Speaking about foresight and perceptiveness in markets, John Maynard Keynes, likely one the most well-known economists ever, said that successful investing is anticipating the anticipations of others. Keynes was also an investor.
But, from the 1929 stock market crash to the volatile postwar currency market, he was as blindsided as anybody else. This was until he changed his strategy in the late 1930s after becoming manager of the investment fund of King’s College at Cambridge University. Rather than second-guessing short-term economic or company events, Keynes focused on the medium-to-long term to let returns compound. Rather than timing the market’s twists and turns, he found better results by spending time in the market. Let’s apply these concepts to today’s world.
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Imagine you’re saving for retirement. As an example, also assume that you’re looking at the world’s largest, most liquid and highest quality equity market: the US.
Since the 1870s, US equities have returned an annual average of 6.8% after inflation. As a first approximation, using these return assumptions to determine how much one would need to save each month to get to the desired nest egg is reasonable.
But what if future returns are lower or you’re caught in a protracted market downturn when you need the money? The answer isn’t just a disclaimer in a financial document (“past performance is no guarantee of future performance”). It’s a lesson to plan for the unexpected.
Former US President Dwight Eisenhower is often quoted to have said that plans are worthless, but planning is everything. The deeper lesson is to plan on your plan not going according to plan. In our investment strategy, this means increasing the margin of error. However, increasing the margin of error is more than just widening the range of outcomes around one’s base case.
The key is building a margin of safety from things one can’t envisage. Avoiding these kinds of unknown risks is, by definition, impossible. But you can mitigate the impact of local events and plan for something going wrong, even if you don’t know precisely what it will be.
Portfolio diversification, as I described in the first blog of this series, is an effective long-term strategy for dealing with uncertainty. It balances investments that could occasionally perform poorly with those doing better. We do this by remaining invested globally across a wide range of asset classes that perform differently in different scenarios.
This is why most critical systems, from hospital equipment to aeroplanes, have multiple backups, and the backups have backups. You don’t want a failing electrical system when undergoing surgery, just like you don’t want to fly relying on just one engine (even though it’s technically possible).
Avoiding single points of failure isn’t just about managing risk. It’s also about seizing opportunity. Let’s look at today’s value of a $10,000 investment in the S&P 500 equity market, starting in January 2003.
Two decades later, if one stayed invested every day, that $10,000 investment would have grown to $64,844. Missing just the ten best trading days would have delivered much less, just $29,708.
Notably, seven of the ten best trading days took place in years when the index fell more than 20% (what investors call a ‘bear market’). Two of the strongest trading days were in October 2008, during the Global Financial Crisis; the S&P 500 gained more than 10% in each of those days. And during the 2020 pandemic, the second-best day happened after the second-worst day.
Of course, one can and should tilt portfolios according to shorter-term convictions to mitigate risks or enhance returns. But the key here is moderation: we want to let compound investing unfold.
Charlie Munger, the right-hand man of world-famous investor Warren Buffett, described the first rule of compound investing quite simply as: never interrupt it unnecessarily.
I discussed compound investing in my previous blog. It’s when you reinvest the returns of your investments rather than banking the income. This allows any growth to multiply, and small amounts of money can grow into larger amounts over time.
To understand this concept, take a piece of paper – just one-tenth of a millimetre. The first fold gives you 0.2mm, the second 0.4mm and the third 0.8mm. All incremental, right? Keep going.
At 11 folds, you’re at 204.8mm, still small. But at 30 folds, you’re at 107 kilometres. At 40 folds, you get to approximately 110,000km. With two more folds, you exceed the distance between the Earth and the Moon.
In the Psychology of Money, Morgan Housel describes the New Horizons spacecraft’s 4.8-billion-kilometre trip to Pluto taking nine and a half years. According to NASA, the trip took approximately one minute less than predicted.
Think about that. In an untested, decade-long journey, NASA’s forecast was 99.9998% accurate. That’s like forecasting a trip from Luxembourg to London and being accurate to within a few millionths of a second.
But astrophysics is a field of precision, while investing is a field of uncertainty. Investors sometimes want it to be like a trip to Pluto, because the idea of being in 99.9998% control of an outcome is comforting.
However, in predicting the future, investors occasionally focus too much on what they know and neglect what they don’t. Occasionally, this can make investors overly confident in their beliefs and neglect the role of chance.
The importance of time in the market is why we remain invested through our long-term strategic asset allocation. It’s a well-diversified portfolio that can be resilient to different scenarios, so it is an effective strategy to compound returns while mitigating risks.
On top of that, while excessively timing the market seems unlikely to produce good outcomes, we can capture shorter-term dynamics in portfolios. We invest tactically to capture opportunities in line with our economic and market views for the next 6-12 months. This allows us to strike a balance between time in the market and timing the market.
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Information correct as of 20 January 2024.
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