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Reversion to the Mean

A basic thesis on Wall Street is that what has worked well in the last market cycle is likely to underperform in a new cycle, and conversely, the underperformers of the last cycle can or should be the outperformers of the new cycle.

The basic logic is intuitive – an asset class that had been a leader in the previous run-up will, at some point, become overpriced and will struggle in the future without significant earnings growth to support the higher prices.  

Historically speaking, small caps outperform large caps. 

This makes sense because investors need to be compensated for the increased volatility and risk in the small-cap space. 

Also, over the long term, value stocks outperform growth stocks. 

Since 1926, value investing returned 1,344,600% vs. 626,600% for growth stocks, according to Forbes Advisor. And some of the most famous investors on the planet (think Warren Buffet and Benjamin Graham) are value investors.     

But largely none of these long-term trends mattered over the last few years of this past market cycle. 

The bull market of the last decade seemed to make investing quite easy, large-cap growth dominated, and as long as you held the big-name tech stocks your portfolio, probably did well.  

This trend was exacerbated during the COVID-19 global pandemic. 

During the 2020 bear market caused by the pandemic, U.S. markets bottomed on March 23, 2020. From that bottom, the S&P Growth Index initiated a historic recovery and peaked on September 1, 2020.  

Much has been made in the media about how quickly markets recovered from the market bottom, but that outperformance was mostly a product of the “Big 5” stocks (Alphabet, Amazon, Apple, Facebook, and Microsoft).  

As of September 2, 2020, those five stocks had a year-to-date performance of 65%, the other 495 stocks in the S&P 500 had a total YTD performance of just 3%. Since the fourth quarter of 2020, the story has begun to shift to the performance of small caps and specifically small-cap value. 

At the end of the first quarter of 2021, the top two performing sectors of the S&P 500 were Energy and Financials.  

reversion to the mean

What Does it Mean?

Is the “reversion to the mean” a story of small caps over larger caps, or is it Energy & Financials over Tech and Consumer Discretionary?  

It is still early and we will continue to watch how this plays out.  The main point here is to not be married to a thesis that worked very well in 2020, because the markets may have already started to revert to the mean.  

“This time is different” is a phrase commonly heard toward the end of market cycles.  

If you hear someone tell you that “this time is different”, run! This time is not different.  

Math does not evolve over time. Corporate price/earnings ratios and other investment metrics matter just as much as they have in the past.  

Don’t chase performance.  

What happened in the past, even in the recent past, is not guaranteed to continue in the future.  

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Investing vs Speculating

“We engage in the folly of short-term speculation and eschew the wisdom of long-term investing.  We ignore the real diamonds of simplicity, seeking instead the illusory rhinestones of complexity.”

– John C. Bogle, Enough: True Measures of Money, Business and Life

The idea of investing to achieve our goals CAN BE very straightforward.

Focus on the long-term, diversify, and do not use products with high fee structures.

The world of investing does not need to be complex and stressful. However, there are some investment firms that seem to do a pretty good job of making it seem so complex that most of us could not figure it out on our own, and this is just simply not true.

Long-term investing can and should be easy to understand.

investing vs speculating

Trading Options

I’ve had several people talk to me about trading options recently.

Perhaps because of recent congressional hearings or perhaps because now even the more conservative retail investment firms are running TV commercials talking about trading “iron condors”.

My opinion is, for the large majority of retail investors, options involve more risk than upside and should be avoided.

Ask yourself, “Who is on the other side of that trade? For me to win my bet, who has to lose?”

Then perhaps ask if you feel you have better information than the large Wall Street firms?

wall street buildings

“Wall Street investment banks are like Las Vegas casinos: They set the odds. The customer who plays zero-sum games against them may win from time to time but never systematically, and never so spectacularly that he bankrupts the casino.”

– Michael Lewis, The Big Short: Inside The Doomsday Machine

It is important to understand the difference between investing vs speculating.

Do you understand the investment you are considering, and why it is going higher or lower?

Do you have experience in the industry and know who is taking the other side?

We have numerous media outlets that now focus on short-term trading, which is fine, as long as we understand that this is speculation, not investing.

investing vs speculation

Investing should not be stressful! 

We should feel good about putting our money to work for us. And if we have a long-term approach it doesn’t take a lot of work on our part. As long as we understand our goals and match our investment strategy to meet those goals, it becomes a straightforward endeavor.

And stay away from get-rich-quick schemes and short-term speculation that is difficult to understand. Knowing the difference between investing vs speculating is empowering.

In the profound words of John C. Bogle…

“The obvious conclusion: investors win; speculators lose.”

– John C. Bogle, Enough: True Measures of Money, Business and Life

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F.I.R.E. (Financial Independence, Retire Early)

“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

– Albert Einstein

What is F.I.R.E.?

FIRE is a lifestyle movement that grew out of the GFC (the recession of 2007-2009 called the Global Financial Crisis).  Its goal, as the name suggests, is for people to gain their financial independence and retire early.  You can see more about it on Wikipedia.

Some great people who give advice about it and that we follow are:

We know we have missed a lot of quality people and if you would like to be added to the list or have a recommendation, drop Nicole an email.

What is interesting about the movement is how down-to-Earth and full of common sense it is.  It is not a “get rich quick” scam but rather uses time-tested methods for living a good life.  Charlie Munger, Warren Buffett’s longtime partner at Berkshire Hathaway, has said, again and again, that the best way to live a long and happy life is to live beneath your means when young so you don’t have to when you are old.  Ben Franklin broke up a person’s life into three parts; getting an education, being productive, giving back.  Albert Einstein is reputed to have said, “Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pays it.”

FIRE boils down to:

  • Save a lot
  • Start early
  • Be nice to others ( I added this last one)

Financial Independence Through Saving Money

One of the best ways to save money is to make sure you never see it.  Apps and savings accounts that automatically round up a credit or debit card purchase to the nearest dollar and put the extra money into a saving or investing account are an example of this.  Another good way is to pay a bit extra in money you owe for credit cards or mortgages.  Never pay only the minimum if you can.  Also, make sure to pay off your credit cards before other debts as they usually have the highest interest rates.

Once you have saved some money, invest it, and then don’t look at the balance every day.  If your money is in the stock market and the market takes a 20%+ tumble which it does every few years, you might panic and take your money out at exactly the wrong time.  As the advertising slogan for the lottery says- “You have to be in it to win it”.

Financial Independence Through Investing

Being in the stock market has historically shown to be a winner.  Since 1926, there have only been two periods when keeping your money in the S&P500 with dividends reinvested over ten years would have resulted in a loss and then, it would have only been for about 10% of your money.  Those two periods were during the Great Depression and the GFC.

If your time horizon for the use of money was 20 years, you would have never had a loss of principal.  Of course, past experience is not an indication of future returns which is why professional advice is helpful as is diversification.  But time is your friend when it comes to investing so don’t look at your account statements too often.

A long, long time ago, in a far off place called New England, there was once a traveler who came upon a small village.  He noticed someone locked in the stockade.  “What have they done?” inquired the traveler.

“He dipped into principal.”

 

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Why Does Investing Seem So Complicated?

You can tell whether a man is clever by his answers; You can tell whether a man is wise by his questions.

– Naguib Mahfouz, Egyptian author and Nobel laureate: Literature (1911 – 2006)

Investing does seem complicated, but it doesn’t necessarily need to be! Part of the problem is the sheer volume of information that comes at us, provided through various forms of media. Some of those forms seem designed to make us feel that everyone else understands investing better than us.

Consider the Time it Takes to Invest

Have you ever watched one of the financial channels and seen the commercials that talk about how “easy” it is to trade options? Trust me, trading options is not easy – unless your goal is to lose money. In that case, it is plenty easy. Keep in mind that television networks that focus on money & investing have many, many hours of programming to fill. And good, fundamental long-term investing is, frankly, boring. Building wealth is a long-term endeavor. Happy investors know this and use it to their advantage – investors that try to find shortcuts usually end up sad.

So what do we do? One way to approach money management and investing is to start with a few basic questions:

  • If I am looking to invest, what is the time period I plan to hold the investment?
  • Is it 1-year, 5-years, or 10+ years?
  • How much debt do I have?
  • If I do have debt, is it a student loan at 5% interest, a car loan at 8%, or am I paying down credit card balances at 17%?

Consider Your Debt

There is a difference between what some call “good” debt, like a mortgage at 3%- 4% and “bad” debt, like a credit card balance that comes with a 16% – 18% interest rate. One rule that many experts agree on is that you should not consider investing in mutual funds, Exchange Traded Funds (ETFs), or individual securities unless you have paid off your credit card debt.

Here is one example: if I am considering an investment in the stock market via ETFs, but I’m currently paying a car loan that charges 8% interest, I should ask myself if I feel very confident that I will experience a return in excess of 8% on the investment. If the answer is “I really don’t know” it may be best to consider paying down the debt. That is a good place to start.

OK, now I’ve paid down my high-interest debt and I’m ready to begin investing.  Start with a basic question. In this case, ask yourself:

  • What am I investing for?
  • Are we saving for a vacation next year?
  • Are we saving to buy a car in five years?
  • Is this likely to be retirement money 20+ years out?

Consider “Money Pools”

It is helpful to start by bucketing your investment dollars based on the expected time horizon for the investment. We can call these buckets “tranches” that allow us to focus on different defined outcomes.  Time is a significant factor when it comes to investing and these outcome-based tranches should be invested differently. When we build these investments within Marygold for our clients we call them “Money Pools.”

Investing in equity markets is generally a solid investment in the long-term, but markets tend to experience significant volatility in the short-term.  For example, the S&P 500 index lost over 4% in 2018 but gained over 31% in 2019.  And there has been nothing normal about 2020, with the S&P 500 dropping 34% from February 19th to March 23rd, and the U.S. economy falling into recession driven by the Covid-19 health crisis.

In the history of the U.S. stock market, we’ve only seen one 30% plunge that happened faster, in 1987 when the S&P 500 fell over 31% in only 14 days culminating in the “Black Monday” crash of October 19th that saw a drop of more than 20% in one day. Global and U.S. stocks have started to recover since March, but volatility is likely to remain elevated.

Consider Your Investment Strategies

If I have an investment tranch that I plan to tap into in the next year or two, I’m going to invest conservatively – think savings accounts, money markets, or other cash equivalents. For my long-term investments like my retirement account that will be invested for a decade or more, utilizing a diversified portfolio of equity and fixed income securities via ETFs is typically a sound strategy. And once we establish our long-term investment strategy we need to stay disciplined and not overreact to short term volatility.  As many experts have cautioned this year, “panic is not a strategy”.

Consider What You Invest In

Lastly, I need to distinguish between smart investing and gambling. If I had $1,000 to invest I would not be “looking for the next Tesla” as I’ve heard some say. I would probably be looking at passively-managed ETFs that are broadly diversified and come with low-expense ratios. There is another old market adage that is always appropriate – “the bull and the bear go to market, but the pig goes to slaughter”.

We can make the process of long-term savings and investment easier by asking ourselves a few basic questions. Do I currently have outstanding debt? If so, is it better to use my savings to pay it down? If I’m ready to put some money to work in the stock market, then I start by asking how long I intend to hold the investment. Time is always an important consideration when investing. If we begin by asking ourselves what we intend to do with the money or said another way, what is the outcome we hope to achieve,  it starts to make the process much more straightforward.

Investing can seem complicated, but it certainly doesn’t need to be.

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The Future of the Stock Market

money pools mobile

Want to know a secret? I know where the stock market will be in 10 years.

– Nicholas Gerber, Founder

The stock market, as measured by a broad index like the S&P500, will be about 55% higher in ten years or about 5,280 up from today’s approximate 3,200. This is down from historical projections of the stock market doubling every ten years or so.

There are two strong proven formulas behind this forecast:

  1. The Bogle Model
  2. The Demographic Model

The Bogle Model

John Bogle (1929-2019) was the founder of The Vanguard Group, one of the first people to create an index fund for retail investors, author, and generally smart & nice guy. In 1991 he wrote an article in the Journal of Portfolio Management called “Investing in the 1990s: Remembrance of things past, and yet to come”. In it, he wrote that only three things mattered in the aggregate when it came to figuring out the long-run returns of the stock market. The stock market’s current yield, the growth of earnings, and the level of price to earnings (PE ratio) at the end compared to the beginning. The S&P500 is currently yielding about 2% a year, earnings are projected to grow slowly at 3% a year and the PE ratio is projected to stay the same at about 22. Historically the PE ratio has averaged about 15 but with interest rates so low, it makes sense to keep PE high or maybe even move it up a bit. So total average long-run growth from today’s levels should be 2% (dividend yield) plus (3% growth of earnings) + 0% (PE ratio change) or 5% a year which comes to about 55% after ten years.

The Demographic Model

Another simple-but-effective model is the Demographic Model. It simply states that stocks are reflections of business and business can only grow if population increases, if productivity increases or if inflation increases. The US Census Bureau estimates that the population will grow by about 1% a year over the next ten years. Productivity has been slow this century and while expected to pick up with the advent of technology being taken advantage of more, a stable conservative number of only 2% a year is warranted. Inflation is low today at about 2% and expected not to grow until the economy can get to full employment again which might take a few years. Once it does, watch out but that is a story for another article. If we add up the components of business growth; 1% population, 2% productivity, and 2% inflation we get 5% a year which again comes to about 55% after ten years.

What to Do?

The best way to take advantage of this knowledge is to invest and forget. Create Money Pools for your savings and investing dollars. Attached goals and end values to the Money Pools like Christmas in 3 years $500, College in 10 years $35,000, or Retirement in 35 years $3,000,000. Once you know how much money you want and when it then becomes simple math to use the formulas above to figure out how much you will need to save today to reach them.

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