It’s February of 2016 and the stock market has rallied over 250% off the 2008 lows in an almost uninterrupted bull market. But some cracks appeared to be showing. China was looking wobbly and the market had flash crashed a few times. Emerging markets were down 30%+ from their highs. Oil had cratered from $110+ to under $30 in 18 months. Industrials and manufacturing sectors in the USA appeared to be in a legitimate recession. And interest rates were still hovering at 0% on the overnight rate and 1.75% on the 10 year treasury.
It was a pretty scary couple of months at times and I repeatedly wrote that the environment reminded me a lot of 1998. That is, the cost of getting scared out of stocks in the short-term was a huge risk, but the longer-term risk of being too exposed to stocks was also high.
With the stock market near its highs and interest rates so low the average investor was confronted with a real problem – the stock market looks super risky, but the bond market has limited upside. And cash is earning 0%. In other words, this was an environment that was about to test a lot of people’s investment behavior. What was an investor to do?
There weren’t a lot of great answers at the time. So the smart investor just said “screw it, I’ll own both stocks and bonds and avoid the guesswork because they both look risky and I don’t know which one will actually end up being riskier”. The investor who owned an even split of 50% stocks and 50% bonds generated a 10% annualized return over the next few years. That’s 1.5% per year from the bonds and 18.5% per year from the stocks.
Now, we can’t rely on 18.5% per year from the stock market, but there are a bunch of useful lessons in here:
- Timing the market is hard. Although stocks and bonds both looked terrible in 2016 they both did okay since then. Cash, which might have looked like the most attractive option to many, turned out to be the worst choice (as is always the case in the long-run).
- Bonds don’t necessarily lose value when rates rise. Rates are up 1.25% since February 2016, but an aggregate bond index has increased in value by over 1%. Not great, but not the nightmare that so many seem to fear. As I so often try to remind people, it’s wrong to assume that bonds will lose value just because rates rise. Instead, it’s better to say that bonds lose value in the short-term when yields rise and benefit from rising rates in the long-term.
- When stocks rise, bond yields also tend to rise. The kicker here is that you own the bonds knowing they won’t perform that well, but that the stock increases should offset the poor performance in bonds. This is because the stock market tends to rise when expectations of future profits are rising. This usually means the economy is healthy and generally coincides with rising rates because prices are rising across the economy. On the other hand, rates tend to fall when the economy is doing poorly and this often coincides with falling stock prices.
- We just don’t know. The exact opposite might have occurred. What if rates had fallen to 0% or negative like they are in Japan or Europe while the stock market dove lower? In that case our bonds would have hedged our stocks to some degree and we wouldn’t have had to worry about being uncomfortably exposed to stocks.
But here’s the real kicker – the reason you diversify is because you would have been somewhat okay with either outcome. If stocks had fallen 20% and bonds had risen 10% then your diversified portfolio would have fallen 10%. You would have felt silly for owning the stocks, but not nearly as silly as the person who wasn’t diversified at all. In other words, you built a more behaviorally robust portfolio.
The market’s a humbling beast. That’s why it’s almost always better to control what you can control (taxes, fees and asset allocation) and build a portfolio that has a good probability of meeting your financial goals within the confines of what’s comfortable for you personally. While we can’t control the market or the future, we can control the parameters within which the market dictates how we’ll respond and that is so often the difference between successful investing and unsuccessful investing.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.