Pattern Recognition Investing

Even for those who can easily recall the history of financial markets, 10 years ago today seems like, well, more than a decade ago. Even as the ball dropped from the top of 1 Times Square, the end of 2009 saw the global economy still perceived as very much at risk of further meltdown. Even worse for those who had been around for a while, the stock market didn’t only plunge at the end of the last decade; it plunged at the beginning of that decade, too. Yes, in a single decade there were two distinct global stock market declines that averaged 54%.¹

Against this backdrop, justifiably traumatized investors hoping to make a little money and find a little safety might have been inclined to look for reassurance in the form of helpful statistics. Reviewing the prior decade at that time investors saw these rates of return across major stock and bond benchmarks:

U.S. Stocks as measured by the S&P 500
Foreign Developed Market Stocks as measured by the MSCI EAFE
Foreign Emerging Market Stocks as measured by the MSCI Emerging Markets Index
Bonds as measured by the Barclays Aggregate Bond Index
Source: Bloomberg. Time period: 1/1/2000–12/31/2009

If this performance summary is all you knew as of January 1, 2010, might you have been then inclined to sell every little bit of what had worked just fine for you in the prior decade so that you could roll all of your money into your most recently disastrous choice?

Probably not.

Which is too bad. Because that would have been the most profitable trade of your life.

U.S. Stocks as measured by the S&P 500
Foreign Developed Market Stocks as measured by the MSCI EAFE
Foreign Emerging Market Stocks as measured by the MSCI Emerging Markets Index
Bonds as measured by the Barclays Aggregate Bond Index
Source: Bloomberg. Time period: 1/1/2010–12/18/2019

Don’t Be Contrary, Necessarily

One potential lesson from these bar charts is that it pays to be a disciplined, contrarian thinker and sell what has done best so that you can rotate into what has done worst. Sell high, buy low, that’s smart. Unfortunately, these graphs tells us little that is useful for tomorrow. Trying to derive an investment strategy out of so little information might well be another case of torturing data until it confesses to something.

Nonetheless, many of us are indeed thinking about the next decade. As you do so, imagine for a moment that you live in a world in which it’s against the law to pursue a diversified approach to investing. Not only do you have to put all your eggs in one basket, but you also are prohibited from changing your decision for the next 10 years. What would you do?

Safe, boring bonds have to be considered. You won’t make much money, but if you are content to be more or less in the same financial situation a decade from now as you are in today, you could surely do worse.

If a 10-year investment time horizon seems long enough for you to make money in almost any reasonable stock market choice available, which market seems most tempting? Would you prefer to have all your money in U.S. stocks, stocks of foreign developed nations such as Japan, the United Kingdom, and France, or stocks of developing markets overseas, such as those of China, Taiwan, South Korea, and India?

Learning from Roulette

Some people enjoy unfair questions so much they play roulette. Watching the ball on the roulette table land in red three times in a row, they urgently bet on red. It’s hot. A friend of mine does the opposite. He waits until there is a third straight red, and then he bets on black. It can’t just be red all the time, he tells me. Black is due. Everyone is right (or wrong) in their own way, though it was Albert Einstein who said, “No one can possibly win at roulette unless he steals money from the table while the croupier isn’t looking.”

What can make this “you aren’t allowed to diversify” game even more challenging is the fact that we may overrate our chances without even thinking about it. Specifically, while we might avoid roulette because we know our chances of losing grow the longer we play, we might casually assume that “reasonable” stock markets will reward our long-term commitment. History shows this can be wrong.

At the end of the 1980s, the value of the Japanese stock market exceeded the value of the United States stock market. It was said then that for the worth of the real estate of Tokyo’s Imperial Palace you could buy all of California. Disparities like this often seem nuts, but they are only clear with the benefit of hindsight. Today, for example, the value of Apple exceeds the value of the entire energy sector of the S&P 500.² Doesn’t that seem odd, too?

Japanese stocks were valuable in 1990 because in the prior decade they rose by 891%.³ But for those more committed to investing long-term than wondering whether the prices they were paying might be insanely high, the next decades were painful. The Nikkei 225 Index fell 29% in the 1990s and then another 31% in the decade after that. Even with the 131% gains of the current decade, the Nikkei 225 Index has delivered through today (December 18, 2019) a total return of less than 13% since December 31, 1989. That is a dismal result for those who made a 30-year commitment to what was at the time the world’s most valuable stock market.

Happy Ending

The good news is that well-designed portfolios of stocks and bonds are not in fact illegal to assemble. They provide long-term investors with attractive returns more often than not. As such, even though we are coming to the end of yet another decade in which a single investment choice ran circles around everything else, forward-looking investors can and should remain committed to broad diversification.

Footnotes

¹ The MSCI ACWI index, a benchmark of global stocks, experienced a drawdown of 50% in 2000–2002 and a drawdown of 58% in 2008–2009. Source: Bloomberg.

² The Financial Times, December 3, 2019

³ As measured by the Nikkei 225 Index, Bloomberg

Disclosure

The article is for informational purposes only and is not intended to be used as a general guide to investing or financial planning, or as a source of any specific recommendations, and makes no implied or express recommendations concerning the manner in which any individual’s investments or assets should or would be handled, as appropriate strategies depend upon each individual’s specific objectives. It is the responsibility of any person or persons in possession of this material to inform himself or herself of, and to seek appropriate advice regarding, any investment or financial planning decisions, legal requirements, and taxation regulations which might be relevant to the topics this article, or the purchase, subscription, holding, exchange, redemption, or disposal or any investments.

The portfolio risk management process includes an effort to monitor and manage risk, but does not imply low risk. Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. Future returns are not guaranteed, and inherent in any investment is the potential for loss.

Opinions expressed in this article are current opinions, which are not reliable as fact, as of the date appearing in this article only and are subject to change.

The article does not constitute a solicitation in any jurisdiction in which such a solicitation is unlawful or to any person to whom it is unlawful. Moreover, the article neither constitutes an offer to enter into an investment agreement with the recipient nor an invitation to respond by making an offer to enter into an investment agreement.

No part of this material may, without the prior written consent of Bingham, Osborn & Scarborough, LLC, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.

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