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Summing It All Up: A Painful 2018

Posted: Farrah Gandhi

As we write this final WJ Notes for 2018, the US stock market has finally succumbed to the poor showing of most investments across the globe. As discussed below, most investment markets (includes stocks, bonds, currencies, commodities and real estate, etc.) have lost money this year. This is unprecedented in 118 years of market history. Concerns about the future path of interest rates, tariffs and a slowing economy are all dragging down investment markets. Many of the long-term, successful strategies that help protect portfolios during stock market declines have failed this year, making it, as the title suggests, a painful year. We discuss the strategies in this WJ Notes.

Before we get into the details, let us discuss why we invest in the first place. Investing means deferring current consumption for future consumption. It means saving while we have the capacity to save for the times when our earnings power inevitably diminishes. Investing is the means that allows us to meet our long-term financial and lifestyle goals. As described, investing is a long-term endeavor (think at least 10+ years or typically a lifetime). In this context our job as wealth managers is to help clients define and quantify goals, define a reasonable investment horizon, define a reasonable investment return, and finally develop a portfolio that maximizes the probability of meeting those goals.

So, what does a portfolio that maximizes the probability of meeting goals look like? Let us first consider what it does not look like.

  1. It excludes investments that are not likely to provide an expected return above inflation, which by definition excludes opportunities that are pure speculation or gambles.
  2. Related to number one, it excludes investments that have not proven to provide a positive expected return over a long-time period (decades at least).
  3. Also related to number one, it excludes investments that may have positive expected returns before fees, but after fees do not.
  4. It excludes investments that may have a positive expected return, but the payoff only comes infrequently. Although we are willing to wait through cycles that sometimes take years, we don’t want to wait forever.

Why is this discussion necessary? Hopefully it helps you as a client understand why your portfolio looks the way it does. It excludes unproven investments like Bitcoin. It eschews high cost investments like annuities and many mutual funds. It is diversified across asset classes, avoiding over-concentration in one geographic area or industry sector. It avoids home country bias (i.e. over-weighting a country just because you live there). It avoids large bets on the direction of interest rates or currency movements. It excludes large bets on over leveraged companies that typically fail when a recession hits. We believe all these decisions maximize the probability of meeting your long-term goals.

Now that we have described what is not in your portfolio, let us discuss what is included. The strategies and investments included in your portfolio are those that have proven over time to generate returns above inflation while minimizing risk. Most importantly, it only includes investments that, in combination, hopefully allow an investor to not abandon them because of irrational fears or the short-term volatility of the market. The single most important factor of investing “success” over an investor’s lifetime has much more to do with avoiding emotional decisions during times of stress than choosing the right investment or strategy. Selling out of stocks at the bottom in 2008 or going all in at the top of the internet bubble would, in most cases, have doomed the long-term success of anyone’s investment plan.

Unfortunately, although we believe strongly in the long-term efficacy of the investments and strategies in your portfolio, in the short term sometimes they do not work. And in rare cases, like this year, they all do not work at the same time. To put it bluntly, most successful long-term strategies failed in 2018. The long-term, successful strategies that have failed this year are as follows:

  1. Stocks beat bonds. Over the past 100 years, stocks outperformed bonds by about 5% per year. This makes sense as the risk of stocks is considerably higher than bonds. This year the opposite was true. A global portfolio of stocks lost 7.3% (all returns presented are year to date through the end of December 14) while bonds lost 0.8%.
  2. All asset classes do not have a bad year at the same time. The following graph produced by Leuthold considers a hypothetical portfolio comprised of seven common asset classes. The premise of the portfolio is that you know what asset class is going to do best before the year starts and you put all your money in that asset class. As you would expect, the portfolio has done exceptional, returning 34% per year since 1973.

But look at what happened this year.  Even if you could predict the future, your reward was a measly 1.6%. You can also see this is one of the worst outcomes over the past 45 years.
As further evidence, the following chart shows that 90% of 70 diverse investment markets have posted negative total returns this year.

This result is unprecedented since 1900. Basically, few investments made money this year. Also note from the chart that 2017 was the best showing since 1900. Everything went up.

  1. Bonds do not lose money. Since 1926 bonds have only lost money in 12 out of 91 years. This year bonds are down 0.8%.
  2. Cheap investments beat expensive investments. International stocks are considerably cheaper than US stocks having underperformed for over a decade. Despite this, US stocks are down 1.5%, while International stocks are down 12.7% this year.
  3. Value stocks beat growth stocks. Numerous studies have shown that unloved, ignored “value” stocks beat more exciting, interesting growth stocks. Investors tend to overpay for sexy stories like Tesla. But not this year, growth-oriented US stocks are beating value stocks by 6.6%. The same story persists when we look at stock markets overseas and across many other investment types.
  4. Trend following strategies like managed futures can provide protection when stock and bond markets perform poorly. Not this year. The primary trend following index we follow is down over 10% for the year.
  5. Alternative asset classes like Reinsurance can provide protection when stock and bond markets suffer. This year, Reinsurance lost about 5%. Multiple hurricanes and a historic wildfire in California sunk the fund late in the year.

We do not expect that every strategy or investment will outperform every year. Some will inevitably do better than others. That is what good diversification means! What is particularly shocking is that they all detracted value at the same time, but that describes 2018. So where do we go from here? One of your managers, Cliff Asness, the CEO of AQR funds, wrote a recent piece called Liquid Alt Ragnarök? (longer than this one, 23 pages in fact, link if you are interested describing their performance struggles this year. Cliff describes the very difficult decision of sticking with a sound, long-term investment strategy that is not working in the short term. Cliff is more eloquent than we will ever be, so rather than paraphrase we quote as follows:

“So, what are we doing? Well, aside from communicating, measuring, monitoring, and considering every theory from the reasonable to the somewhat wacky, mostly we’re doing the hardest thing. Nothing. At least nothing in terms of radically altering our investment process. Doing nothing, in this context, runs against every [behavioral] bias out there but we think is usually the right thing, particularly when done consciously after considering the evidence. In fact, if things get worse, but no new evidence of broken strategies appears, we pledge to do nothing with even more vigor.”

Although we are not changing our strategy, we do regularly look for opportunities to rebalance portfolios, take tax losses, and invest cash. For these reasons we will be placing trades this week. In addition, we are replacing one of our managers, the Ishares MSCI USA Size (SIZE) fund. SIZE is adjusting its investment process to focus more on US small companies and it no longer meets our requirements. The replacement fund, PIMCO StocksPLUS (PSTKX), has an excellent long-term record and reasonable expenses.

Thank you for your continued relationship and trust in WJ Interests. We appreciate the opportunity to assist you in reaching your goals and dreams and take the responsibility very seriously. We are always available to discuss your particular circumstances, so please contact us if you are interested. We wish all of you a Merry Christmas and a Happy New Year.

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