Clear, simple and wrong

complexityAmerican journalist, satirist, and scholar H.L. Mencken is credited with the saying “For every complex problem there is an answer that is clear, simple and wrong.” There can be no doubt that the intricacies of and interrelationships between macro and micro economics, human behavior, trading algorithms and regulation make successful investing a very complex undertaking indeed. Understanding this perfectly well, the financial products and services industry took the work of academicians in the 1950s and 1960s out of its intended context, ignoring underlying assumptions and caveats in order to market Modern Portfolio Theory (MPT) as the simple answer to the complex question. Buying and holding a diversified portfolio of stocks and bonds and a smattering of other asset classes to achieve an ideal level of risk and return became the accepted truth of rational investing, largely as a reaction to the severe bear market of 1973-1974. It also provided industry professionals with a permanent buy side. It is fair to say that the current financial products and services industry is a product of MPT. Even the dramatic market correction of 2007-2008 did not dislodge MPT from the core of investing belief and practice. Just when investors were supposed to be able to rely upon diversification to shelter them from losses, the market pricing of most asset classes became positively correlated as prices fell. This was not an anomaly. Price movement correlations among different asset classes have strengthened in many historical market downturns. Nonetheless, MPT has benefitted from the 1982-2000 and 2009-present bull markets.

Investors who have experienced several market cycles know that MPT provides precision without accuracy. They have had to listen to their advisor explain away losses with the painful platitude “don’t worry, we’re in this for the long term”. Never mind that during periods when MPT-based investing approaches are working, much of the time is spent recovering from prior losses. Most insidiously, as defined benefit pensions were replaced with 401k plans, plan administrators offered only diversified buy and hold options.

Since the financial crisis of 2008, markets for risk assets have benefitted from central bank interventions providing liquidity and extraordinarily low interest rates. Corporate borrowing costs fell and share buy-backs and M&A proliferated. Notwithstanding a weak recovery, economic and political uncertainties in foreign markets have made the US and the rising dollar the best looking alternative. This created a lollapalooza effect for risk assets like US stocks and high yield bonds. The 2015 earnings season has revealed disappointing revenues and slow growth prospects for earnings. Most companies seem to have wrung about all they can out of cost cutting and financial engineering. We are left with what seems to be a somewhat “toppy” stock market, and bond yields and interest rates that can’t go much lower. The growing disconnect between asset valuations and fundamentals continues to widen at a brisk pace, as economic reality is masked by free money and market manipulation. Most money managers are telling investors to expect low returns for the foreseeable future.

What does this portend for the continued application of MPT in investing? Is buy and hold still a good idea? Are bonds really a lower risk investment? Should anyone believe that the simple diversification advice coming from either a human or an online robo-advisor is viable? The problem with investing regimens based on MPT is that they base recommendations on long term average returns for different asset classes as well as long term average price change correlations. Remembering that a man six feet tall can drown while crossing a stream that is on average six inches deep, now might be a dangerous time to be relying on the simple answer to the complex problem.

Consider a person approaching retirement, or saving to buy a house. They may be a long term investor, but they also may have to tap into their investment funds sometime within the next five years. The chart below shows the rolling five year annualized returns of portfolios holding a range of stock/bond combinations. Since most people allocate at least 40% to stocks, I truncated the chart at 40/60 stocks and bonds. Notice that while you can reasonably expect that on average you will make between 8 and 11% per year. Notice also that you can also experience negative average annual returns for five years.

5 year rolling returns stocks-bonds

“Diversification is protection against ignorance, it makes little sense for those who know what they’re doing.”

– Warren Buffett

The answer to the complex problem of investing is this: Find something that either you or your advisor knows a lot about. Buy it when its prospects are good. Sell it when its prospects are poor. Watch it like a hawk. Remember that a good company is not necessarily a good investment and a poorly run company is not necessarily a poor investment. Remember that when a market turns, all issues will be pushed up or down with the trend. Don’t fight the trend. Always be ready to change your mind.

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