevertheless doing so, the manager was in effect forecasting a much lower equity return than came to pass, and he was wrong. The moral of the story, as before, remains humility.)
I am reminded of the late Harry Browne, the one-time investment advisory service editor who became the Libertarian Party’s candidate for president in the 1990s. He pleaded with readers not to bet all or nothing on any one prediction or adviser — no matter how good his record.
In his book “Why the Best-Laid Investment Plans Usually Go Wrong,” Browne wrote: “Almost nothing turns out as expected. Forecasts rarely come true, trading systems never produce the results advertised for them, investment advisers with records of phenomenal success fail to deliver when your money is on the line, the best investment analysis is contradicted by reality. In short, the best-laid investment plans usually go wrong. Not sometimes, not occasionally — but usually.”
Even if you don’t go so far as to completely embrace Browne’s pessimism, I think you will agree that his position is not that far from being an accurate portrayal of how the world really works.
2. Tops are harder to call than bottoms …
… but that isn’t to say that bottoms are easy to identify in real time. They most definitely are not. But bull market tops are even harder to call than bottoms.
The reason this is an important lesson to draw now: Gurus are falling over themselves trying to call the exact top of the market. So far their predictions have been wrong.
Someday, one of the gurus will be right, of course, and his name will be in neon — for a while. But what the focus on his “spectacular” call will overlook is how much money was lost following other gurus who got it wrong, or how much money was lost in past years when the newly-on-target guru was himself wrong.
In contrast to market bottoms, which tend to be characterized by sharp and explosive reversals, market tops in the past have tended to be long and drawn out, with various sectors topping out at different points over a several-month (or longer) period.
Most of the successful market timers over the long term don’t focus on picking the exact day of the top and instead try to differentiate between market declines that are mere corrections and those that are the beginnings of major bear markets. That means that, even when they’re right, they will not only miss the exact day of the top, but also get out of the market several percentage points lower than the peak. That affords far few bragging rights, but is nevertheless more successful over the long term.
To use a baseball analogy: Market timers who try to pick the day of the top are like the batter who tries to hit a home run every time at bat — and who often ends up striking out. The more successful ones are willing to settle for a good on-base percentage, even if they miss out on the glory of hitting a home run.
Once again, we are brought back to our first lesson that humility is a virtue.
3. Risk is rewarded only up to a point
My final lesson is that risk isn’t always rewarded. I know that this flies in the face of much conventional wisdom, but my four decades of performance tracking show that it’s nevertheless true. The highly leveraged advisers I track hardly ever stay at the top of the performance scoreboards for long, even when the market is going their way. Slow-and-steady almost always wins the race over the long term.
The reason this lesson is so crucial right now is that the bull market will end. When it does, you will be grateful to be following a lower-risk strategy. But there’s no reason to wait until then to reduce your portfolio’s risk, since even in bull markets higher-risk strategies often stumble and fall.
In closing: It’s been a pleasure penning these periodic columns over the past year, and I thank you for reading them. I commit to a healthy dose of humility in 2018, and I count on you to remind me when I fail.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email email@example.com.