It’s human nature to want to know the future, and accepting that we don’t know it is a hard pill to swallow. But thinking we know is very costly to our returns. It causes us to invest in what’s hot, only to dump the investment when it cools off or turns downright cold.
Yet even more than this, it goes against mathematics. Although I won’t go into the details of the math, at a high level, moving into and out of markets and picking parts of the market increases the average volatility of a portfolio. Even being right half of the time leads to the same arithmetic mean but a lower total return (geometric mean). And most portfolios I review aren’t even close to right half of the time.
While financial gurus brag about what they think they know, I’ll brag about what I know I don’t know.
Here's a simple mathematical explanation of this extra risk.
A portfolio which is 50% stock will lose 20% of its value if the stock market drops 40%.
A portfolio which is 100% stock half the time and 0% stock half the time will lose 20% of its value half the time the stock market drops 20%.
It is much more than twice as likely to have a 20% drop as a 40% drop. Therefore, an average market timer, who gets no extra expected return, also takes significantly more risk. Even an above-average market timer is likely not to be compensated adequately for the risk; a market timer who is right 60% of the time probably has more risk than a fixed portfolio which is 60% stock and which thus has the same expected return.
Thank you for posting this, Rowan, and thank you Allan for a very direct, and very clear picture of what we don''t, and can't know.
B,H,R...B,H,R....
I hope you can figure out what that stands for...
Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.