It is human nature to ask questions with the word “should”. Should I behave this way? Should I go or should I not? The world of financial advice is no exception to this. Should the S&P 500 Index be at 26,000? Should stocks be going up in the midst of a pandemic? Should the Federal Reserve have a balance sheet worth $7 trillion made up out of thin air?
Yet, worthwhile as these questions can be, we should not use them as the basis for our investment decisions. Investing and creating a portfolio of diverse assets isn’t about being “right” on an ideological level of what should or should not be happening in the markets. It’s about making sure that our portfolios—or those of our clients, if we are financial advisors—are ready for what might happen, and ready to achieve our objectives within the context of our risk tolerance.
As an example, an investor might have been right that the long-term consequences of the Federal Reserve having a $4 trillion balance sheet during the last recession would be the destruction of the US dollar—but if that investor constantly invested from 2009-2019 in the assumption that the dollar would tumble and gold would skyrocket, their being right would not have helped them make money.
That’s because, in markets, there is no benefit to being “right” when the market is “wrong.” Being short (that is, betting that the stock market will decline in value) while the market is going up because we believe the market is overvalued may be right ideologically (perhaps, in a fair world, the market is overvalued), but it is certainly not putting our portfolio in a successful position because we would be losing money the whole way.
Investing requires us to be nimble, to be open to the fact that what we think might happen might not happen after all. To be sure, investors and financial advisors have economic forecasts and expectations, but portfolio management also takes into account the risk that those expectations do not come to pass. It does no good to say, “This should have happened” if it didn’t and the financial advisor was never ready for the alternative to occur.
This is one of the many purposes of asset allocation, or the diversifying of a portfolio into many different asset classes (e.g. stocks, bonds, real estate, gold, cash, etc.) These asset classes do not move all in the same direction all the time; in other words, they are not completely correlated to one another.
A portfolio that has all its eggs in one basket is subject to the possibility that, if what the financial advisor thinks should happen doesn’t happen, the portfolio is lost.
A diversified portfolio is nimbler; the financial advisor recognizes that even if the markets are “wrong” in our opinion, we still want to be in on the upside.
You might ask, though: doesn’t this method “give up” on the possibility of winning big? After all, if the markets are like a casino, then there’s no point in playing the roulette wheel only to put one dollar on every single number, red and black alike. The markets, however, are not like a casino in this way because a casino is ultimately a zero-sum game: you can only win if somebody else loses (if everybody loses, it’s because the casino wins).
Long-term, prudent investing is not zero-sum. As we discussed recently on our blog, the value of a stock is not a random number but the value of future dividends (dividends are cash paid by a company to those who own shares of its stock). Some stocks pay dividends now, others we expect to do so in the future.
That’s not zero-sum. Another investor does not have to lose for you to receive a stock’s dividend. Likewise, a bond is a promise by a company to pay back what you lent it with interest (also cash paid to you on a recurring basis). Another investor does not have to lose on the trade for that bond to pay its interest.
The only market transactions that are zero-sum, or casino-like, are those seeking short-term gains. Day trading (buying and selling a stock frequently) in an attempt to make big sums quickly, bear more resemblance to zero-sum: to win consistently by buying and selling over a day means that you have to consistently be smarter than the person who is on the other end of the trade. There are no future dividends or growth being aimed at in a day trade: there is only the hope that the price will go up over the course of a few hours or days, at which point someone will buy the stock from you.
In the end, the investor and financial advisor must always be wary of these two forces: thinking we are “smarter” than the markets, and thinking we can “win” the casino, zero-sum game.
The diversified portfolio, designed in response to a specific individual’s long-term goals and risk tolerance, and with focused and monitored asset allocation, helps counteract both these temptations. It does not have all its eggs in one basket, trying to outsmart the markets or what we think “should” happen. Nor does it try to “win big” today, but instead recognizes that investing in the long-term future can be a successful endeavor for many.
No financial advisor can be right all the time. But we should be ready.