Counterintuitive Lessons from a Downturn

In its relatively short life, Seaborn has seen two major market downturns, and beyond that I personally have witnessed two recessions (since being old enough to pay attention to such things, anyway). If you're reading this blog, you're probably smart enough to have already learned the lessons such events can teach us: your personal risk tolerance, the importance of diversification, etc.

You Can Afford to Lose Money -- Even in Retirement.

Warren Buffett famously said, "The first rule of an investment is don't lose [money]. And the second rule of an investment is don't forget the first rule." So...we should never invest in things that might lose money, right? No! That's clearly not what he meant, because Buffett himself has invested in many things that have subsequently gone down in value...in the short term. No, his main concern was to minimize his chance of permanent losses on his investment. He didn't care about the short term, because he had those bases covered, and thus he could afford to lose the short-term bet in favor of the long-term one. 

Now, with an individual stock, this is relatively hard to do...but with a well-diversified portfolio, it's kind of a slam dunk. The chances of you permanently losing money in a well-diversified portfolio are almost exactly the same as that of a permanent global economic catastrophe.

But your time horizon almost certainly isn't infinite -- for most of Seaborn's clients, it's limited to their lifespan. So if you're approaching retirement, can you really afford to lose money? What if another 2008 happens when you only have around a decade or two left? I was curious myself, so I ran a 60% stock/40% bond model portfolio through a simulation starting 10/1/2007 (near the top of the pre-2008-recession). Its return over the period from then until 3/1/2009 (the bottom of the aforementioned recession) was around -26% annualized. But the return from 10/1/2007 to five years later, 10/1/2012? Around 4% annualized.  

Now, 4% isn't anything to write home about, it's true. But if the choice is between 4% and what an all-cash portfolio would have done during that time (~0.5%), which do you think would be better for most people in retirement?

I say "most" -- some people really can't afford short-term losses. That's why it's important to measure your risk capacity and build your portfolio from there. Just don't assume that a short-term downturn will wreck your retirement -- no matter how much time you have left!

This Time it's the Same, and This Time it's Different.

"But this time it's different" has been the bane of many a solid investment plan! In the late 90's, the World Wide Web took the world by storm, and investors were convinced by the sales pitch that value was being created out of thin air...and while it was indeed a revolution, it didn't quite justify the explosive growth of that time period, as we saw in 2000-2001. We saw something similar happen in 2018-2021 with Web 3.0, among other things...and 2021/early 2022 let the air out of that balloon, as well. (As this article is being written mid-2022, we'll see what the coming months have in store!) 

Each time, we saw completely unsustainable growth in the price of tech stocks, justified by "this time it's different"...only to find that it was not, in fact, different. But let's not be fooled into thinking that history repeats itself exactly! The 2021-2022 downturn has the fun new component of high inflation, naturally coupled with high interest rates; while a heavy bond portfolio would have been a reasonable buffer in 2000, it would not have performed nearly as well over the past twelve months!  

Instead of trying to assume either similarities or differences, it's important to keep an open mind, and to design a diversified portfolio of uncorrelated asset classes that hedge appropriately against as many different outcomes as makes sense -- while still providing a positive expected real return (I'm looking at you, commodities).

Liquidity is Your Best Friend, and Your Worst Enemy.

Flexibility is the unsung hero of many a financial plan -- the ability to access money if you need it can be the difference between happiness, annoyance, and misery! This is why it's important to have emergency savings in accessible cash-equivalents, and to be careful about investing in illiquid assets like directly-owned rental properties, private equity, etc. What good is the money if you can't get at it when you want it? (And we often misjudge just when we will, in fact, want it!)

However, there's a dark side to liquidity, specifically with regards to non-cash investments in publicly-traded markets: because you can theoretically sell those assets at any time, you can see the value fluctuate in real time. This leads to all kinds of irrational decisions, from refusing to sell a concentrated employer stock position because "it just keeps going up", to selling out of a diversified portfolio because "it just keeps going down". The short-term behavior of publicly-traded securities is almost entirely noise -- the research is clear that very little of the information is actionable, because very little of the information can be used to reliably predict future behavior, which is what we care about! (Also, when I say "short-term", that can include multi-decade periods. Remember that time when long-term bonds outperformed the S&P500 over a 30-year period?)

Any engineer will tell you what happens when you let noise unduly influence the behavior of a system -- you get bad systems! The trick here is to focus primarily on actionable data -- the Monte Carlo success rate of your financial plan, your rebalancing thresholds, the interest rate of I-Bonds, etc. -- and ignore the rest.

Don't Invest in What (You Think) You Know.

In the late 90's, I heard copious stories of engineer friends who invested their 401(k)'s in high-flying tech stocks representing companies that they worked for, competed with, etc. -- companies they knew. Everyone wanted to be a day-trader; they couldn't lose! Until, of course, they did...and they lost years of retirement in the process.

Fast-forward to 2018, and I saw it again. Particularly during the onset of the 2020 pandemic, I saw tech professionals investing in Amazon, Peloton, Zoom, Netflix -- all companies that were "guaranteed" to make a ton of money. (These folks knew this, because they worked in that space -- and in many cases, for the companies in question!) And many of those stocks did quite well...for a while. Then 2021-2022 came along, and they lost their proverbial shirts. (I feel particularly bad for Netflix employees, who were adamant that the 10-year NFLX call options their employer sold them (yes, sold) were leverage that was worth buying, and saw said options completely vaporize. Leverage is a two-edged sword.)

Markets are highly efficient -- don't think you know something the market doesn't! Sure, you can bet against it, and sure, you might win on occasion...but just like a gambler in a casino, you're almost guaranteed to lose in the long run.

It's Always* a Good Time to Buy.

Assuming your short-term needs are taken care of, when is a good time to invest in stocks, or bonds, or liquid real estate, or anything else that makes up a good diversified portfolio? Answer: just about always.

But what if the price-to-earnings ratios of stocks are high, and the interest rates of bonds are low? Doesn't that mean that the returns of a portfolio are low? Why yes, those are reasonably good and well-established long-term performance predictors...but the follow-up question is: low compared to what? Sure, when interest rates are low, bonds are a poor investment...except compared to everything else with such a low volatility. And sure, when P/E's are high, the expected returns on stocks are lower than otherwise...but "lower" doesn't mean "below inflation"!

Public markets are highly efficient -- if it's ever a good time to buy an asset class, it's almost always a good time to buy an asset class. Because stocks are inherently riskier than bonds, they'll always have higher expected volatility, and higher expected (demanded!) returns, no matter what P/E ratios do. Because bonds are inherently riskier than cash, the same relationship holds between them, as well, no matter what interest rates do. And because commodities have high volatility and a near zero expected return net of inflation, it's pretty rare that it makes sense to include them in a portfolio. These expectations may not always meet reality, but betting against them is, as we've mentioned before, a loser's game.

Of course, just because it's a good bet doesn't mean that you won't lose, which is why dollar-cost averaging over the course of a year is a good strategy for hedging without leaving too much on the table. And, of course, making sure your portfolio meets your overall risk tolerance and risk capacity!