October 16, 2015
The Concept Of An Investment Lifetime
Many investors are more financially sophisticated than they were decades ago thanks in part to the availability of information on personal finance and investing. But there is also a large portion of the investing public that has a tendency to get whipsawed— over and over. They have a regency bias that can contribute to performance chasing; they give up too soon when an investment disappoints; they are overconfident in their ability to make sense of investment markets and specific investments; and they are susceptible to the grass is always greener way of thinking triggered by the onslaught of opinion presented by the financial media and perpetual financial marketing. They bounce around like a pinball from strategy to strategy and from fund to fund. The end result can be too much buying high and selling low—a practice that cuts into returns and is inconsistent with achieving long-term financial goals. The behavior also results in frictional costs through transactions and taxes.
To guard against these very common human tendencies, investors must do two things:
The Benefits Of a Lifetime Investment Horizon
A very long time horizon provides a needed perspective that should inform how investors think about their broad investment strategy, their portfolio, and how they evaluate their portfolio’s performance.
Here are just a few examples based on our experience managing money for our clients.
A lifetime investment horizon makes it easier for investors to benefit from the long-term investment odds, which are likely to be reliable. When valuations are extreme, when cycles have moved beyond reason, when investment fundamentals are not reflected in prices—a lifetime horizon should make
it easier for investors to accept that patience will allow the odds and the fundamentals to play out.
It provides the comfort of knowing that trying to squeeze the last bit of return out of a hot market is not worth the risk, and is not material to their 40-year average return. Conversely, knowing that bear-market pessimism will pass, and even if one jumps in to a cheap market a little too early, they will eventually be rewarded.
It provides the context and confidence to dismiss fads and cycles so as not to get sucked into something that common sense suggests shouldn’t last, but is nevertheless tempting when so many others believe.
The patience that comes with a lifetime perspective also makes it easier to accept that periods of subpar performance will not necessarily carry into the future. This does not mean that strategies, managers, or positions should never be jettisoned from a portfolio. What it does mean is that there should be sound reasons for doing so that go beyond raw performance numbers.
So, being a lifetime investor facilitates accepting certain investment realities, including the very real cycles of over- and under performance that portfolios experience. The investor can accept that over a lifetime, a prudent investment approach may disappoint at times, but over the long term, common sense discipline wins. These periods of underwhelming performance are likely not material to investment returns over longer periods. Understanding this helps to protect the investor from giving up on something that will work well over the long run.
What this all gets at is being disciplined about building and sticking with an investment program. It’s easy to say but surprisingly difficult to do.
Adopting A Lifetime Investor Perspective
Once an investment philosophy is identified, there are a few principles and disciplines that can facilitate developing the steady hand at the tiller that is the ultimate benefit from thinking like a lifetime investor.
One’s investment philosophy and values, long-term investment goals, and risk tolerance should be regularly reviewed. The purpose of the review is to reinforce and internalize them so that investment decisions are always thought of in this context. Without this regular review process the philosophy may become something that was once discussed but fades from consciousness over time.
Developing some historical context is also helpful. Specifically, there are characteristics of investment markets that are eternal. Perhaps the most important is that investment markets are cyclical and there are many types of cycles. There is the economic cycle and the accompanying investment cycle. There are longer-term “secular” cycles such as the long decline in interest rates we’ve experienced since 1982. Sometimes a market or a sector experiences a cycle that becomes a mania.
Some investors fully buy into the underlying stories, which may be based on “new era” thinking. “Experts” tout the underlying rationale. The result can be a cult-like belief in the stories (and the financial industry is expert at feeding these stories to investors), and this leads investors to make costly mistakes by buying and owning overpriced assets and avoiding underpriced and unloved opportunities. Understanding how cycles work can help investors resist this temptation.
An obvious example of a mania was the tech bubble of the late 1990s, when anything tech and, specifically, Internet-related surged in price over several years. Companies with questionable business models, no profits, and sometimes no revenues had multibillion-dollar valuations. The tech mania ended and the technology sector saw prices drop dramatically. And while technology was and is a game changer, it has taken time, and many tech and Internet companies have not succeeded in a very competitive and rapidly changing environment. Another recent example was the belief that house prices would never decline. And going back some years, Japan in the 1980s was widely viewed as an economic powerhouse that was going to dominate the 21st century. The stock market reflected that belief and it generated a much higher return than the U.S. market in the 1980s. But the belief turned into a mania and Japanese stocks became grossly overvalued. As it turned out, Japan was not an economic powerhouse and has floundered during the 25 years since. The Japanese stock market has lost enormous value over that time, while the U.S. stock market has generated positive returns. Manias often last much longer than one would think, and the challenge this presents for investors (and investment managers) is sticking to rational analysis when it seems misplaced, sometimes for as long as several years.
Another facilitator of a very long-term investment perspective has to do with evaluating the investment portfolio in the context of one’s long-term investment philosophy and goals. That is, looking at performance numbers as a means to an end (the investment goals). This can be a challenge given the shorter-term, benchmark- related performance reporting common in the investment industry, which can be inconsistent with a longer-term, goal-oriented focus. In a world where performance data may be available daily and is surely provided at least quarterly, context and perspective are especially important.
Applying These Lessons In Today's Market
We have so far outlined the theoretical benefits of a lifetime investment perspective, including the increased ability to stick with an investment program in rough waters or when temptations come knocking. In looking at today’s investment environment, we can highlight a number of temptations.
The U.S. equity market has had a very strong run over the past few years and by most valuation measures is stretched. After six years of generally rising stock prices, investors may be complacent about the potential risk. Those risks may or may not be imminent, although there are certainly signs that suggest potential returns in coming years could be quite low (likely driven by a bear market along the way, possibly brought on by an intensification of global growth concerns or uncertainty regarding monetary policy, both of which have prompted short-term declines in recent months).
U.S. and foreign stocks have a habit of going through multiyear periods in which one outperforms the other, followed by a reversal. For example, in the late 1990s/ early 2000s, U.S. stocks enjoyed a streak of out performing over international stocks; however, from 2002 to 2007, international stocks trumped U.S. stocks by a wide margin. Over the last few years, U.S. stocks have charged ahead. Because markets move in cycles, there will always be periods where global diversification doesn’t appear to “work” and investors will begin to question their allocations. However, we believe the reversal of this current cycle may not be long in coming given the relative attractiveness of foreign stock market valuations (stock prices) and the potential for foreign company earnings to improve from currently depressed levels.
The financial services industry is masterful at developing and marketing new compelling investment products. Unfortunately, their benefits are often oversold. These days there is an onslaught of “alternative” investments. Some are compelling and we use some of these. However, most are not, and many charge exorbitant fees in exchange for questionable value. Careful research is essential when wading into new, hot investment offerings.
Core Tenets of Our Investment Philosophy
Investment Fundamentals Ultimately Drive Returns:
This gets down to the economics of the investment. Specifically, whether we’re evaluating stocks, bonds, real estate, or another asset class, the value of an investment is generally determined by the cash flows the investment or investment market generates over time. We also assess the risk associated with those cash flows. Finally, given all of this, we determine a reasonable price range for the investment under different scenarios.
Acknowledge No one Can Predict “The” Outcome:
Our use of scenarios reflects our acknowledgement that in an uncertain world we can’t predict the outcome, but we don’t think anyone else can either. However, we can more confidently evaluate a range of possible outcomes in order to understand the full scope of potential returns for one investment or asset class relative to another. Our objective is to always emphasize undervalued investments and de-emphasize overvalued investments while structuring a portfolio that we believe will deliver the highest long-term return in line with the client’s risk tolerance.
Investment Opportunities Come to Those with Patience:
Of great importance is our understanding and acceptance that this fundamental approach is a long-term one. Which is to say, we’re highly confident in its soundness and likely success over the long run while knowing that market prices can get out of whack relative to their fundamentals over shorter time periods, sometimes lasting for years. But the tendency for market pricing to occasionally get out of whack is exactly
what creates great opportunities resulting from temporarily undervalued and overvalued investment assets. This reality is the basis for our investment philosophy, which is to build well-diversified portfolios that skew toward undervalued assets and away from overvalued asset classes. In implementing our approach we know that it’s not possible to get short-term timing right, so our philosophy requires that we patiently wait for markets to normalize while also being intellectually honest as we reassess and question our decisions on an ongoing basis.
We have a longer list of fundamental investment beliefs, but those described here are the essence of our philosophy and the basic belief system it is based on.
The Bottom Line
The long-term perspective of a lifetime investor should facilitate discipline and steady decision-making across every scenario leading to a sense of confidence in achieving long-term outcomes and less worry along the way.