The Market Is Ambiguous. Does Your Investment Strategy Need to Be?

Focusing on equity markets, the following distribution curve illustrates the historical one-year performance returns of the S&P 500 going back to 1950.  As you can see, the range is all over the place.  Analysts as a rule are not known for accurately predicting performance one year forward. Further complicating this is the career path nuances of the analyst profession – well-known analysts are better served placing a "down the fairway" number on their prediction, since they don't want too much egg on their face, while lesser known analysts are better off taking a shot on predicting an outlier (if they are right they may get some positive attention but if they are wrong, it will likely escape notice). Next-year returns can really fall anywhere on the spectrum, with a 20/20 hindsight narrative that make the outcome look obvious in retrospect.

It's Not Just Overall Performance, It's the Path to Get There That's Important

Not only are strategies at the mercy of overall market performance, but also the nuance of the path the market takes to get there. Even if I know the market is going to return 5% next year, the degrees of volatility and correlation among stocks will affect whether a long/short strategy is likely to outperform.   

There are infinite paths the market can take going from a known point A to a known point B.  Here are four historical one year time periods showing identical market performance with wildly different paths:

Except for the most static strategies, the path will not only have a different effect on the performance of a strategy but will affect the investor and how they interact with the market. At points of stress, does the investor decide to adjust his strategy?  Here's an illustration:  In the 2004 performance line above, the market went from +6% to -2% in about six months – it must have been pretty tempting for someone with market exposure to rotate to defensive strategies at that point, but that would likely have been the wrong move as the market then proceeded to zoom up 12% over the next four months. 

Learning to Set It and Forget It

Given the wide range of potential market and fund outcomes, the likelihood of repeat strong performances is low. Rather than picking winners, investors should pick funds that deliver a return profile that fits their needs and temperament.  

Can an investor live with investment strategies that do not have a lot of definition surrounding risk and return? Behavioral finance gurus such as Khaneman and Tversky suggest generally not.  People are generally governed by their aversions, and open-ended risk and ambiguity almost inevitably leads investors to fret about their investments. When constructing a portfolio, it is important to keep aversions in mind when navigating the client through the thick and thin of what the market is likely to give them. Given that we are certain that there will be uncertainty, here are some suggestions:

1. Use a strategy (e.g., defined outcome investing) with clearly defined worst-case scenarios and risk-return expectations.

2. Communicate those expectations to clients so they can comfortably manage their personal fears. The more clear those expectations can be illustrated to clients and seemingly followed in the future, the easier it will be to manage client expectations.
3. Stay away from investment situations not easily understood or ably explained.

Adhering to these guidelines can result in an investment strategy that brings clarity to a market that tends to be unclear, and help clients avoid chasing yesterday's winners, which rarely turn out to be tomorrow's top performers.