September 30, 2019
Wouldn’t it be nice if we knew in advance what the stock market was going to do tomorrow? Imagine how fun it would be to buy before the market goes up and then sell before the market goes down. With our advance knowledge we could move money into or out of the market to capture gains and avoid losses. What investor hasn’t dreamed of living in such a world?
Deep down we know this is impossible. Markets are complex, adaptive systems which reflect human behavior. When the news is good, buyers sometimes become over-exuberant, extrapolating a short-term trend too far into the future. Prices go up and the risk of any surprise is to the downside. When the news is bad, sellers can become despondent, extrapolating a short-term problem too far into the future. Prices go down and the risk of surprise is to the upside.
Here’s what we know for sure: it hurts to lose money and it is fun to make money. Because of this simple truth, we tend to chase performance, adding capital to what’s been doing well and ignoring what’s been doing poorly. It’s in our nature to behave this way, and this is precisely why markets can overshoot on the upside and the downside.
As Robert Arnott is often fond of saying, “what is comfortable is rarely profitable.” Bad news and legitimate fear help create an environment where bargains can emerge. Good news and happy stories help create an environment where assets are fully priced. Assets can remain loved or unloved for longer than you would think. Stories are powerful, both good and bad, and trends can persist for a long time. We would be prudent to search for opportunity among the unloved. Not everything there is a gem, but that’s where the bargains are likely to be found.
So, knowing that we cannot time the markets, and knowing that bargains are likely to be found among the unloved, what’s an investor to do? A simple answer is to periodically rebalance your portfolio. In other words, trim what has done well and roll the proceeds into what has done poorly (but is expected to do well in the future). Sounds simple enough, but it is often uncomfortable and difficult to execute under the constant barrage of the 24-hour news cycle. What – you want me to sell some of my technology shares and roll the proceeds into auto manufacturers? Microsoft is killing it and Volkswagen has all kinds of troubles. Agreed. But research suggests periodically rebalancing your portfolio will increase your returns and dampen your volatility over time.
In the real world we must factor in taxes and trading costs. Still it’s a worthwhile exercise to evaluate how we can nudge our portfolios back toward their long-term strategic targets. Tomorrow’s leaders often emerge from today’s laggards and vice versa. If we only focused on the loved, we’ll be missing out on some of the greatest opportunities the market has to offer.