Cadence's asset class investing portfolios are strategically invested with a focus on long-term performance objectives. Portfolio allocations and investments are not adjusted in response to market news or economic events; however, our investment committee evaluates and reports on market and economic conditions to provide our investors with perspective and to put portfolio performance in proper context.
When looking at market performance in recent years, U.S. stocks have outperformed international stocks, and growth stocks have outperformed value stocks. This has led many to question the benefits of diversification and ask what they should do when an investment strategy performs poorly. We should begin with a look at the appropriate lens through which to view investment strategy performance. Then we will address several issues that work to fog our lens and challenge our ability to stay the course. Taken together, we believe an understanding of these topics fosters the mindset necessary to remain disciplined in the face of adversity.
Our investment strategy is grounded in three fundamental principles.
First, we believe markets are highly efficient pricing mechanisms. This leads us to conclude that active management is a loser’s game.
Second, because we believe markets are highly efficient, it follows that all unique sources of risk (asset classes) have similar risk-adjusted returns; not similar returns, but similar risk-adjusted returns.
Third, because all unique sources of risk have similar risk-adjusted returns, we also believe portfolios should be diversified across many unique, or independent, sources of risk and return. Moreover, the premiums associated with these unique sources of risk and return should be: persistent, pervasive, robust, implementable, and have intuitive (risk-or behavioral-based) explanations. In other words, we want to see the evidence that this risk-adjusted diversification has produced strong returns over very long periods of time. No gambling here, friends.
These three principles form the foundation of an investment process that culminates in a portfolio fine-tuned to provide the greatest probability of achieving your life and financial goals.
Having a process in place, however, is the easy part. Sticking to it is the real challenge.
As Warren Buffett noted, “Investing is simple, but not easy.” While diversification has been called the “only free lunch in investing,” it doesn’t eliminate the risk of losses. Diversification requires you to accept that parts of your portfolio will behave entirely differently than the portfolio itself. And your portfolio may underperform a broad index like the S&P500 for a long time, in large part because the portfolio is far more broadly diversified.
The result is that diversification is HARD. And, because misery loves company, losing unconventionally with a portfolio that doesn’t look like the S&P 500, on which the media reports daily is more challenging than losing conventionally. In addition, living through difficult times is more challenging than observing them historically – another reason it’s so hard to be a successful investor.
This leads us into how we’re wired to react when times get tough AKA behavioral bias.
Hindsight bias, or the tendency after an outcome is known to see it as virtually inevitable, contributes to the mistake of resulting, the belief you can predict an outcome based on the past.
To avoid this mistake, John Stepek, author of “The Sceptical Investor,” advised:
“You must accept that you can neither know the future nor control it. Thus, the key to investing well is to make good decisions in the face of uncertainty, based on a strong understanding of your goals and a strong understanding of the tools available to help you achieve those goals. A single good decision can lead to a bad outcome. And a single bad decision may lead to a good outcome. But the making of many good decisions, over time, should compound into a better outcome than making a series of bad decisions. Making good decisions is mostly about putting distance between your gut and your investment choices.”
The bottom line is that because we live in a world of uncertainty, where at best we can only estimate the odds of investment outcomes, the quality of a strategy should be judged before, not after, the outcome is known. Otherwise, you risk the mistake of confusing strategy with the outcome.
Next, up recency bias, in which recent observations have a larger impact on our memory and, thus, our perception of what will happen next. It leads investors to focus on the most recent returns and project them into the future. This can result in buying what has recently done well (at high prices, when expected returns are lower) and selling what has recently done poorly (at low prices, when expected returns are higher).
Buying high and selling low does NOT lead to investment success. Yet the research shows that this is exactly what many investors do, presumably because of recency bias.
While achieving diversification is simple, living with it is hard.
When it comes to investing, Warren Buffett believes that temperament, a source for the discipline to adhere to a well-thought-out plan, is more important than intelligence.
Knowing your tolerance for discomfiting news that the S&P 500 is up, but your portfolio is down (known as tracking-variance risk) and then investing accordingly, will help keep you disciplined. Yet, taking more of this type of risk than you can stomach could lead to failing decisions like selling when financial news is bad, or buying when the financial news is good.
If you have the discipline to stick with a globally diversified, evidence-based asset class strategy, you are likely to be rewarded for it.
We hope this serves as helpful insight as we all head into the next financial news cycle,
"I don't know...something just doesn't feel right," you mumble through your mask to your primary care doctor while sitting on the examination table under a flickering fluorescent light in a room decorated with anatomical charts and hand-sanitizer dispensers. After listening to your heart and your lungs, the doctor diagnoses your feelings of worry as a mild condition that is easily treatable but could become dangerous if a proper treatment regimen isn't followed. The doctor gives two treatment plans: one coming from the New England Journal of Medicine and the other from a health magazine that can be purchased at your local convenience store. Which plan do you choose?
The health magazines are filled with tips and tricks, such as how to burn body fat, jump-start the body’s metabolic rate, and build immune system strength. And they might even work sometimes. If you want to choose the treatment plan with the highest odds of success, it might give you more confidence to know that the medical journal, and its recommendations, are based on decades of data collected from research studies performed by medical experts and peer-reviewed by the medical community.
We face the same decision when it comes to investing. Numerous publications tout the latest investment trends and implore their readers to jump on the bandwagon or miss out on the impending financial windfall. And to their credit—sometimes they work. But just like our physical health, we can place more confidence in an evidence-based approach to support our long-term investment plans and, ultimately, our financial well-being.
Evidence-based investing and evidence-based planning is the foundation of your financial life plan and our philosophy. It is an approach guided by thoroughly vetted, peer-reviewed research and carried out by industry thought-leaders, academicians, and practitioners that are tested against decades of empirical data. We used this research to design your portfolio so that you can focus on today and know that your portfolio will be there to support your lifestyle in the future, regardless of what the pundits claim are the latest investment trends in the markets today.
The next time you find yourself questioning your financial well-being or if your portfolio "just doesn't feel right," look at what the evidence says. Are you giving yourself the best odds of long-term success?