Do Expectations Live Up To Reality?

The one constant in life is change. Sometimes we can anticipate an impending change and be fairly certain of the result, as in: “it’s going to rain tomorrow.” Other times, change happens when we least expect it and with an uncertain outcome—remember December 7th, 1941! Over the ages when the Brits spoke “The King is dead. Long live the King!” it was a recognition that change is normal but that life must go on, and people must adapt despite everything that has occurred. 2016 was a year of some major changes and some very surprising, unexpected results. Change can be relatively easily accepted by most people since evolutionary change has gotten humankind to its present position. It is the surprise that can be upsetting. Investors in particular expect constant change since values of securities are reset with every trade, but they are still upset at the very least, when the resets are beyond the expected boundaries. As we saw in 2008-09, the upset can quickly turn to panic if conditions are right. Forecasting is nothing more than making an educated guess as to the outcome of the changes that will occur in the foreseeable future. The chart below illustrates the difference between what investors believed the stock market’s performance would be for the coming year versus what it actually was. In most years, investors were looking for a 5-8% total

return (even below the past 90 year average of 10% annually), and were pleasantly surprised by higher performance. In 2008 after anticipating an 11% gain and being hugely disappointed, many investors drastically changed their investing behavior.


As we think about 2017, we should ask ourselves: how realistic are our predictions? We found the recent Wall Street Journal article titled “Investors Should Ask: How Will I Be Wrong?” to be fascinating and quite insightful, since investing is all about forecasting and investor behavior. The author, James Zweig who writes The Intelligent Investor column, did not ask “Will I Be Wrong?” since it is a given that you will! He points out that great investors like Warren Buffet constantly test their investing assumptions to determine whether they are correct. He talks about biases that we all have and gives suggestions on how to guard against them. Specifically, he notes that psychologists have labeled two quirks of the human mind: confirmation bias and hindsight bias. The first drives us to seek and favor evidence that confirms our pre-existing beliefs while ignoring warning signs that we might be wrong. The second compels us, after everyone knows the outcome, to believe we saw it coming all along. In addition, Zweig quotes from a new book, “The Rationality Quotient” by Stanovich, West and Toplak, that rational beliefs “must correspond to the way the world is,” not to the way you think the world ought to be. Finally, we would agree with Zweig that if you can’t be honest about the difference between the truth and what you think ought to be true, you may be intelligent, but you are not rational, and for investors, this is a critical point. We, as investment managers, must recognize our biases as we analyze companies and markets. We must also be honest with ourselves to see the world as it is, and not base our investment assumptions on events, circumstances and hoped-for outcomes. For example, we could make a convincing argument that a pharmaceutical company’s new wonder drug will be a multi-billion dollar success or that oil prices will return to $100 per barrel levels. But, these arguments must be tested by focusing on “what will go wrong.” 

Our predictions for 2017 at this juncture are pretty mainstream, since we don’t have any solid insight into the future which would suggest something radically different. Hindsight bias does not really come into play in our analysis, except for possibly our use of quantitative models and screens that identify “theoretically attractive” investment candidates based on the past. Confirmation bias on the other hand, is a constant threat to our analysis and one that we consciously guard against. When a new idea is presented, the investment case assumptions are thoroughly challenged by our portfolio managers and analysts. The intent is to uncover what can go wrong so that we can then make an informed decision about the probability and magnitude of a flawed investment decision. Being wrong sometimes is simply part of the investment management business. Investing is not about avoiding risk; it is about seeking out reasonable risk and controlling it.

While predicting the future is very difficult, predicting people’s reactions to surprises—when a highly confident outcome is wrong—is next to impossible. In the investment world, there are always two sides to a trade—for every buyer, there must be a seller. Each has a different belief as to the future profitability of holding a particular asset. The buyer believes that he or she will receive a relatively high return while the seller believes that his or her money is better invested elsewhere. Which person is ultimately correct depends on the timeframe being measured and where the seller invests the proceeds. It has little to do with what a majority of investors believe. Sometimes the conventional wisdom is correct, but sometimes being a contrarian is more correct. Finally, for some clients the monetary reward is not the only reason for buying or selling. A client’s wealth is very personal and not all clients invest with exactly the same objectives. The psychological reward of a specific asset allocation or avoidance of certain types of stocks can easily outweigh the possibility of higher performance. What is important for all investors is to understand how their wealth is invested and whether it comports with their own beliefs and desires.

Predictions for higher interest rates, a growing economy, higher inflation, rising wages, a strong dollar, and probable large amounts of infrastructure spending are the norm. The elephant in the room on any 2017 prediction is the incoming administration. Exactly what changes from the path that we have been on for the past several years will occur, no one knows. However, some changes are far more likely to occur than others. Infrastructure spending appears to have bipartisan support, thus will likely happen. How it is paid for is another question. Regulation, especially for the financial sector, will likely be curtailed somewhat which may have a positive effect on general risk taking and economic growth. The Fed finally raised interest rates in December and has suggested that three more increases in 2017 is likely, subject to actions by the Trump administration or Congress. Lowering the corporate tax rate would be a positive for the markets, for job creation and for capital spending. It would also likely keep more companies and jobs in the U.S., but a change in the tax code may be more difficult for Congress. If Trump can be taken at his word, there will be more emphasis on the middle class. That large swath of our population has not seen a rise in its standard of living for decades. But, consumer confidence currently is at the highest level since 2001 which bodes well for continued economic growth and consumer spending.

Regardless of what surprises are in store for 2017, we will manage our clients’ assets with the same diligence that we always have. We may not agree with or think that certain rules, regulations or events are rational or desirable for our country or financial markets, but that does not impact our investment process. We always play the cards that we are dealt. We invest for the long term, both in selecting securities for portfolios and in asset allocations for our clients. Portfolio performance is one measure of how well we are managing our clients’ wealth, but it is not the only measure. The “sleep-at-night” component, knowing that your assets are being managed as you expect and in a manner you understand, is equally important. In a rising stock market, normal human behavior is to want to fully participate in the gains. In a bear market, it is just the opposite. The performance number is simply how the total portfolio has performed during a specific period of time. Performance will change, sometimes dramatically, as the time frame changes. Performance can also be broken down into an almost infinite number of subcategories (by asset class, sector, industry, security, company size, location, month, day, year, etc.) and can be compared to an equally almost infinite number of benchmarks, which can be interesting to look at, but does not provide much insight into what to do in the future. While most investment managers, including ourselves, are very concerned with and knowledgeable about both portfolio and benchmark performance, clients are interested in making sure that their investment decisions help them meet their real life goals. For those who are, we have provided a more in-depth explanation of performance and benchmarks on our website.

One final thought on market timing. We do not try to time the markets. As we have touched on in the paragraphs above, trying to anticipate markets’ reactions to events is difficult, at best. First, staying invested based on a well thought out plan involves one, hopefully correct, decision. Selling because one believes that stock prices will fall involves two, hopefully correct, decisions: when to sell and when to buy back in. A significant problem with this is that if decision number one is correct and the market falls, it takes a very disciplined investor to reinvest in the face of the disappointing news or the event that caused the decline. In the majority of cases, if you are close to fully invested, most often the best decision around volatility or anticipated volatility—is actually no decision. Numerous academic studies support this view. One such study at The Ross School of Business at University of Michigan studied a 42-year period of market returns between 1963 and 2004 and found that less than 1% of trading days accounted for over 95% of market gains. In fact, being “out of the market” during the 10 best trading days each year resulted in returns 41% below a fully-invested account. This effect is exacerbated by the fact that raising cash means the foregone gains can no longer be compounded during the rest of the holding period.

Some of this is basic behavioral psychology and is easier said than done, but it underlines one reason why investors should focus on their own long term plan rather than on what might happen to “the market” in the short term. It sounds clichéd—but we remain believers in buying and owning fundamentally sound businesses with sustainable, competitive products/services—and holding onto them through market volatility.