Takeaways:

• Framing returns matters: performance over the past couple of years can look good or bad in any asset class depending on what time frame you pick.

• Time horizons also matter because combining short termism with recency bias can lead you to make poor evaluations of performance, and therefore poor adjustments. Ultimately you want to look at longer time horizons.

• Over the past two years, stocks were flat while bonds—which are usually safer—lost 8%. Overall conditions have been adverse, leaving allocators with very few places to go where they didn't lose money over that timeframe.

• A properly diversified and rebalanced allocation framework is still the most proven path to success against the adverse economic backdrop characterized by a doubling of interest rates. While this creates opportunities to profit from fixed income, it also creates a much higher hurdle rate for corporations to beat without facing a drop in stock values. This basic economic truth stresses all assets especially if rates are higher for longer than the current estimates.

Daniel Kahneman won the 2002 Nobel Prize for economic work noticing that the frame within which numbers are presented affects our judgment of their quality.  For example, as recently as 3 months ago, the S&P 500 was approaching a 15% return for the year.  Since then, it has declined about 5%.  A year ago, it had lost 25% and two-year returns are negative 0.23%—a lost biennial for stock investors. It gets worse for bondholders; two years ago, the highest Treasury rate available was 2.02%.  It has now doubled to 4% and we are seeing riskier bonds yielding 8-9%.  As rates rise, bond prices fall; consequently, fixed income indices have lost 8.23% during the past two years.  Asset allocators on this roller coaster should thank their lucky stars if they, outperformed over that time period.  What is one to make of this?

First, maybe it wasn’t luck, but rather, skill.  Did you know that in a recent academic study, of a group of investors given only an S&P 500 mutual fund were unable to get the return of the S&P 500?  Amazingly, 80% of them underperformed!  Using index returns as a benchmark assumes skilled investing; without that, outcomes are worse.  This makes our clients the exception, over that time we outperformed our blended benchmarks, which are comprised of both the bond and stock markets.

Second, it shows us that time frames matter.  It’s easy to cherry pick times when the market rose 18% and say, “it was obvious we should have been all in on risk.”  A year ago, looking at a 25% loss on stocks (worse on tech), it was easy to want to be out.  But in advance it’s hard to call the turning points.  Our time frames are longer than 2 years, therefore it is important to keep this in mind in the face of the data-intensive short-term oriented quarterly reports that we send.

Third, valuations matter.  The difference between investing and gambling is that investments that go down often have more upside and vice versa. Because of “survivor bias,” ^[1] it’s almost impossible for an index investor to lose everything the way a gambler could.  There’s always another opportunity, so index losses can be seen in light of future potential.  That’s why our security selection process utilizes many index funds and looks for cheap opportunities when deploying cash.

The key to overcoming recency bias is to use an objective process that counterintuitively takes risk in down markets and vice versa.  This contrarian countercyclicality is embedded in your investments through our rebalancing process.  This also leads to the second key: getting good risk adjusted returns.  This comes out in terms of smooth growth that doesn’t out or underperform in any given quarter but beats the market over longer time frames.

The big risk, and the thing that keeps me awake, is not underperforming in any quarter, but rather living in one of the many historical 10–20-year periods that have delivered lackluster earnings to capital even for those that outperform the indices.  What can we do if the lost biennial turns into a lost decade?  These normally correlate to massive social disruptions like wars/insurrections (40’s), natural disasters (30’s dust bowl), or resource shocks(70’s).  While the past two years haven’t been great, we’ve succeeded due to hard work and some luck.

We cannot know what the future holds, but the past holds clues to the path that’s most likely to succeed.  Learning and studying what is most likely to work is the foundation of the investment process we employ.  It is the key to being able to replicate success and sustain growth over very long time-horizons which is critical to achieving your goals.

Looking at the last few months, we can think about what worked and what didn’t by looking at our decision-making alongside the outcomes.  Going into this year the big economic issues were threefold: inflation was high and sticky, we faced the most rapid interest-rate rises in the history of the United States, and liquidity coming out of Japan and China.  From an investing standpoint, this led to an emphasis on inflation protection, shortening of bond durations and, because higher interest rates lead to lower equity evaluations, we were defensive emphasizing consumer staples, financials, and industrials.  We managed to avoid the sectors that suffered the most last quarter by making some changes that seemed to be right on time.  This primarily consisted of rotating away from utilities and more heavily into energy investments.  There are no right answers but this way of framing our thinking ensures we reduce the amount of bias and keeps me humble as we evaluate wins and losses in terms of the decision quality that led us there.

^[1]Survivorship bias or survivor bias is the tendency to view the performance of existing stocks or funds in the market as a representative comprehensive sample without regarding those that have gone bust. Survivorship bias can result in the overestimation of historical performance and general attributes of a fund or market index.

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