In investing, nothing is written in stone. Yet, investors often operate as if the opposite is true…to their own detriment.
One mistake investors make is to focus too much on the averages of history while ignoring the deviation from the averages that always seem to happen in the short term. The clearest example of this is the stock market itself, via the S&P 500. It’s never, not once, earned its average annual return in a single year. Check for yourself.
Then there are the investing rules of thumb we all rely on because they work…most of the time. The mistake, of course, is to never question them.
Peter Bernstein reiterates this point in summing up market history. Investing is guided by the past but the future is not limited to what has already happened. A level of uncertainty, however small, always exists that can surprise us:
The lesson of history is that norms are never normal forever. Paradigm shifts belie blind faith in regression to the mean… For 170 years, the highest-quality long-term bonds in the United States yielded an average of 4.2 percent within a standard deviation of only a percentage point. In 1970, yields broke through the old upper limits and started heading for 7 percent. Investors stared: how could they decide whether this was a blip or a new era? And then there was the moment in the late 1950s when the dividend yield on stocks slipped below bond yields. Again, investors back then had no handy rules to tell them whether this totally unexpected development was a fundamental shift in market structure or just a temporary aberration that would soon correct itself, with the “normal” spread of stocks yields over bond yields reestablishing itself.
John Maynard Keynes, who knew a few things about investing, probability, and economics, took a dim view of the idea that you can look through the noise to find the signal. In a famous passage, he declared that:
“The long run is a misleading guide to current affairs. In the long run, we are all dead. Economists set themselves too easy, too useless a task if in the tempestuous seasons they can only tell us that when the storm is long past the ocean will be flat.”
Keynes is suggesting that the tempestuous seasons are the norm. The oceans will never be flat soon enough to matter. In Keynes’ philosophy equilibrium and central values are myths, not the foundations on which we build our structures. We cannot escape the short run…
Those who believe in the permanence of tempestuous seasons will view life as a succession of short runs, where noise dominates signals and the frailty of the basic parameters makes normal too elusive a concept to worry about. These people are pessimists who see nothing in the future but clouds of uncertainty. They make decisions based only on the short distance ahead that they can see.
Those who live by regression to the mean spread their time entirely differently. They expect the storm to pass, so that one day the ocean will be flat. On that assumption, they can make the decision to ride out the storm. They are optimists who see the signals by which they will steer their ships toward that happy day when the sun shines through.
My own view of the matter is a mixture of these two approaches. Hard experience has taught me that chasing noise leads me to miss the main trend too often. At the same time, having lived through the bond yield/stock yield shift of the late 1950s and the breakthrough of bond yields into the stratosphere beyond 6 percent in the late 1960s — just to mention two such shattering events out of many — I look with suspicion at all main trends and all those means to which variables are supposed to regress. To me, the primary task in investing is to test and then retest some more the parameters that appear to govern daily events. Betting against them is dangerous when they look solid, but accepting them without question is the most dangerous step of all.
Is Investing for the Long Term Theory or Just Mumbo-Jumbo?
Peter Bernstein: Embracing Surprise
Peter Bernstein on Hidden Variety in Averages