Are Your Signals Working?
February 07, 2022
There’s an old joke where a driver asks for help to see if his turn signal is working. His helper walks behind the vehicle to observe the signal and replies: “It’s working . . . it’s not working . . . it’s working . . . it’s not working . . .”
With volatility back in the markets, inflation and Fed tightening top of mind, and fresh geopolitical risks not far behind, investors are right to wonder if their signals are working. After being humbled by financial markets for a few decades now, I would suggest the answer is “they’re working . . . they’re not working . . . they’re working . . . they’re not working . . .”
In all seriousness, there are useful strategies one could adopt in one’s investment program. Some of them “work” reliably over long periods of time, such as diversification. By “work,” I mean they provide some measurable benefit like reduced volatility. The benefit is usually most noticeable over a complete market cycle, including both the Bull and Bear phases. None of the strategies (that I am aware of, at least) work continuously. In my experience, effective strategies move into and out of favor in the short run but tend to accrue their benefits over the long term.
A couple of examples come to mind. In the late 1990s, internet and technology stocks were all the rage. Growth and momentum strategies were in vogue. Cocktail party chatter never made its way to the dull topic of the relative attractiveness of small-cap value stocks. In a few short years, however, it became apparent that small-cap value stocks were much more resilient as internet and technology names deflated. Less concentrated and more diversified portfolios behaved more favorably during that period of market stress.
A similar lesson could be learned from 2008 and 2009. In the three years leading up to the Great Financial Crisis, emerging market (EM) equities were one of the best performing asset classes, up more than 25% in 2005, 2006, and 2007 according to www.visualcapitalist.com. Once the crisis hit, EM equities were one of the worst performers, down nearly 53% in 2008. The following year, they were back on top, up 71.5% in 2009 and up another 17.2% in 2010. Once again, diversified portfolios behaved more favorably during that period of market stress.
This much we know: the investing future is uncertain, and it always arrives in a surprising way. We have various investment tools and strategies, but none of them “work” all the time. Investing is like making good gumbo: if you want a superior result, you need lots of good ingredients. With investing, diversification is key. The trick is to assemble a master strategy that builds on the underlying trends and themes playing out in the markets. If history is any guide, these themes will ebb and flow over time. A very sound approach is to maintain diversity over time, leaning into unloved areas at the margin and dialing back on areas that have recently outperformed. It is not always comfortable to execute, but it can add value in the long run.
Mike Masters
