Investing in stocks, bonds, and other securities has always been about balancing risk and reward.  Prior to the mid-1970s, stock and bond markets mostly involved the assets of institutions and wealthy investors, largely managed by professionals; the exceptions occurred within speculative bubbles, such as the one in the 1920s.  Less affluent individuals mostly relied on savings accounts and defined-benefit pension plans to provide for their retirement needs.  Mutual funds became important in the 60s, but did not yet serve a “mass market.”

 

Then, in the 1980s, the world of “individual retirement savings” met the world of “institutional finance” for the first time; as a result, both underwent a revolutionary change. Defined-contribution “retirement savings plans,” especially tax-advantaged IRAs and 401Ks, quickly replaced defined-benefit retirement programs as the primary investment vehicles. Much of this money flowed into equity and fixed income mutual funds, and later, ETFs.

 

As a result, the 70s and 80’s witnessed the emergence of today’s “Conventional Investment Wisdom.”   It represents the attempt by academia and the investment industry to resolve, or “paper over,” three distinct dilemmas:

 

- Active vs. Passive Investment Management
- Managing risks of low investment returns vs managing risks of volatility, and
- Adopting a buy-and-hold strategy vs. a market-timing strategy.

Unfortunately, like so many ways of doing things that grew out of a consensus, the Conventional Investment Wisdom has been slow to evolve and still reflects the realities of 40 years ago.

 

To understand this situation, let’s consider the first dilemma: Active vs. Passive Investment Management.

 

Today’s conventional investment “wisdom” was strongly influenced by A Random Walk Down Wall Street which was written in 1973 by Princeton’s Burton F. Malkiel.   Malkiel asserted that active managers can’t consistently outperform the stock market indices.  Therefore, he argued that investors should rely on “passive index funds” which mimic indexes such as the S&P 500.  Since at least the end of the 18th Century, the U.S. and global economies have consistently grown, driven by innovation and population growth.  And since larger companies tend to get a disproportionate share of industry earnings, (due to scale, scope, and network effects) investing in a capitalization-weighted index fund makes sense.  Couple this with the effect of lemming-like passive investors rushing into these funds during bull markets and you have a “more than adequate” vehicle for retirement.    So, this certainly can be a prudent approach for many investors.

 

The conventional investment wisdom tells most investors to put money into a low-fee index fund via a tax-advantaged IRA or 401K account and keep adding the maximum contribution every month without touching it until retirement. Over the 22 years from January 1, 1998, to December 31, 2019, this strategy would have generated a total return of 405%.  And, in spite of the pandemic, the total return was 451% through August 26, 2020, which works out to 7.89% annually.
  

However, it turns out that Malkiel’s underlying assumption is flawed.  After fees, the universe of all active mutual funds underperforms the universe of all passive index funds, over the long-term.  However, this is largely a function of statistics. The poor performance of some active managers cancels out the superb performance of others. And since factors like industry sector, growth vs value, and big-cap vs small-cap go in and out of favor, managers dogmatically wedded to these parameters will see periods of overperformance followed by periods of underperformance.  Over the period from January 1998 to August 2020 mentioned earlier, Berkshire Hathaway returned 8.99% annually vs. 7.89% for the S&P 500.  Meanwhile, the PARE-5 strategy used by the Trends editors has returned almost 25% annually including 23% a year over the past 3 years.

 

So, the fact is that discerning investors can definitely sprint past those taking “A Random Walk Down Wall Street.”  But this requires research and common sense.  In short, the first aspect of Conventional Investment Wisdom is true for some but certainly not for all.

 

If the conventional wisdom stopped there, everything would be fine for the investor whose motto is “I’m no worse than average.”  The problem is that the conventional wisdom doesn’t stop there.  It encourages most investors to use asset allocation to reduce one aspect of risk, even though it typically increases other aspects of risk.

 

And that brings us to the second dilemma, managing "risks of low investment returns" vs "managing risks of volatility."

 

The conventional investment wisdom as used by most financial services marketers involves a curious sleight-of-hand: Marketing ads typically ask customers, “are you worried about running out of money in retirement.”  This legitimate fear has more to do with whether the client will have enough principal at retirement and whether he or she can take out sufficient funds during their remaining lifetime to meet their total anticipated needs.  In this case, the goal is to be statistically confident that their money will grow sufficiently, pre- and post-retirement.  That’s mostly a function of the long-term rate of return.

 

Then, once the marketer has the attention of the client, he or she typically asks, “do you want to maximize your returns, or do you want to avoid losing money.”  At this point, the marketer has changed the definition of the word “risk.”  Rather than talking about the risk of inadequate performance, the discussion has subtly shifted to choosing from a portfolio of assets designed to avoid volatility.

 

Financial markets, especially for equities, inevitably move up and down based on many factors.  The biggest of these factors is the business cycle.
 

In recent decades, the fluctuations have been unusually large because the Treasury and Federal Reserve have proactively worked to mute the ordinary business cycle.  As a result, most crashes result from speculative bubbles bursting as in 2000 and 2008 or genuine “black swans” like COVID19 in 2020.  And these are often exacerbated by government policies or hidden market mechanisms.  Examples of these include mark-to-market accounting rules and Credit Default Swaps which worked together to paralyze the markets in 2008.

 

The level of volatility is especially important to recognize as we are now immersed in the most spectacular period of change in our lifetimes.
 

Consider the facts:

 

The 21st Century’s “Fourth-turning,” which was forecast by historians William Strauss and Neil Howe in their landmark book, Generations, is transforming our nation and the world.   The post-war consensus is being swept away and a new social contract is being forged.  We’re in a new era of opportunity resembling the Revolutionary War, Civil War, and World War II; great fortunes will be made and lost.  Those who are frightened by volatility are doomed to subpar results.  Everything from wealth creation to our fundamental social contract is being reshaped.  The world is awash in capital driving down the Weighted Average Cost of Capital, and that’s bad news for fixed income investors now and long-term.

 

Even more importantly, we’ve finally passed the “ignition point” for the “Golden Age” of the Fifth   Techno-Economic Revolution as forecast 20 years ago by Cambridge economist Carlota Perez.  Institutional changes required to fully exploit the new technologies are being implemented.  New technologies and new business models will leave the old economy behind.  In this market, being “average” will not be good enough.

 

And, we’re also facing a “Clash of Civilizations” which was forecast by Princeton’s Samuel P. Huntington.  This paradigm shift is redefining foreign policy and defense preparedness, globally.  More importantly, the struggle between a U.S.-led democratic coalition and a Chinese-led authoritarian coalition is decisively reshaping the global order.  Assumptions about trade and alliances that have existed since at least 1990 are being transformed.

 

In Trends, Business Briefings, and other outlets, our team has been highlighting the trends in technology, demography, and human behavior that drive and enable revolutionary change for over 30 years.  And we can confidently say, "this period is like nothing we’ve encountered before."

 

The world we’ve known since World War II has seen brief periods of quantum change which were followed by plateaus of stability; paleontologists refer to such patterns as “punctuated equilibrium.”  In the United States, in particular, the social contract formulated in the New Deal era remained the bedrock for how business and government functioned.  Admittedly, there have been some pretty big shocks to the system over the past 35 years, such as:

 

- the rise of the World Wide Web beginning in 1993,
- the end of the Cold War from 1988 to 1991,
- the Dot-Com crash of 2000,
- the terrorist attacks of September 11, 2001, and
- the Global Financial Crisis of 2008 to 2009.

 

Each of these shocks created both threats and opportunities for managers, consumers, and investors.  Yet, in every case, innovators were able to create enormous value through new technologies and new business models.  Those who looked ahead to “the new economy” made fortunes, those looking to the past saw their careers and portfolios decimated.  Meanwhile, fixed income rates continued to slump from a high in 1981 to a generational low in 2020.

 

Importantly, history shows that the U.S. economy and the associated equity markets came roaring back after every correction.  And every time someone said, “it’s different this time,” they soon discovered that it wasn't.
 

Notably, studies clearly show that over 5, 10, and 20-year periods, the average return on equities is roughly twice that of the asset-allocation funds, which firms have designed to avoid volatility.  And, not surprisingly, fixed-income funds do even worse.  Obviously, for some very nervous investors, the asset-allocation funds make sense as do fixed income funds. But for most investors, Conventional Investment Wisdom leads them to make "poor choices." 

 

A wiser alternative used by the Trends Editors is to place only the funds that will be needed in the next five years into fixed-income investments and put the rest into equities.  When a shock to the markets occurs, there will be plenty of time for the equities to snap-back before funds in fixed-income instruments are depleted.

 

Now let’s consider the final dilemma addressed by Conventional Investment Wisdom: adopting a buy-and-hold strategy vs. a market-timing strategy.  CNBC, Fox Business, and Bloomberg exist largely because millions of market-timers think they can get out at the top and get back in at the bottom of each cycle.  However, the evidence is clear, decade-after-decade investors who buy market-leading, innovative companies and hold them until fundamental trends in technology, demography, and human behavior  justify replacing them with other companies, are the big winners.  Near perfect execution of this strategy on an enormous scale is why Warren Buffett is legendary. 
 

Here the Conventional Investment Wisdom is clear and well-supported by the facts.  Those who have a solid rationale for a strategy should “buy and hold.”  This is true whether we’re talking about individual stocks, ETFs, or index funds. Consider the three examples we cited earlier: An S&P 500 index fund, Berkshire Hathaway, and the PARE-5 strategy, which is the favorite of the Trends editors.
 

Over the 20 years ending December 31, 2019, the S&P 500 returned 6.06% per year compounded for buy-and-hold investors while Berkshire Hathaway returned 9.53% per year, and the PARE-5 returned 19.5% per year. But, largely due to market-timing efforts, the average investor in equity funds earned just 4.25% annually.  Over 20 years, $100,000 at 6% annually from the S&P 500 turned into over $320,000, and an investor using PARE-5 ended up with $3,526.000.  Meanwhile, the average market timer earned 4.25% annually and ended up with just $230,000.  Worse yet, an average market-timer using asset allocation to reduce risk, earned only 2.54%, according to Dalbar’s 2020 Quantitative Analysis of Investor Behavior (or QAIB); that left them with just $165,000.

 

This raises an obvious question:  "Why do so many people fall into the market-timing trap when the evidence is so clear?"  The answer is "human nature!"  When we are struggling to make “buy, sell, or hold decisions,” all of the decision-making biases we humans normally exhibit, are exaggerated.  All too often, this leads intelligent people to make big mistakes simply because emotions intervene; every crash and every bubble proves it.   A graphic from Dalbar, reproduced in the printable issue of Trends highlights these nine psychological biases; it’s worth taking a look at. 
 

The fact is, when it’s our own money on the line, none of us is immune.  We have seen this play out many times. Since the Trends editors live in a world where almost everyone, we know is an elite MBA, it’s tempting to think we are immune from this problem because we know all the theories and most of the available facts.  Unfortunately, that’s not enough.

 

Worse yet, 21st-century trading platforms give every novice all the tools needed to make a fortune or to lose one.  Time-after-time, we’ve seen smart people make horrendously bad decisions by following the crowd.  They either sell just before a surge of buy just before a crash.  They possess neither the experience nor the objectivity needed to confidently execute a winning strategy.

 

At times like this, we are reminded of the old saying, “a lawyer who represents himself in court has a fool for a client.”  The implication is that everyone needs an advisor to help them make important decisions and avoid psychological pitfalls when the stakes are the highest.  As with lawyers, financial advisors vary dramatically in price and quality and the two don’t necessarily correlate.
 

More importantly, as in so many areas, penny-wise and pound-foolish thinking is all too common in the investment arena.  The expert who “talked you back off the ledge” when you were ready to jump in March 2020 saved you a fortune.  Meanwhile, using a free mobile app that encouraged you to “avoid the next leg down,” would have proven itself incredibly expensive.  The key is to hire an advisor who delivers solid performance and to get rid of him or her if they don’t.  To have the best odds of doing so, check out their track records and only choose someone who has demonstrated proven success through multiple market cycles and can boast of high client satisfaction and retention.

 

So, what’s the bottom line?

 

First, buying and holding stocks until the rationale for owning them changes almost always beats trying to time the market.  Why?  Because market-timers almost always fall victim to hard-wired human biases.  A competent financial advisor with a solid track record is worth their weight in gold, when it comes to executing a winning “buy-and-hold strategy, year-after-year.”

 

Second, investors face two primary kinds of risk: risk of underperforming the market and market volatility.  History shows that investors who use asset allocation models to minimize exposure to market volatility routinely increase the probability of underperformance.  For many people, other risk management approaches have proven superior.  And,

 

Third, proficient active money managers executing proven strategies are likely to outperform passive index funds over the long term. However, there are many active managers who underperform the indexes after fees.  Even though past performance is not a guarantee of future results, using multiple strategies with track records of strong outperformance should give you the best results.
 
In a nutshell, that is the essence of genuine investment wisdom.  We expect it to be validated further in the coming decade.

 

Given this trend, we offer the following forecasts for your consideration.

 

First, revolutionary changes in technology, demography, and public policy will create an enormous sense of fear among investors.

 

This fear takes two forms.  The first form is conventional “fear of loss," usually referred to as FUD; FUD stands for “Fear, Uncertainty, and Doubt.”  The other form of fear is “Fear of Missing Out,” often referred to as FOMO.  As revolutionary change comes in waves, expect the mood to lurch from FUD to FOMO and back again multiple times during the 2020s.

 

Second, in a world jostled between FUD and FOMO, amateur investors, who disproportionately invest in passive index funds, will exacerbate volatility.

 

In 2019, for the first time ever, passive mutual funds and ETFs represented half of all individual investments; that makes sense because they enable smaller “buy-and-hold investors to achieve” average long-term results.  However, because such a large group of inexperienced and poorly informed investors are concentrated in one asset class, they are particularly susceptible to a "herd mentality" which can move the market.  Market timing attempts by these unsophisticated investors amplify normal volatility into crashes and bubbles.  For example, experts estimate that 70% of Baby Boomers liquidated their holdings during the COVID19 Crash and, as of September 9, 2020, the American Association of Individual Investors' Sentiment Survey shows that only 24% of individual investors expected stocks to be “higher in six months.”

 

Third, the world will remain awash in capital and this will be bad for fixed income investors. 

 

Over the 20 years ending August 31, 2020, the Barkley’s Aggregate Bond Index was up only 5% a year and we expect bond returns to be lower than that over the next 20 years.   With inflation running at an estimated 2% a year over that period, even the disciplined “buy-and-hold” bond investor will generate little real gain after paying a 35%+ combined state and Federal tax rate on their IRA withdrawals.  Similarly, these poor fixed income investment returns will impact those who use asset-allocation strategies to reduce exposure to volatility.

 

Fourth, the performance of the “new economy” stocks will increasingly diverge from that of “old economy” stocks throughout the coming decade.

 

Innovative companies that leverage new technologies and new business models will dramatically outperform less innovative companies.  We can already see this happening.  For the year ending September 1, 2020, Berkshire Hathaway (which is mostly invested in the “old economy”) was up 7.44%, while PARE-5’s “new economy” portfolio was up 50.43%.  (If you’re interested in finding out more about PARE-5, call 1-312-706-6850 or email carolyn.thur@ampf.com.)

 

Fifth, the best active managers will continue to deliver better results than passive index funds after fees and taxes.

 

The key challenge will be to identify money managers who have proven themselves able to adapt to changing market conditions.  To use a sports analogy, you want the New England Patriots of investing, not the Detroit Lions.  A long track record of superior results and client retention is the best indicator.
 
 

Sixth, market timing will not work in the coming decade any more than it worked in past decades, because of psychological biases.

 

Human nature does not change; the nine biases highlighted earlier will always get in the way and few investors can overcome them.  Trying to time the market and avoid volatility explains why the “average asset-allocation investor” barely beat inflation, before taxes, over the 20 years ending December 31, 2019.  After taxes, they actually lost money.  And,

 

Seventh, with few exceptions, the investors who perform best will make effective use of a trusted financial advisor. 

 

When buffeted by the competing forces of FUD and FOMO, hard-wired behaviors inevitably take charge and lead to costly and irrational decisions.  Obviously, apps and trading platforms provide access to data and the ability to execute; but that’s like substituting Legal Zoom for Alan Dershowitz.  Look around at the investors who strongly outperform the indexes; you’ll find that only a tiny fraction of them “go it alone.”

 

**

 

References List :
1. W. Norton & Company. January 14, 2020. Burton F. Malkiel. A Random Walk Down Wall Street: Twelfth Edition.
https://www.amazon.com/Random-Walk-Down-Wall-Street-dp-1324002182/

 

2. William Morrow & Co. January 1, 1991.  William Strauss & Neil Howe.  GENERATIONS: The History of America's Future 1584 to 2069.
https://www.amazon.com/GENERATIONS-History-Americas-Future-1584/

 

3. Three Rivers Press. December 29, 1997. William Strauss & Neil Howe.  The Fourth Turning - An American Prophecy: What the Cycles of History Tell Us About America's Next Rendezvous with Destiny.
https://www.amazon.co.uk/Fourth-Turning-American-Prophecy/dp/0767900464

 

4. Simon & Schuster. November 19, 1996. Samuel Huntington.  The Clash of Civilizations.
https://www.amazon.com/Clash-Civilizations-Remaking-World-Order/

 

5. Edward Elgar Publishers. April 26, 2003.  Carlota Perez.  Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages.
https://www.amazon.com/Technological-Revolutions-Financial-Capital-Dynamics/

 

6. com. July 11, 2013. Fred A. Rogers & Richard Lalich.  Ride the Wave: How 12 Technologies Will Change the World and Make You Rich.
https://www.amazon.com/Ride-Wave-Technologies-Change-World/

 

7. Dalbar, Inc.   Dalbar Research.  2020 QAIB Report.
https://www.dalbar.com/QAIB/Index

 

8. Dalbar, Inc.   Dalbar Research.  2016 QAIB Report.
https://www.dalbar.com/QAIB/Index

 

9. Harvard Business Review. March-April 2017.  Michael Mankins, Karen Harris, and David Harding.  Strategy in the Age of Superabundant Capital.
https://hbr.org/2017/03/strategy-in-the-age-of-superabundant-capital