As investors, we gain invaluable insights by experiencing various markets and events, and by reflecting on our actions—those we took and those we didn’t. I firmly believe that experience is the key factor in preventing costly investment mistakes.
Hence, I dedicate time each year to ponder the lessons provided by the market in the preceding year. These important lessons are available to those who actively seek them out.
Lesson 1: Expectations and forecasts can change on a dime
In 2021 and 2022, I cautioned that interest rate expectations can change on a dime. In the second half of 2023, many commentators forecasted that interest rates would need to rise to such an extent to tame inflation that it would cause a global recession. As such, markets declined significantly in September and October. However, by year’s end, there was a significant shift: the market anticipated that inflation could be tamed without a recession and even started pricing in a series of interest rate cuts in the US, and possibly one or two in Australia.
Market expectations changed dramatically over the course of 2023.
The key takeaway is that forecasts and expectations often feel very compelling at the time. So much so that they resemble certainties more than educated guesses. The truth is, that short-term outcomes remain unpredictable. No existing methodology reliably predicts short-term market movements.
Consequently, it’s wise to disregard forecasts that don’t align with our long-term investment goals. For instance, if we’re investing for 10+ years, only long-term forecasts merit consideration.
Focusing on short-term forecasts may lead to costly errors, bringing us to the second lesson of 2023…
Lesson 2: Resist the temptation to make changes
In both 2021 and 2022, bonds experienced their most significant declines since the inception of indexes in the 1970s. This outcome might not be surprising, considering the substantial monetary support deployed by central banks and their persistent message that interest rates would remain low for many years.
Despite being considered a safe asset class, as taught in textbooks, bonds didn’t exhibit the expected characteristics during these years. Normally, their capital value isn’t as volatile as stocks. Additionally, bonds are usually negatively correlated with shares which means when shares fall, bonds should rise in value. However, in 2021 and 2022, these norms didn’t hold true.
This deviation challenged our belief in the traditional role of bonds within a portfolio. It was tempting to perceive these changes as permanent and seek alternatives to bond investments.
However, 2023 presented a more “typical” performance for bonds, showing modest positive returns. Chris Joye, Australia’s preeminent fixed-income investment manager, anticipates that bonds will outperform in the next 2 to 3 years, although it’s worth noting his role as a fixed-income manager can influence this prediction – he has a vested interest in promoting fixed-income investments. That being the case, I do respect his work.
The lesson here is about maintaining confidence and resilience. Extraordinary market occurrences are not uncommon, and while the triggering factors may seem unique, the market has navigated similar situations before. Investors must have the discipline to not react to these market events. This sets the stage for the third lesson…
Lesson 3: Almost nothing warrants a change in investments or strategy
As 2023 began, most economists held the belief that a global recession was all but inevitable. Surely a staggering 5.2% hike in interest rates in the US would damage the world’s largest developed economy.
Given this outlook, I considered what adjustments we should make in client portfolios to brace for this seemingly certain recession.
Despite extensive contemplation and discussions, we ultimately opted for no changes. Our existing strategy had already skewed portfolios towards higher quality companies (quality factor indexes) and investments that were relatively undervalued (value indexes), which theoretically offer better resilience against the impact of a recession.
The crucial lesson learned here is the unwavering importance of sticking to a long-term investment approach. Regardless of the severity of an event – whether it’s a global recession, financial crisis, pandemic, high-interest rates, or wars – studies consistently demonstrate that investors who make fewer changes tend to yield higher returns.
Assuming your investments are fundamentally sound, the only justifiable reason to modify your strategy should stem from changes in personal circumstances or goals. Otherwise, staying committed to your strategy is key.
Lesson 4: Irrational market conditions can last longer than anyone can anticipate
As 2023 began, I held the belief that higher interest rates would weigh negatively on growth stock valuations. Over the last decade and a half, growth had outperformed value (measured on a 5-year rolling basis) since around 2007. My expectation was that an increase in interest rates would trigger a resurgence in value stocks, which are the cheapest they have ever been in history relative to growth, according to Research Affiliates.
I was wrong. Surprisingly, the seven largest growth stocks were the primary drivers behind the S&P500’s impressive 24% return in 2023 (see here & here). These seven stocks now constitute about 25% of the total index, posing a significant concentration risk. The central investment theme revolves around the impact of AI. Of course, AI is likely to be positive for the economy and stocks, but I think its upside is well and truly reflected in current prices!
Quoting the renowned economist John Keynes, “the markets can remain irrational longer than you can remain solvent.” This underscores the idea that betting against rising markets, even when they appear irrational, can be risky. A stock’s potential to ascend is limitless, while its downside is finite as it can only fall to zero.
Despite nearly a century of data indicating that value stocks historically yield better long-term returns (see here), the timing of their resurgence remains uncertain. We understand that value appears “cheap” and should eventually revert to the mean, leading to significant outperformance compared to growth. The uncertainty lies in predicting when this shift will occur.
The takeaway here is to avoid betting against the market’s trajectory. Embrace a long-term approach while acknowledging that reaping the benefits might necessitate several years of patience and adherence to this strategy.
Journalists and forecasters will fill your ears but never your wallet
The subheading above is adapted from a quote by Warren Buffett.
While you may absorb market insights, forecasts, predictions, and advice, the reality is that much of this information doesn’t significantly aid in making sound, long-term investment decisions. Most commentary tends to be rooted in negativity or focuses excessively on short-term perspectives.
Recently, I read an interesting book titled Factfulness. The book discusses why our instincts about data often lead to misconceptions. The author cites many facts which are contrary to popular belief, such as:
- In the last 20 years, the proportion of people living in extreme poverty globally has nearly halved.
- Deaths from terrorism in developed countries were three times higher in the period from 1997 to 2006 compared to 2007 to 2016.
- Contrary to concerns about overpopulation, by 2100, the world population is projected to decline.
- Violent crime rates per capita in the US almost halved over the past 3 decades in the USA.
The author cites many reasons why most people think the world is in a lot worse shape than it is. This book reminded me of the importance of always looking at the data.
It’s evident that relying on media for investment decisions is unreliable. Much of the “news” we receive is not only short-term but also lacks reliability.
When it comes to investments, often the best course of action is to do nothing, especially if the original investment decision was well-founded. This serves as a significant reminder I’ll carry into 2024 and beyond.
What investment lessons did you learn in 2023 and how will you use these learnings in 2024?