Billionaire businessman Warren Buffett wrote in his 1992 Berkshire Hathaway Shareholder Letter, “We’ve long felt that the only value of stock forecasters is to make fortune tellers look good.”
I couldn’t agree more. Until very recently, stocks — especially anything artificial intelligence-related — were on a tear, and many pundits were predicting continued heroic returns.
Consider approximate annualized returns over the past three calendar years in the nearby chart. Investors continued to pile into the AI trade as “fear of missing out” (FOMO) was strong.
But markets can change quickly, and we saw this on the second day after the November midterm elections as “fear of being in” (FOBI) hit hard.
On Nov. 5, the S&P 500 was down -4.36% and the tech-heavy NASDAQ was down -5.52%, putting the NASDAQ in 10% correction territory from its recent high.
Media commentators are already busy offering views about what happened and what’s ahead. Some will almost certainly be right and others wrong.
What I find most interesting is that much of the discussion is focused on short-term expectations, which might be of interest to traders but perhaps not so much for long-term investors.
On Schwab’s monthly Market Talk for advisers, chief investment strategist Liz Ann Sonders concluded her comments with a powerful reminder about the importance of diversification and periodic rebalancing.
While economics is considered a science, it seems fair to say there is a lot of art to the craft as well.
The National Bureau of Economic Research is the official organization that determines and dates U.S. recessions and expansions.
The late Nobel Prize-winning economist Paul Samuelson joked that Wall Street had “predicted nine of the past five recessions,” highlighting the art within the science.
And Buffett’s joke about stock forecasters and fortune tellers is clearly supported by history.
If either of these professions was very accurate, arguments for diversification and rebalancing would be unnecessary. But they aren’t.
Diversification is as simple as your mother telling you not to put all of your eggs in one basket — or in gambling terms, spreading your bets.
“The stock market has predicted nine of the last five recessions.”
PAUL SAMUELSON
History shows that asset classes, sectors and investment styles come in and go out of favor often, and without warning.
And rebalancing is a disciplined way to systematically “sell high and buy low” to keep a portfolio aligned with target allocations.
Let’s say your target was 70% stocks and 30% bonds, and stocks saw great returns, which left your portfolio with 80% stocks and 20% bonds.
To rebalance, you’d sell stocks and buy more bonds (or add new cash) to get back to your 70/30 targets.
Many portfolios include more asset classes (U.S. stocks, foreign stocks, real estate, commodities, bonds, cash, etc.), but the idea of rebalancing remains the same.
Note that there are no guarantees that rebalancing will work, but history would argue for its benefits.
One of the great challenges for investors is to follow these principles. It can be challenging to include an asset class that has underperformed and to reduce exposure to something that has outperformed.
But sticking to a strategy that is consistent with your financial goals, time horizon and risk tolerance can help investors stay on track.
And while lots of folks talk about wanting big returns and being very risk tolerant, if you cannot stomach a powerful downturn and sell out of panic, it can be difficult or even impossible to recover.
For clients who wanted to make some bets on an idea, I suggested a core portfolio that followed the principles of diversification and rebalancing with a modest separate account for specific investments.
That way, they could participate in big returns if the ideas won without jeopardizing their long-term goals.
I followed this approach for my own investing with a few bets on companies like Amazon, Microsoft, Costco, Nvidia and Google while having the bulk of my portfolio in a moderate risk global asset allocation with an eye on keeping fees and taxes down.
It has served me well for many years. And I sleep well without trying to find someone with that magic crystal ball to forecast the future.
