The Wisdom of Knowing What You Don’t Know

With the stock market off to its worst start in history (as of Thursday evening, the S&P 500 is down 9% year to date), it may seem like a good time for a financial advisor like me to send out some kind of prognostication as to what is going to happen in the next week or month.

But I’m not going to do that.

Instead, I think it’s more instructive relay my view on what’s causing this downturn, then frame this in a broader, more constructive context. In my view, the stock market is repricing new information that is essentially not good for corporate earnings relative to prior expectations.  These factors include a stronger US currency, a slowing Chinese (and maybe global) economy and an uncertain / unstable geopolitical environment.  However, I do believe the long term trend is essentially positive given economic indicators such as housing data, unemployment data, consumer inflation, lower gas prices and the yield curve.   So in short, I do NOT believe this is the time for knee jerk reaction and panic selling.

Quite frankly, I think it’s more instructive to provide two contrasting lists to illustrate what I think is the “job” of an investment portfolio- which is to provide the proper risk adjusted returns in a variety of economic scenarios.questioning image

So the first list is what I DO NOT know and the second is what I DO know.  After you read the lists, you may wonder about the relevancy but stick with me and read on:

What I DO NOT KNOW:

  • Where the stock market is going in the next week
  • What stocks are a “buy” and which are a “sell” right now
  • What the Federal Reserve is going to do with interest rate policy
  • How China might react to their slowing economy and declining currency
  • Where oil prices or gold prices will go
  • How Russia is going to react to lower oil prices
  • Who is going to win the US Presidential election in 2016
  • North Korea’s next move with weapons testing
  • The Cleveland Browns record next year (although I have a pretty good guess on this one)

Of course- I could go on and on with this list as I don’t know a lot about the future.  But what is the dirty little secret that you won’t hear talked about on CNBC or Bloomberg? No one else really knows these answers either!

What I (and my Clients) DO KNOW:

  • The relative risk / stability of their paycheck
  • The number of dependents they have
  • How much they are paying for their investment advice
  • Their income tax liability
  • How they reacted to other market downturns
  • How much business risk they are taking
  • How much inflation protection they have with real estate
  • How much deflation protection they have with US Treasuries
  • The magnitude of the liabilities they must cover with insurance

Thankfully, when working with clients we don’t try to “know the unknowable”.  Instead we invest by factoring in risk factors that we DO know and use these to design a portfolio.  Sure- we do have to make assumptions about future returns to do the math on projected balances but what we really try to capture in constructing a portfolio is this:  the amount of risk we should be taking based on factors we can control.

That said, a portfolio should not be designed to ONLY maximize returns.  No- it should be constructed to maximize RISK ADJUSTED returns.  Knowing that, we keep our fund fees low and follow the old saw:  “Don’t put all your eggs in one basket!”

In short- a month like this is why we maintain a diversified portfolio that aligns with the endogenous (internal) risks that we can actually control.   What’s the value of a diversified approach?  I think it can be summed up in one chart (see below).  This shows the year-to-date percentage move of both the S&P500 (blue line) and SPDR® Barclays Long Term Treasury ETF (the red line, Ticker: TLO) which holds a portfolio of US Treasuries.  The S&P 500 fund is down 9% while TLO is actually UP 3.7%. 

sp500 chart 1

Bottom line:  No one really knows what’s going to happen next.  But investments should be allocated in accordance with the riskiness of a personal scenario- not just what we think might happen in the world or with financial markets.    This means broad diversification, low costs and risk adjusted allocations and expectations.

(Note:  For a deeper dive into my manifesto on investing, feel free to click this link to the Kure Net Worth Management Investment Philosophy.  There is no cost and you don’t have to sign up for anything.)

2 Comments

  1. Tony great points. Thanks. Always enjoy reading these when I can. You are correct unfortunately about the ‘don’t know about Browns!’ 😉 I sent what is for me big bump of cash at 15.6K Dow this week at my kids college funds and my equities accounts while still leaving about a 3 year safety net cash position in the event Intel decides I suck and am too old and expensive. – tj

    Reply

  2. Tony: Another great article. So glad we did the portfolio realignment this past summer and divested some to risky hold assets. Keep up the good work.

    Reply

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