In Friday’s column, I noted that – with the pandemic receding, the economy reopening, interest rates low, and consumers and businesses flush with cash – the U.S. economy should boom this year.
J.P. Morgan, Goldman Sachs and Morgan Stanley are all forecasting GDP growth of around 8% this year.
That would make this the best year for the economy since the 1950s.
I also noted, however, that this sunny outlook is widely recognized by investors and mostly discounted in share prices.
So, while it’s reasonable to believe that corporate earnings – and therefore share prices – will keep rising, it’s important to recognize that things can and will often go wrong.
And often in ways that we can’t imagine.
No one predicted the stock market crash of 1987, Saddam Hussein’s invasion of Kuwait in 1990 (which led to a bear market and then the first Gulf War), the collapse of Long-Term Capital Management (which caused a financial panic and a coordinated Wall Street bailout in 1998), 9/11 (which caused the stock market to close for a week and then plunge when it opened), the collapse of Bear Stearns and Lehman Brothers (which kicked off the financial crisis and the Great Recession), or the COVID-19 pandemic (which caused the fastest bear market in history).
In short, don’t be complacent just because the economic outlook is – admittedly – terrific.
The sophisticated investor realizes that the outlook is always cloudy and prepares in advance for the rainy days ahead.
However, long-term investors and short-term traders should handle things differently.
The most important consideration for long-term investors is their asset allocation.
That refers to how you divide your portfolio up among various, imperfectly correlated assets, like stocks, bonds, Treasury Inflation-Protected Securities, real estate investment trusts and precious metals.
Studies consistently show that 90% of investors’ long-term returns are due to their asset allocation. (The remainder is due to security selection, investment costs and taxes.)
To give an example, it wouldn’t matter if you were a phenomenal stock picker if you had only 20% of your portfolio in stocks, with the rest in bonds and cash.
Another investor with, say, 60% in a plain-vanilla S&P 500 index fund would have three times as much equity exposure, and would therefore earn several times as much as the years turn into decades.
The key question for long-term investors is not “What will the economy do?” or “What is the near-term outlook for the market?” – which can’t be known anyway – but “Do I have a sensible asset allocation?”
There are plenty of economic expansions and recessions ahead of us. Plenty of bull markets and bear markets, too.
But glance at a chart of the stock market for the past 10 years, 50 years or 200 years.
Nothing outperforms a diversified portfolio of common stocks or, better yet, of uncommonly good stocks.
Every dip, correction and nail-biting bear market – in the luxury of hindsight – was a buying opportunity.
That means long-termers can make investing dead simple.
You need only asset allocate properly, minimize your investment costs and tax-manage your portfolio.
The only work that remains is to rebalance your portfolio once a year to bring your asset allocation back into alignment.
The rest of the time you are free to play golf, travel… or go fishin’.
(In fact, I wrote a book on just this subject, with a foreword by longtime subscriber Bill O’Reilly. It is currently a No. 1 bestseller on Amazon. You can find it here.)
But that’s for longer-term investors.
Some readers are short-term traders. (And the two activities are hardly mutually exclusive. There is no reason you can’t be both.)
Traders should focus on the outlook for individual companies.
Yes, their earnings are often dependent on the strength of the economy.
And their share prices are often dependent on the short-term trend in the market.
But – again – we can’t know these in advance.
So how do traders control risk?
- Stick to high-quality securities. They have plenty of upside potential and will hold up best in a correction or bear market. The companies with the flimsiest fundamentals will perform worst.
- Diversify across various countries, industries and sectors. Not all nations’ stock markets move in the same direction at the same time. And some industries – like healthcare, defense, food and utilities – are largely recession-proof.
- Run trailing stops behind each position. You can’t know when the stocks you own will peak. But trailing stops protect your profits during the good times and your principal during the bad ones. They give you unlimited upside potential with strictly limited downside risk.
Follow these guidelines and you are already ahead of 95% of investors.
(And ahead of 100% of those “investing” in Dogecoin, nonfungible tokens and most SPACs.)
To a great extent, the future is unknowable.
Experienced investors often concede this but then add, “so you have to guess what the market will do next.”
No. You don’t. And you shouldn’t. That’s my whole point.
One of the primary goals of intelligent risk management is to take as much guesswork as possible out of the equation.
How do you do that? By accepting that uncertainty will forever be your inseparable companion – and using proven principles of wealth management.
Like the ones I just mentioned.