I usually don’t comment on market gyrations, because they’re mostly irrelevant to mindful investing.  But since about March this year, everyone seems to be talking about how the crazy stock market is levitating despite the pandemic’s obvious impact on the economy.  So, I couldn’t resist investigating why this is happening.

This graph from FiveThirtyEight shows that the most common economic indicators imply that the stock market should be tumbling.

But the stock market doesn’t seem to care, as shown in this year-to-date graph of the S&P 500.

In late March, the S&P 500 was down by more than 30%.  But so far this year, the S&P 500 is up by 1.6%.  And before September started, it was up by 10%!  It just seems insane.

What are the possible explanations for why the stock market is ignoring the ongoing pandemic and dismal economy?

The Stock Market Is Not the Economy

The most common explanation for the apparent disconnect between the stock market and the economy is that the two aren’t as closely linked as you might assume.  To start, consider that out of the 600,000 U.S. companies with more than 20 employees, only 3,600 are publically listed (or less than 1%).

So, it’s not terribly surprising that economic growth is negatively correlated with stock market growth in countries around the globe.  In fact, data indicate that past investors would have netted better returns by investing in countries with lower per capita Gross Domestic Product (GDP) growth as opposed to countries with the highest growth rates!

Particularly in the U.S., history suggests there is a strong link between stocks and the economy.  But the economy has changed a lot in the last half-century.  For example, back in 1962, the two biggest U.S. companies (AT&T and General Motors) employed nearly 1.2 million people combined.  But last year, the two largest companies in the S&P 500 (Microsoft and Apple) employed just 280,000 people.  So, the link between big business and employment, one of the most common economic indicators, is much weaker than it used to be.

Although most of the economic indicators look pretty scary right now, none of them are necessarily direct predictors of short-term stock market moves.  If they were, then investing would be as simple as timing the market based on leading economic indicators.  But we know that routinely timing the market is impossible.

Short-Term Earnings Aren’t That Important

But what about earnings?  They’re a direct measure of stock’s intrinsic value, and they’ve also crashed this year.  Here’s a chart showing the quarterly percent change in S&P 500 earnings per share and price over the last six quarters.

Again, this seems crazy.  As compared to the beginning of 2019, earnings plummeted by 70% in the first quarter of 2020.  At the same time, the price of the S&P 500 declined by a mere 10% since the start of 2019 and was up 8% by the end of the last quarter.

But market fundamentalists point out that this apparent disconnect between earnings and prices simply shows that the most recent earnings (at least in isolation) are not that important to a stock’s long-term valuation.  Consider that the median price/earnings ratio for the S&P 500 going back to the 1880s is about 15 and the median annual earnings growth is about 12%.  If you do the math on these numbers, it means that investors are routinely willing to pay a price for a stock that’s equivalent to the next 8 years’ worth of earnings.  So, from this highly rational perspective, half a year of bad earnings only represents about one-sixteenth of a stock’s present value.

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It’s time once again for my annual update of expected return forecasts for stocks and bonds.  Actually, it’s a bit early for my update, but I have more time now than I’ll have later this fall.  My self-imposed task each year is to compile annual forecasts of long-term stock and bond returns from various investing companies and report them here.

[I also normally use this information to update my regular Mindfully Investing article on expected future returns and risks.  But regular readers be warned, I probably won’t get to that until later in the month.]

While no one can forecast the future exactly, the investing goals in a mindful investing plan should be based on realistic expected future rates of return.  Too often investors, including professionals, create investing plans with an overly optimistic view based on historical returns.

For example, the U.S. has one of the best long-term track records for stock returns in the world, with a historical average annual return of about 9%.  But global investors are routinely expecting to exceed that average over the next five years as shown in this graph from Schroders, a British asset management firm.

Can our investing plans live up to these great expectations?

The 2020 Data

This plot shows long-term return expectations for various asset classes from a dozen or so companies that issue these forecasts each year.

All returns are on a nominal basis, meaning they are not adjusted for inflation.  Most of the forecasts are estimates for the next 10 years, except for two that cover 7 and 15 years, respectively.  “Non-US stocks” are mostly developed markets that exclude the U.S., although in some cases it’s unclear whether the forecasters included the U.S. in this category.

It seems that professional investors are assuming that the long-term returns for U.S. large-cap stocks will be somewhere between about -3% and 7%, well below the 9% historical average.  But in case your thinking that’s a cue to switch to bonds, most professionals are still expecting that stock returns will greatly exceed bond returns.

Most of these forecasts also predict that both developed and emerging-market international stocks will outperform U.S. large-cap stocks.  Conversely, U.S. government bonds are generally expected to keep pace with or slightly outperform international government bonds.

GMO’s forecasts are particularly sobering given they forecast near zero or negative returns for every asset class except non-U.S. stocks and emerging markets.  However, GMO is famous for publishing perennially bearish return predictions.  If we exclude GMO, the range of expected U.S. large-cap stock returns is about 2% to 7%.

The Trend

Like last year, I also wanted to look at how much the forecasts have been changing since I started tracking these forecasts in 2018.  This plot compares the 2020 forecasts to the 2018 forecasts for those companies that published estimates in both years.

You were probably expecting a bar graph or something like that, so I should explain this plot.  The horizontal axis shows the 2018 forecast, and the vertical axis shows the 2020 forecast.  Each dot represents one company’s forecast for the asset class noted in the color legend.  The black “match line” indicates where dots would fall if there was no change in the annual forecasts.  When dots fall above the match line, that means the 2020 forecast was higher than the 2018 forecast—the forecast went up.  When dots fall below the match line, that means the forecast went down.

Like last year, most of these companies have continued to shift their stock return expectations upward slightly from 2018.  Although there are outliers in this plot, quite a few of the stock forecasts have gone up slightly as shown by the blue circle for U.S. large-cap stocks and the orange circle, which covers both non-U.S. stocks and U.S. small-cap stocks.

However, most of the bond forecasts have shifted downward slightly as shown by the green circle for U.S. bonds and the purple circle for non-U.S. bonds.  Lower expected returns for bonds is not surprising given that bond yields plummeted in early 2020.  This was due to the Federal Reserve reducing base interest rates to essentially zero in response to the COVID-19 pandemic.  Given that bond returns come mostly from yield, historically low yields do not bode well for long-term bond investors.

The Uncertainties

It’s also important to consider the uncertainties surrounding the estimates.  For example, here’s a Vanguard graph showing the range of their forecasts.

Although the Vanguard article doesn’t go into the details, based on their past work, it appears that the ranges here represent the 25th to 75th percentiles, which only covers 50% of the total forecast distribution.  So, the entire range of their estimates must be much wider.  For example, last year Vanguard reported the 5th and 95th percentiles ranged from less than -2% to more than 10% annual return!  So, we should take all these forecasts with a large grain of salt.

An additional uncertainty with this year’s forecasts is that some of them predate the COVID-19 stock market plunge in March, and some of them came during or after the subsequent market recovery.  Given that most of these forecasts factor in current stock valuations, the large fall and bounce-back in stock prices this year means the starting assumptions used across all these forecasts vary widely.

The Conclusion

Despite the market turmoils this year, overall stock return forecasts really haven’t changed that much in the past year or two.  But bond returns are now expected to be considerably lower for the logical (and perhaps somewhat obvious) reason that bonds yield are close to nothing right now.

Checking these forecasts against my own investing plan tells me there’s no need to change my plan’s return assumptions, particularly since I don’t hold any bonds.  But if you’re one of those optimistic investors that are hoping for annual stock returns in excess of 10% for the next decade, you might want to check your expectations and reassess your investing plan.

Two years ago my stock-picking monkey challenged the best stock pickers in the world to a contest.  Today’s post is my annual update on how the contest is going.  You can see the results of the first year of the contest in this post from June 2019.

But first, here’s a brief recap of the reason I set up this contest in 2018 and how the contest works.

The Reason

I provided some stark statistics in both my 2018 and 2019 contest posts showing that, although stock-picking sounds easy, it’s very hard.  This is because the large majority of individual¹ stocks are likely to be future losers—they will produce negative returns over the long term.  Depending on how you measure it, something like 40% to 80% of stocks in U.S. history were long-term losers.  (See the past posts for more specific statistics and references.)

Given the difficulty of consistently picking winner stocks, I intended my contest to help answer two questions:

1. How successful are the “best” stock pickers’ recommendations?
2. What does the success (or failure) of the “best” stock pickers tell us about our own stock-picking abilities, given that we don’t have the benefit of a staff of researchers with a huge budget?

The Contest

To represent random² uninformed stock picks, my monkey picked 10 individual stocks in May 2018 for his portfolio in the contest.  The best stock pickers in the world communicated their stock picks to me through the media, specifically via these two articles in May of 2018:

• Here Are Morgan Stanley’s 30 Top Stock Picks
• Here Are The 20 Stocks That The Biggest Hedge Funds Love Most.

I also added a simple low-cost index fund of the S&P 500 to round out the final roster of contestants:

1. Morgan Stanley Top 30 Portfolio – equal-weighted
2. Big Hedge Fund Top 20 Portfolio – equal-weighted
3. The Monkey Top 10 Portfolio – equal-weighted
4. S&P 500 – as represented by the market-cap-weighted fund VOO

If you want to know more about the set up of the contest and the complete list of the stocks in each portfolio, see my 2018 post.  In summary, the winner is determined by the total returns (price changes plus dividends reinvested quarterly) expressed as percent annualized return.  Total return results were calculated from June 1, 2018, through May 31, 2020, using Portfolio Visualizer data.

And the Winner Is…

Which portfolio had the highest returns over the last two years?  This graph and table show the results.

Portfolio	Annualized Return (CAGR)	Average Volatility (Standard Deviation)	Return-Risk Ratio
Morgan Stanley Top 30	14.5%	27.0%	0.54
Big Hedge Fund Top 20	11.5%	29.7%	0.39
Monkey Top 10	4.7%	30.4%	0.16
S&P 500	8.2%	19.9%	0.41

The third column of the table shows volatility, calculated as the average standard deviation of all the stocks in the portfolios.  And in the fourth column, I calculated the return-risk ratio, which is the annualized return divided by the average volatility.  This ratio measures how much return you get for each percent of volatility you experience and is sometimes called the “risk-adjusted return”.

The performance of these four portfolios over two years is an almost complete reversal of the results for the first year of the contest.  At this same time last year, the Monkey and Morgan Stanley portfolios were in a virtual tie for the lead, and the Hedge Fund portfolio was posting negative returns.  But now after two years, the Monkey portfolio is badly lagging the expert portfolios, as well as the S&P 500 index fund.  Further, the volatility of the Monkey portfolio was relatively high, resulting in a dismal risk-adjusted return.  It’s also noteworthy that both of the expert portfolios outperformed the S&P 500 index fund over the last two years.

While my monkey looked brilliant last year, this year he looks more like the stupid monkey from the fable of the Miser and The Monkey, popularized by Jean de La Fontaine in the late 17th century.  In the fable, a monkey gains access to a miser’s gold stashed in a tower by the sea.  The monkey has great fun throwing the miser’s gold out the tower window and into the ocean below (see illustration at the top of this post).

What Happened?

I took a closer look at the three stock-pick portfolios to find out what caused the Monkey portfolio to falter so badly over the last year.  I noticed that both of the expert portfolios are riddled with well known mega-cap names including all of the glorified FAANG stocks: Facebook, Amazon, Apple, Netflix, and Google.  In contrast, I don’t expect that you know much about any of the companies in the randomly selected Monkey portfolio, with the possible exceptions of Expedia or Walgreens.

My criticism of the expert’s stereotypical big-name stock picks probably sounds like sour grapes.  Regardless, I point this out because the last two years have been remarkably good for U.S. large-cap and mega-cap stocks as shown by this Portfolio Visualizer data:

• U.S. Mid-caps underperformed large-caps by 5.0% annualized
• U.S. Small-caps underperformed by 10.7%
• Foreign Developed Markets underperformed by 12.4%
• Emerging Markets underperformed by 13.6%!

Perhaps more importantly, this trend has been firmly in place for the last 10 years.   Although my evidence is circumstantial, it seems like the success of the expert portfolios could easily be the product of several cognitive biases, particularly confirmation bias, recency bias, and the bandwagon effect.  In other words, it seems like the experts were heavily influenced by recent history and the perceived public interest in a few of the most exciting big-name stocks.  For the last two years, those biases have boosted returns, but there’s no guarantee that the next two years will be the same.  There may be hope for my monkey yet, but only if the decade-long superiority of these mega-cap tech companies starts to wane.

Bonds Over Stocks?

Evaluating these portfolios through the coronavirus stock market crash in March (and subsequent recovery so far) illustrates something else that’s mostly unrelated to this contest.  The conventional wisdom is that all kinds of stocks are much riskier than holding government bonds, and individual stock picking is much riskier than holding more diversified stock index funds.

So, I was curious about how these risky stock portfolios performed relative to a “safer” combined portfolio that includes some bonds.  The most popular example of a combined stock/bond portfolio is 60% U.S. stocks and 40% U.S. 10-Year Treasury bonds (known as the “60/40” portfolio).  The performance of the 60/40 portfolio from June of 2018 through the end of May 2020 is shown in this table.

Portfolio	Annualized Return (CAGR)	Average Volatility (Standard Deviation)	Return-Risk Ratio
60/40 Portfolio (U.S. Stocks/10-Yr T-Bonds)	8.6%	11.2%	0.77

The 60/40 portfolio produced a slightly better return than the S&P 500 index fund, but with much less volatility.

Based on similar data, many commentators have suggested that bonds “worked perfectly” this year.  In this case, the bonds in a 60/40 portfolio helped cushion some of the stock crash in March, but those same bonds are now slowing the recovery of the 60/40 portfolio.  We’ve seen that some very risky portfolios of individual stocks have easily outperformed the 60/40 portfolio over the last two years, even though early 2020 economic conditions were supposed to favor bonds.  And if the stock market continues to recover, the S&P 500 index fund will likely soon surpass the 60/40 portfolio too.

So, I guess bond investors got a fleeting warm and fuzzy feeling in March when their portfolios held up relatively well for the short term.  But in contrast, whatever anxiety the stock pickers had in March, it quickly evaporated and was replaced with a feeling of vindication less than two months later.  Early 2020 was a good example of how difficult it is for combined portfolio investors to claim that their emotional rollercoaster feels “better” than the rides experienced by even the most adventurous stock investors, though the two experiences are undeniably different.

Conclusion

Going back to the main two questions that started this whole contest, we can now say that:

1. The “best” stock pickers’ recommendations may outperform random chance and even market benchmarks over specific periods.
2. Given that the process behind the experts’ stock picks appears qualitative and even biased, individual investors probably have a similar shot at generating decent performing stock portfolios, even without a huge staff and research budget.

These conclusions are nearly the opposite of last year’s conclusions, which tells me that this contest is unlikely to ever finally prove that stock picking is a loser’s game, even if I continue to track these portfolios for ten more years.  While stock pickers may outperform in any given period, it will always be hard to tell the extent to which that outperformance was due to skill versus unpredictable market conditions.

Saying that stock pickers “may outperform” in specific periods implies some probability of success, but this particular contest won’t ever be able to quantify that probability.  This contest also can’t quantify how long any outperformance might be reasonably expected to last.  Fortunately, we know from other data that consistently outperforming index funds year after year is almost impossible, regardless of whether you’re an expert or an amateur.

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 1 – As opposed to mutual or exchange-traded funds, which represent baskets of stocks.

2 – My monkey wants you to know that he strongly disagrees with the notion that his stock picks are random.  But his recent track record undercuts this claim.

In my last post, I discussed the merits of a combined portfolio of stocks and bonds as compared to an all-stock portfolio.  I found that the bonds in a combined portfolio will often help mitigate losses when stocks are declining, as is happening right now.  But as recent events have shown, that mitigation can be fickle, and a combined portfolio will rarely generate positive returns when an all-stock portfolio is experiencing a major correction or crash.  For example, a portfolio of 60% stocks and 40% bonds (60/40 portfolio) historically experienced about half the annual loss of an all-stock portfolio in years when stocks declined.

Because stock returns have easily trounced bond returns over most of U.S. market history, I concluded last time that the main reason people hold bonds is to feel better during a temporary stock correction.  But the reduced losses offered by a combined portfolio might still be too much emotional pain for some investors.  When stocks decline by -30%, there’s no guarantee that the average investor won’t panic and sell when their combined portfolio drops by only -15%.  Since I first wrote that about two weeks ago, the ongoing market turmoil has caused me to think a lot more about the assumptions surrounding investor moods.

How Do You Really Feel?

The idea that bonds will insulate you from emotionally-driven bad decisions seems reasonable on its face, but what’s the evidence supporting this claim?  Just in the last month, I’ve witnessed multiple professional investors giving media quotes like, “In these turbulent times, having some bonds will allow you to sleep at night”.  How do these professionals know that I will sleep better at night with a 60/40 portfolio?  How do they even know that such statements apply to clients they’ve known for years?  Perhaps some clients with bond-heavy portfolios are too embarrassed to admit that they pace the floor at night anyway.  The more I thought about it, the more I realized that most investors and advisers spend tons of time quantifying asset values and movements, but almost no time trying to systematically assess their own emotions or those of their clients¹.

Further, focusing on how we feel during temporary losses seems to miss a large part of the emotional spectrum.  What about feeling good when our portfolios perform well?  Does that help counteract bad feelings when our portfolios are in decline?  How quickly does one emotional extreme erase the lingering effects of the last emotional extreme?  And don’t we feel regret when another simple portfolio outperforms our portfolio for many years?  Do our negative or positive moods compound in response to mounting losses or gains over time?  Or do we become numb to more losses and accustomed to more gains the longer they continue?  What’s our aggregate mood as all these competing emotions swirl in and out of our heads over time?

Right now, the entire investing world is focused on the fear of further stock market plunges.  So, I can’t think of a better time to attempt a broader assessment of our investing emotions.  While I can’t hope to answer all the questions I posed in the previous paragraph, it seems entirely possible to more systematically assess the cumulative impact of a wider spectrum of investing emotions.

I call my more systematic assessment the “Happy-Crappy Investometer”.  As you’ll see, the H-C Meter (for short) is not entirely objective or quantitative because our emotions are inherently subjective.  However, the H-C Meter is at least semi-quantitative because:

• It uses portfolio returns and volatility to score the magnitude of several emotional drivers
• Consistently quantifies those drivers
• And tracks their cumulative changes over time.

While the H-C Meter has tons of limitations and caveats, it seems infinitely better than unsupported platitudes that focus solely on our fear of crashes.  And examining a wider spectrum of emotions over longer periods might give us all a little better perspective on how we feel right now when the stock market can drop by 10% in one day.  Perhaps the H-C Meter might even tell us something about the conventional wisdom of holding bonds.

Building The Happy-Crappy Investometer

First, recent market events make it pretty clear that investors feel happier when portfolio values increase and sadder (and/or madder) when values decrease.  The social scientists Daniel Kahneman and Simon Teversky have quantified through experiments that we usually feel about 2 to 2.5 times worse about losses than we feel good about gains, although in some cases they found the multiplier was much higher.  They called this cognitive bias “loss aversion”.

Second, it also seems self-evident that we feel some pride when our portfolio is outperforming other standard portfolios and envy when we’re underperforming those same portfolios.  For example, an investor in an all-stock portfolio would feel pride in beating the 60/40 portfolio (as in, “I’m so smart I didn’t include those useless bonds”).  But they would feel envy if they underperformed that same portfolio (as in, “I’m so stupid to have not diversified more”).

Third, observing my own investing life, both my good and bad feelings seem to fade with time.  One of the central tenants of Buddhism is the idea of impermanence; the only constant in life is change itself.  Let’s say my portfolio’s annual return was +20% five years ago, and it’s gone neither up nor down since then.  I’m sure I would feel pretty jazzed about those gains when they first occurred, but five years later that thrill would have mostly faded away, and my mind would be more focused on my portfolio’s recent lack of progress.

Using these three measures of investing mood, I built the H-C meter by adding them together to give a total cumulative mood score as shown in this graphic (click on the image to enlarge).

For each measure, one percent contributes one point to the total score, except for absolute losses, which I multiplied by 2.5 to represent loss aversion.  The scale of the rightmost “mood score” is entirely relative and has no meaningful units.  As the overall mood score gets higher or lower, the investor theoretically feels progressively better or worse.

I calculated the H-C score on an annual basis for an all-stock portfolio (S&P 500) and an all-bond portfolio (10-year U.S. Treasury) using return statistics from Aswath Damodaran going back to 1928.  And from those data, I calculated the same scores for a 60/40 portfolio assuming annual rebalancing.

The relative performance metric is calculated by comparing the all-stock and all-bond portfolios to the performance of the 60/40 portfolio.  The 60/40 portfolio is compared to the all-stock portfolio because loss aversion theory suggests that a 60/40 portfolio holder would pay more attention to underperforming stocks than outperforming bonds.

Given that mindful investors have a long-term horizon, I calculated the cumulative total mood scores over 10-year periods.  So, the mood effect from years of gains gets subtracted out by years of losses (and vice versa) in both absolute and relative terms.

Finally, the mood fader is a simple calculation that subtracts two percent if a portfolio had a positive score in the previous year and adds two percent if the previous year’s score was negative.  I guessed that the rate of mood fade might be something like 2% per year.  So, I’m assuming that the increased “comfort” generated by, for example, a 10% gain one year will have completely faded five years later.  So, all the scores are gently pushed overtime back to an equilibrium mood state, which on the total mood score scale I called a “tolerable” condition.

Of course, the H-C Meter covers only some of the many questions about investing emotions that I raised at the outset.  But at least it covers some of the questions in a fairly reasonable, semi-quantitative, and consistent way.  And it covers way more than just thinking about how temporarily scared we are from this month’s stock market plunge.

Happy-Crappy Investometer Results

So, what does the H-C Meter tell us about the likely overall moods of long-term investors in each of the three portfolios (all-stock, 60/40, and all-bond)?  Let’s start by looking at an example of a very crappy decade for investing (1928-1937) and a relatively happy and recent decade (2010-2019).  Here’s the graph for the crappy decade involving the Great Depression.

The stock portfolio investor had a pretty happy first year (green zone), but his mood was dismal five years later (red zone), as the stock market plummeted.  The bond portfolio investor bumps around in a mostly tolerable mood (yellow zone) for the entire decade.  By 1932, the bond investor’s not ecstatic, but she’s got a slight smile on her face because she knows she’s avoiding all the stock carnage and even making some meager gains.  As you might expect, the 60/40 portfolio investor’s mood is somewhere in between the other two investors.  At least in this period, bonds functioned as advertised and help buoy a bond investor’s mood.

Now let’s look at a happy decade.

As you might have expected, the stock investor just got happier and happier.  Even though the mood from previous years’ gains is continually fading, the successive new gains keep restoking the happiness fire.  In contrast, the bond investor is still bumping around in the “tolerable” range.  And if anything, her mood is getting a little worse toward the end of the decade because her relatively meager bond gains fuel envy of the stock portfolio’s terrific gains.  The 60/40 investor is moderately happy by the end, but he’s also pretty envious of the all-stock portfolio.

These comparisons confirm that in a down stock market the all-bond investor will probably feel better than the all-stock investor.  And that’s the prevailing mood right now.  But in an up stock market, the bond investor will feel just okay, assuming he or she can tolerate a high FOMO level.  But looking at individual decades still doesn’t tell us which portfolio will maximize our mood because we can’t predict whether the next decade will be good or bad.

What if we look instead at the entire history of stock and bond returns and calculate the rolling-average cumulative mood score for every possible decade?  In that case, we’d be looking at the rightmost datapoint on each decade graph that I could generate from these data.  In other words, we’re answering this question: “If I was holding any of these three portfolios, how would I have felt at the end of every possible decade since 1928?”  Here’s that graph.

It turns out that holding an all-stock portfolio would have made you feel pretty good over the majority of stock/bond market history.  But there would have been a few times when you could have felt pretty darn bad.  Holding an all-bond portfolio would have made you feel ambivalent (or tolerable) over most of market history.  But there would have been a few times when you could have felt bad, particularly the 15 years ending from about 1950 to 1965, and a few times when you could have felt pretty good.  Again, the 60/40 portfolio produced moods intermediate between stock and bonds with a few brief exceptions.

If we assume history is indicative of a future range of possible market conditions, we can estimate the probabilities of various future moods with each portfolio from this summary graph of the rolling-decade analysis above.

If past is prologue, then the H-C Meter says there’s a 70% probability of feeling “good” or “great” when investing in an all-stock portfolio and only a 10% chance of feeling “bad” or “terrible”.  With the all-bond portfolio, there’s actually a greater chance (20%) of feeling bad but a much lower chance (23%) of feeling good, basically at times when the stock market crashes.  And there’s nearly a 60% chance that the all-bond investor will simply feel ambivalent or “tolerable”.  The 60/40 investor’s chances of feeling bad are only 5%, even better than with stocks, but the trade-off is a pretty low (30%) chance of feeling good.

Conclusions

I’m sure some readers are thinking: “But my all-stock portfolio is making me feel supremely crappy right now.”  So, the H-C Meter may seem like an irrelevant and misguided measure of our actual moods.  But that’s missing the point.  The H-C Meter is looking at cumulative moods as they change over 10-year periods.  Current events in the stock market are just a temporary blip on your emotional radar.  But it’s hard for any of us to see that right now.

When we’re in a fender bender it’s hard to think about how everything will be back to normal soon or consider all the great things in our lives².  All we can feel is anger at ourselves or the other driver, dismay at the upcoming hassles, and fear about the possible consequences—paying for repairs, getting cited by the police, getting hit with higher insurance rates, etc.  It’s hard to realize that in a year or so we might look back and laugh at the incident, even though in some corner of our minds we know that’s probably true.  So, if you’re investing solely to maximize your long-term investing mood, I think the H-C Meter points you in the right direction.  The best probability of feeling net good over the long-term is with an all-stock portfolio.

I’m not here to tell you that what you’re feeling right now is “wrong”.  You feel how you feel, and standard mindful practice is to allow those short-term feelings and examine them with a dash of judgment-free curiosity.  Mindful self-examination reminds us that extreme momentary fear will pass.  That’s because everything passes, even our worst feelings.  And they invariably transform into something new or different.

The H-C Meter is just an imperfect reminder that this too shall pass.  Assuming you have an investing plan and you stick to it, you should be able to recognize that an all-stock portfolio has offered a great long-term mood over the last decade.  And all evidence suggests that you will return to a long-term good mood if you can simply not respond to those temporary waves of fear today.

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1 – Some advisers spend a considerable portion of their time assessing their clients’ emotions.  Some even go so far as to say that the primary role of an adviser is emotional management.  Kudos to them.

2 – Although it might not feel like it right now, I think most Americans know they have many blessings, particularly as compared to people in third-world countries who face even more substantial health and economic uncertainties every day.  

Seems like everybody has a friend or relative that loves to find the perfect Christmas tree every year.  Perhaps you’re the tree perfectionistic in your family.  Or maybe it’s your Dad or your spouse, or even one of your offspring.

You know the type.  They keep circling the tree lot hoping to find something that’s probably not there.  They endlessly rotate candidate trees trying to expose any tiny gaps in the branches or barely perceptible bends in the trunk.  They compare the same trees over and over again until the whole family is freezing and apathetic.  Then there’s the type that insists on driving around to three or four different tree lots hoping to find something better.   And the worst is the “wild tree” hunter who forces the family to trudge miles through deep snow in some icy forest.  The tree hunter particularly enjoys testing the limits of what’s too big and heavy to drag back to the car.

Unfortunately, some people approach investing just like a Christmas tree perfectionist.  I’d love to see a study analyzing the similarities between tree perfectionists and investing perfectionists.  I suspect the Venn diagram shows substantial overlap.  The worst outcome for the tree perfectionist is a temporarily hostile family and a halfway decent tree.  However, the worst outcome for the investing perfectionist is a dismal quality of life or a lousy retirement.

I’ve written mountains of words at Mindfully Investing about the ways a perfectionist can over-design an investing plan.  Common pitfalls include:

1. Micro-slicing asset allocations
2. Over-diversifying portfolios
3. Buying individual stocks instead of low-cost index funds that represent broad swaths of the market.

In this post, I want to talk more about a fourth pitfall, which is over-reaching for higher returns.  The perfectionist looks at a reasonably diversified portfolio and thinks, “Hey, I bet I can boost the returns of this portfolio by adding a little bit more of X or Y.”  In investor jargon, the perfectionist decides to “tilt” the portfolio more towards assets or factors that have garnered superior returns in the past.  The perfectionist then finds him or herself on a slippery slope of finding even better or more extreme tilts based on historical returns.  Lather, rinse, and repeat until the perfectionist arrives at a ridiculous portfolio.

The Best-Looking Tree on The Lot

Let’s illustrate this pitfall with a more concrete example.  Let’s say a perfectionist investor was trying to devise a stock portfolio right before Christmas in 1999.¹  Regardless of your investing strategy, the primary information available for stock portfolio construction is historical stock data.  And so, our investor would have considered the history of stock performance and other characteristics of the stock market up through 1999.  One of the simplest portfolios that has many strong advocates is holding the entire global market in stocks and/or bonds.  (Because mindful investors focus mostly on stocks, we’ll assume our 1999 investor was constructing an all-stock portfolio—we’ll leave bonds and cash out of the picture.)

So, our 1999 investor (let’s assume she’s female) might first have considered holding just one or two funds that cover the entire global stock market.  If so, she would have found that from 1980 through to the end of 1999 the global stock market returned about 14.2% annualized (Compound Annual Growth Rate or CAGR).   (All the return results presented in this post are from Portfolio Visualizer unless otherwise noted.)   Being a perfectionist, our investor might reasonably have wondered if she could improve upon those returns with a more selective portfolio.  As this festive little graph shows, there are almost always multiple ways to refine a portfolio for better historical returns.

My Christmas tree graph needs a little explanation.  Each colored bar on the graph, or tier of branches if you prefer, represents one possible stock portfolio.  As you climb from the bottom to the top of the tree, the portfolios become progressively more selective for higher historical returns.  The horizontal width of each bar corresponds to the breadth of the entire global stock market covered by the portfolio in question.  So, the global stock market portfolio at the bottom has the widest bar because it covers 100% of the global stock market.  The vertical height of each bar is set proportional to the annualized returns (CAGR) achieved by each portfolio from 1980 to 1999.  So, the bars get taller as we move up through the more selective portfolios.

The Christmas tree graph shows how easily a perfectionist can be enticed into increasingly selective portfolios.  In this period, the U.S. stock market (16.7% CAGR) performed considerably better than a globally diversified stock portfolio (14.2% CAGR).  So, our perfectionist might decide to hold U.S. stocks only, which seems reasonable.  Or she might take it even further and focus on just U.S. large caps (17.6% CAGR), or just U.S. large-cap growth stocks (19.0% CAGR).  And our perfectionist would have likely noticed that the U.S. Telecom sector did even a little better (19.5% CAGR)².  And if she was a real risk-taker, she might have been beguiled by all the news stories in 1999 about how Nokia was dominating the cell phone industry (85.2% CAGR).

As she climbs up each branch of the Christmas tree, the portfolios represent an ever-smaller slice of the stock universe with ever-less diversification.  Going from one branch to the next may seem like a reasonable decision individually, but the top and bottom of the tree represent opposite investing strategies.

Bringing Home The Charlie Brown Tree

My perfect Christmas tree was generated using 20 years of data ending in 1999.  We have only to project these portfolios forward 20 years to see what happened to the tree after our perfectionist investor took it home and decorated it.  Here’s the same graph using data from 2000 to 2019.

That’s a crappy looking tree if I ever saw one.  Several things warped our tree after 1999.  First, the tree got vertically squished, because the 2000 to 2019 returns for all portfolios were a fraction of the 1980 to 1999 returns.  For example, the total U.S. stock market annualized return went from 16.7% to just 6.2%, a more than 10% drop!  Second, the branches of the tree got all mixed up.  The bottom of the tree is balanced on the tip of the dismal returns from the least diversified portfolios consisting of the U.S. Telecom sector and only Nokia, whose market cap dwindled by more than 90% after the turn of the century.  Third, even the performance of the moderately diversified portfolios got mixed up.  For example, the small outperformance of Large Cap Growth over the U.S. stock market in the late 20th Century became a small underperformance in the early 21st Century.  The road to perfection ended up in chaos.

Conclusions

The moral of the story is that you might feel like your portfolio is perfect using historical data, but the world will almost always throw something unexpected at your perfection and mess it up completely.  But that’s a pretty fatalistic view of the Christmas tree hunt.  Even if the future is unpredictable, we still need to pick a Christmas tree.

A more empowering view is that almost any of the moderately diversified portfolios performed relatively well in both periods.  I’d say that any of the darker green options from the Global Stock Market portfolio to the U.S. Large Cap portfolio represent usefully diversified stock portfolios.  In both periods you would have achieved decently positive, if not outstanding, returns.  In comparison, including factor tilts (growth in this example), or particularly focusing only on individual sectors or stocks, is a real gamble.  You might retire early with a fantastic 85% annualized return or never retire at all because of dismal negative annualized returns.

I’ve written before about the limitations of back-testing portfolios with historical data.  Back-tests are useful to a certain extent, but they never predict the future clearly.  Because the future is inherently uncertain, some sort of moderately diversified portfolio makes the most sense.  I’ve argued before that the exact type of diversification matters much less than the mere fact of diversifying at all.

Mindful investors accept that there will always be other portfolios that outperformed their chosen portfolio in any given period.  The Christmas tree that looked so perfect on the lot will always look more mangled after you’ve had it at home for a while.  The trick is to appreciate the tree for what it is, not what you hoped it could be.

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1 – I picked this year for two reasons.  One, it pretty evenly splits the historical return data available in Portfolio Visualizer, which extends roughly back to 1980 for most major asset classes.  Two, it happens to be when I first started seriously investing.  So, I can claim this is a real-world example based on at least one person’s real-life experience (mine).

2 – Sector returns data come from a chart presented by Bespoke.