Our society values action. We enjoy “action movies”, we use “action verbs” on our resumes, and we praise active people. When we hear news, we think about what action to take. If we hear that the economy is booming, we want to take more investment risk. If a company announces record earnings, we want to buy more of its stock. If everyone says interest rates will go up, we want to sell our bonds. Often the right strategy is counter to our nature and we should hold to our established plan. Here are three reasons why.
1) Daily news has very limited value for long-term investors.
When we hear about economic growth or record corporate earnings, we are being told about past performance. While the past may continue for a time, it won’t indefinitely, and an investment’s current value is based only on future returns. High growth stocks can’t grow forever. Single events seldom repeat. Unless the new information materially changes the value of future returns, it should not trigger a change to your investment plan. Even recessions should not warrant a change in a well-designed strategy since they do occur as a normal part of an economic cycle and should have been a factor in the original design of your plan.
2) Only where there is risk, is there the potential for return.
If an investment’s return were sure, it would be close to the yield on U.S. Treasury securities. Seeking higher returns requires accepting uncertainty as to the eventual result. Shares which are certain to appreciate would have already. Markets incorporate new information into pricing quickly. Interest rates which are certain to increase are already reflected in the current yield on longer maturity bonds. It would be a mistake to change a strategy simply because a future event now may seem certain.
3) Reality may differ from expectations in the short run.
The science of investing is not that dissimilar from the science of weather. A meteorologist determines there is only a 25% chance of rain tomorrow. Then it turns out it actually rains. An unlikely event occurred, but there is no reason to change the weather forecasting model. The weather doesn’t always behave as expected.
Investing requires a similar approach to understanding uncertainty. Professional investors estimate the probability of future returns based on factors which have influenced past returns. Diversified portfolios are positioned to benefit from these factors over time, but they may not benefit all of the time. For example, over any five-year period since 1926, small company stocks outperform large company stocks 64% of the time and value stocks return more than growth stocks 75% of the time. In the most recent 5 year period, this has not been the case. The fact that the likely outcome was not the actual outcome does not require abandoning the research or the strategy.
When action is required
The best strategy, given the uncertainty of future returns, is to be well diversified all the time. If you are properly positioned to capture returns commensurate with the risk taken, there is no reason to change your strategy except when there is a material change to the assumptions. If your future savings or spending needs change, you should review the plan. If there is an unexpected change to the economic environment, action may be required. Barring major unexpected changes, often the best course of action is the hardest: take no action at all!