Investing With a Broken Compass: the Broken Analogy

This ad is part of an ongoing series from BNY Mellon and other large financial services firms that are aimed at unsettling investors and heightening their fear that the economy and financial markets have changed in fundamental ways that require a new way of thinking and acting. And, of course, Mellon and other firms are happy to offer you that “new way” of investing that will help you navigate a transformed landscape.  Along these lines, BNY Mellon has another ad that proclaims: “staying the course is like navigating a new world with an old map.”  Note that they’re very specifically working to demonize the phrase “stay the course,” which they know many investors are hearing from their current advisors.  When it comes to considering the nature of the world today and what it means for investing, we’re more inclined to agree with legendary investor Sir John Templeton, who declared:

“The four most dangerous words in investing are ‘This time it’s different.”

Of course, it’s always different in the details, but the core phenomena that drive the economy and markets don’t change. So you can focus on the superficial differences or you can focus on the core drivers when developing an investment strategy.  We think a focus on the core drivers will bear more fruit for any patient investor (on this point, we particularly enjoy Jason Thomas’ analogy of the dog and the dog walker).

Those who would goad one into imprudent action, however, will offer up any number of ways in which the world is different: globalization, high-frequency trading, financial innovation, the explosive growth in derivatives, and rising volatility, to name a few. And, of course, these things are real, lending a patina of credibility to the argument. More importantly, however, they’re just details, not core drivers. The real question is whether you can actually create profitable trading strategies that exploit these phenomena. All the best evidence suggests not. And while rising volatility presents greater risk to the average investor – a greater chance of being fleeced by Wall Street pros – it’s only true for the investor who tries to trade on that volatility. We believe the core reality is this:

The deep regularities that drive economies and financial markets are unaffected by heightened surface volatility, just as a storm that whips up towering waves on the surface of the ocean leaves the deep currents untouched.

Deep Regularities and Core Drivers

Let’s begin with the nature of any free market economy, which have come to represent most of the world today. The individual decisions that you, your family, your friends, your neighbors, and everyone else in society make with respect to earning, saving, spending, and investing, all aggregate up to what we call the economy. Economies are resilient because people are resilient. When we hit a rough patch, we modify our behavior, as does everyone around us, and, slowly but surely, those behavior changes shift the course of the economy as a whole. To adopt the dystopian view that we’re entering some kind of “Mad Max” world of permanent stagnation and decay is to believe that human beings will stop striving to make their lives and the lives of their families better. You have to have a particularly dark view of human nature to embrace such a pessimistic view.

As for the financial markets, which exist to price securities such that risk will be appropriately rewarded, here again, we turn to human nature for insight. Many will say that the historical relationship between risk and reward – that owning “risky” assets tends to provide higher returns over time – is gone. They will tell you that financial innovation and all the other things mentioned previously have conspired to unhitch reward from risk. To which we must respond: nonsense! The historical relationship between risk and reward was not some accident that arose for transient reasons that can be swept away by the appearance of high-frequency trading or any other innovation. The systematic relationship between risk and reward is, instead, the manifestation of something that was millions of years in the making: the natural human aversion to risk.  One might even say that it was billions of years in the making, since all living creatures are possessed of a healthy aversion to risk.  It was only risk-averse creatures that lived long enough to pass their genetic heritage down to us.

Human beings won’t take on risk unless given a proper inducement, and markets continually reprice securities to maintain that delicate balance.

To be sure, individual and group perception of the magnitude of risk at any given moment in time can get out of whack – we all remember the dot-com bubble – but markets eventually and inevitably move to correct such imbalances. The key for an investor is to avoid “calling the winners” and instead spread their risk capital far and wide, across companies, across industries, and across continents. Asset allocation and rebalancing are the key.  Our true and trusty compass is our asset allocation plan yoked to a disciplined and evidence-based approach to rebalancing, which keeps us pointed toward the broad market categories that we know are systematically priced for attractive returns.

When we rebalance our portfolios, we are using our one true compass to make a correction that restores us to our original course.

When large financial service enterprises tell you that “this time it’s different” and that you must chart a new course and embrace a new way of investing, it’s important to remember the nature of THEIR core drivers: they’re all in the manufacturing business more than the advice business. They manufacture no end of proprietary products – hedge funds, absolute return funds, inverse funds, variable annuities, commodity futures funds, the list goes on and on – and the factory must be fed!

You should always ask yourself: do these recommendations serve my needs or the needs of someone’s financial product factory?

As always, it’s better to be resilient than nimble. And resilience comes from having a working compass that helps you stay the course, wherever the winds and tides may push you.