Last week I attended a two day conference in Sydney on the topic of long-term investing, titled “The long and short of it – is the concept of long-term investing increasing irrelevant?”
The conference was jam packed with around 500 delegates and over 50 leading international and local investment professionals. The conference facilitated debate on the markets, strategies, and investing, with a particular focus on the friction between short-term and long-term investing imperatives – and the portfolio construction decisions that must be made.
Theory tells us that investing is supposed to be about the incremental replacement of human capital with financial capital over the long-term. Every day, the theory is challenged however, by human beings’ behavioural biases, fuelled by the 24/7 news cycle, which encourages shorter and shorter cycles and thinking.
The question remains a valid one, is the concept of long-term investing increasing irrelevant?
It depends who you ask. Here’s what I learnt:
Our cognitive biases force us to make bad decisions
The human brain is a natural wonder and a very powerful processor – producing more than 50,000 thoughts each day and 100,000 chemical reactions each second. Yet our judgement is quite inaccurate. Our brain’s reliance on short-cuts wreaks havoc by forcing us to make poor irrational judgement.
Here are three biases that effect our decision making:
- Clustering illusion
This is the tendency to see patterns in random events. It is central to various gambling fallacies, like the idea that red is more or less likely to turn up on a roulette table after a string of reds.
The tendency to do what everyone else is doing, especially in difficult or uncertain times. It illustrates how we like to make decisions based on what feels good (doing what everyone else is doing), even if they’re poor alternatives.
- Hyperbolic discounting
The tendency for people to want an immediate payoff rather than a larger gain later on. Or the desire for instant gratification.
If we can learn more about how we’re wired, we may be able to see through the knee-jerk, emotional, and irrational decision making and focus on the long-term game.
This time is not different, we’re just predisposed to think so
We live in uncertain times. Markets are volatile and events are unprecedented – or at least that’s what we’re told and have been conditioned to believe. The truth is a bit different. It’s true that we live in uncertain times and markets are volatile, but they always have been and they always will be. Investors should build their portfolios based on facts and evidence, not on conventional wisdom derived through sentiment, so as to navigate financial markets over the long-term based on knowledge of data, not conjecture.
In this day and age, we’re super lucky to have such a large data set to help us make better investment decisions. Today, markets are extremely uncertain. Why? Because we can’t see far enough ahead into the future. We can’t be blamed, we’re not wired for it.
I’ve done some research and analysed the returns of the Australian stock market from the short-term right through to the long-term. I’ve also included in this analysis the best and worst returns for these same time frames. The data is from 1980 to July 2016 – the longest data set I could get my hands on for the Australian share market.
Source: Returns 2.0
The table above summarises the average annual return for each period, as well as the best and worst annual return for the same period.
As an adviser and investor, I pay close attention to the potential downside to an investment as part of my investigation. In the table above, I note the high level of uncertainty via the downside/worst return during short time frames (1, 3 and 5 year). Push the time frame out to 10 years and see how your downside/worst return transforms to a positive 5.69% pa for 10 years – the worst return!
Although over long periods of time the behaviour of different asset classes may be somewhat predictable, the way they behave during shorter time frames can be very unpredictable and sometimes quite frightening.
For these reasons, when deciding on the mix of your investments, it’s essential to understand the behaviour of different asset classes. This time is not different.
Inflated bonds will lose you money
Traditional portfolio management tells us to mix your stock portfolio with bonds, because although stocks give us long-term growth, bonds provide diversification by providing stability and liquidity for when things go wrong.
Given the current interest rate landscape where more and more governments around the world are issuing bonds at negative yields, investors are questioning this relationship. Maybe in this new paradigm, investors should be asking themselves how stocks can help diversify their bond portfolio. Which begs the questions, what happens to stocks when bonds lose money?
I’ve cherry picked data from Ben Carlson of A Wealth of Common Sense to help answer this question. The data is on the S&P 500 and the US 10 Year from 1928-2015. We look back at every calendar year that bonds showed an annual loss with the corresponding return of the US stock market:
Source: Ben Carlson
Throughout the 88 years, bonds experienced a loss 16 times. In just 3 of those years, stocks were also down. History tells us that more than 80% of the time when bonds have experienced a loss, stocks have been up – and on average with a pretty decent spread.
And here’s the data adjusted for inflation:
Source: Ben Carlson
Throughout the 88 years, bonds have lost money 37 times, or roughly 42% of the time. During those 37 years, the stock market was down only 12 times, which means stocks have returned a positive return almost 70% of the time when bond returns were negative.
The data tells us that stocks do in fact help diversify away from bonds. Right now, we’re seeing both the stock market and bond market rise in value. Understandably, investors are concerned that both asset classes may decline in value. If history is any guide, and that bonds are inflated, stocks are a pretty good to place to be.
Bringing it all together
Is the concept of long-term investing increasing irrelevant? I believe long term is only as relevant as one’s personal horizon – there goals and aspirations. For some, long-term may mean the next 5 years, for others, it’s a generation. There is no right or wrong answer.