How to Invest Without a Crystal Ball

By Dr. James M. Dahle, WCI Founder

Q. There are so many opinions out there among gurus and “talking heads” about what the stock market, interest rates, inflation, housing prices, and cryptocurrency are going to do in the future. I’m not sure who to listen to. Any advice?

A. The CXO Advisory Group once looked at thousands of stock market predictions by dozens of financial gurus over a 15-year period. It found that the gurus (ie, public commentators) were only correct around 47 percent of the time; on average, an investor would have been better off simply flipping a coin. Gurus get paid for having an opinion, not for being correct. In fact, marketed properly, one good (or perhaps lucky) prediction can cement a commentator’s reputation for decades.

However, the truth is that “nobody knows nuthin’.” When investors realize there is no reliable resource out there that will give them the future returns of various investments or the direction of interest rates, it can be an immensely freeing experience. All of a sudden, those investors realize trying to game the system is a waste of time and energy. Instead, they can concentrate on the factors they can control, such as how much they earn, how much they save, and their overall mix of investments.

Some people think they really can make good predictions. I propose an exercise. Get a notebook. Every time you have a prediction about the future performance of a particular investment, write it down. Be specific. Don’t just write, “I think Tesla will do well.” Write, “I think Tesla will outperform other large-growth companies by at least 3 percent over the next six months.” Do the same thing with interest rate projections, housing prices, inflation, and anything else that you think you can predict with any degree of accuracy. Circle back and see how many of your predictions turned out to be correct. Within a year or two, you will likely convince yourself that your crystal ball is just as cloudy as anyone else's. As investors, we are not always rational. Retrospectively, we believe it was much easier to predict the future than it was. Only honest evaluation of an exercise like this can reveal that bias.

 

How Should You Invest?

There are many types of investments, or asset classes. These include various types of stocks, bonds, real estate, commodities, currencies, precious metals, and others. An investor need not invest in everything—and in fact, there are no “called strikes” in investing. If you do not like a particular investment, you can take a pass. There will be another “pitch” coming soon. However, every asset class is likely to have its day in the sun. These periods of time are usually preceded and followed by periods of underperformance. These investing cycles are natural and should not be a cause of worry to a long-term investor, especially since the cycles are far shorter than a typical investing career.

The natural inclination of an investor, unfortunately, is to “performance chase.” Investors, as a whole, pile into investments after they have done well and seem to bail out of investments just before they start doing well again. This results in buying high and selling low repeatedly. Done too often, this can prevent an investor from reaching even reasonably modest financial goals. One of the best ways to avoid performance chasing is to use a static asset allocation and rebalance periodically.

A static asset allocation means that you divide your portfolio among the various asset classes you wish to invest in and assign a percentage to each investment. Perhaps you have decided to invest 30 percent in U.S. stocks, 20 percent in international stocks, 25 percent in bonds, and 25 percent in real estate. Going forward, no matter how each of these asset classes perform, at the end of the year you rebalance the portfolio back to the original percentages. If bonds have had a particularly good year and stocks did poorly, perhaps your portfolio now consists of 25 percent U.S. stocks, 15 percent international stocks, 32 percent bonds, and 28 percent real estate. So you sell a little bit of real estate and a lot of bonds to get back to your original 30-20-25-25 asset allocation. The next year, perhaps international stocks do particularly well, so you sell some of that asset class at the end of the year and buy more U.S. stocks, bonds, and real estate.

In the early years, investors often do not actually need to sell the overperforming asset class. They can simply direct new contributions at the underperforming asset classes to keep the portfolio in balance.

Maintaining a static asset allocation and rebalancing periodically ensures that investors are constantly selling high and buying low—or at least not consistently doing the opposite. More important, investors are maintaining the level of desired risk in the portfolio. The best part of this approach is that it does not require investors to know anything about what is going to happen in the future to be successful. Investors are freed from trying to divine future performance. They are much less likely to mistakenly assume that past performance indicates future performance, an idea so bad that mutual funds are required by law to tell you that such guarantees can never be made.

Successful investors know that investing is a single-player game—them against their goals. They avoid making mistakes due to the fear of missing out (FOMO) and stick to their written financial plan. They know that reaching their goals depends far more on saving enough money and risk control than about “hitting home runs” with their investments. Just as lots of singles and doubles win baseball games, slow and steady saving into a periodically rebalanced static asset allocation leads to a life free of financial worry.

[This article originally published at ACEPNow]