Was That a Bottom? Should We Even Care?

Maybe, maybe not. We don’t know and no one else does either. At least not today.

Nonetheless, it’s tempting to say that Tuesday’s intraday low of 1200.44 for the S&P 500 certainly looks like the trough–for the moment. Yesterday’s bounce skyward already has some pundits speculating that a return of the good ole’ days is imminent. And, of course, there’s a few select bits of news to support that notion, including a sharp drop in oil prices, a confidence-boosting announcement for the battered financials by way of a dividend hike for Wells Fargo, and some better-than-expected news on business conditions for three stalwart names in the Dow Jones Industrials.

Of course, we could easily counter the upbeat reports with bearish ones. In fact, that’s always true. There’s never a shortage of reasons to worry, or to hope. Depending on your mood, you can find corroborating evidence to support the forecast preference du jour.

Alas, there’s virtually no chance of calling bottoms or identifying tops, at least not in advance, or ex ante, as the academics say. The rear-view mirror, on the other hand, is always reliably lucid. No wonder, then, that looking backward tends to have an oversized influence on investor sentiment today. The problem is that the past, sans an informed and thoughtful historical perspective, is of little help to the strategic-minded investor.

Indeed, developing strategic perspective is an unnatural act for the human species. That’s not to say that it can’t be learned. But the path of least resistance is one of extrapolating from the very recent past as a basis for anticipating the very near future. That may work for traders and sail boat enthusiasts checking the weather at sea, but it’s bound to lead you astray eventually when it comes to finance.

For those with an investment horizon of considerable length–five years or more–there’s a better way, or certainly a way that’s less prone to egregious error. The better path starts by admitting that the 14 oz. mass of tissue within our craniums isn’t normally suited to thinking strategically. Tactical notions are more its style. Exhibit A is the rush of pleasure most of us get when we buy or sell when doing so with the crowd; or, the pain we suffer when we act alone.

Volumes have been written on how investors are at risk of becoming their own worst enemy when it comes to strategic thinking on matters of investing. We won’t belabor the point here, other than to remind that the intersection of human psychology and money is a broad and rich field of study that’s dispatched a sea of insights into how Mother Nature has left us high and dry for thinking prudently on matters financial. (For any one who’s curious about behavioral finance, here’s a solid overview of the literature.)

Reprogramming our heads for winning the investment game isn’t easy, nor is it clear that there’s a solution per se. More than 50 years of research in financial economics has taught us much about what works, and doesn’t work in money management. But there are still no guarantees, and much of what we’ve learned has application only for long-term investing horizons. In many ways, we’re as clueless about the short run as we’ve ever been, although that doesn’t stop many from asserting otherwise.

As for the basic strategic lessons, it all boils down to:

1) Diversify broadly, across as many asset classes as you can reasonably and efficiently own; if you’re not sure about how to weight and choose assets, Mr. Market’s asset allocation will probably fare modestly well over time.

2) Minimize trading, reserving it for those times when your confidence about the future is relatively high. If you don’t have much confidence about weighing the odds for what will happen down the road, then rebalance your portfolio every year or so, or perhaps more frequently when markets move dramatically. This advice, of course, requires a solid asset allocation benchmark as a basis for rebalancing. Not sure how to proceed? See item 1 above.

3) Keep expenses low, which is to say favor index funds as a general rule unless you have a deep conviction otherwise. But for most investors, passive investing will do quite nicely, even though it won’t win the horse race.

4) Stay focused on the long run. Alternatively, if you don’t have a long-run horizon, act accordingly with risk allocations.

If you’re inclined to be active in your portfolio decisions, start by looking to take advantage of extreme moments on an individual asset class basis. That requires patience, since extreme moments, by definition, don’t come along every other Tuesday. That said, if stocks are selling at high valuations, pare your exposure; if they’re selling at relatively low valuations, raise the equity weight in your portfolio. (For some recent perspective on equity valuation, see our post from last week.) The same concept also applies to the other asset clases. In sum, be opportunistic, but neither chase performance or fall into a perma-bear state when prices slump for an extended period. And when you do rebalance, look to roll out the changes over the course of a cycle so that you don’t bet the farm on thinking we’ve identified the bottom, or top, in real time.

Recognize, too, that almost everything we’ve learned about strategic-minded investing is less about boosting return than it is about lowering risk without paring much, if any return.

Finally, try not to get caught up in the tick-by-tick mentality of trading. We humans are highly vulnerable to what’s happening now, this minute, this second. And we like to judge our success, or failure, based on what happened in the previous week. It doesn’t help that we like to mingle with other investors at cocktail parities and compare notes. No, we’re not suggesting that we all become monks and cancel our news subscriptions and real-time data services. But strategic success will require some compromise and concession, and that includes giving up some of the entertainment that comes by watching markets in real time.

A little common sense, in other words, is also necessary for strategic success. Perhaps there’s some hope of investment victory after all.


Originally published at The Capital Spectator and reproduced here with the author’s permission.