Hindsight is 2020


 

To say 2020 has been a crazy year is a massive understatement.  On Dec 31, 2019 the economy was doing well, the stock market was near all-time highs, and most people probably assumed the election would be far and away the biggest news cycle of the upcoming year.  Fast forward 8 months and we’re still in the midst of the biggest global crisis since WWII, unemployment hit levels unseen since the great depression, and the global economy came grinding to a halt. The only thing certain about 2020 is that NO ONE saw this coming.  It’s commonplace for investors and those in financial media to make predictions on what’s going to happen to the economy and in the geopolitical landscape and then use this as the basis of their expectations for the stock market.  The obvious point one could make here is that there are too many unknown variables that impact the future, and therefore making investment decisions based on these predictions is unwise…but that’s not what I’m going to do.  In fact, I’m going to do exactly the opposite.  Let’s pretend that we go back to New Year’s Eve and we somehow get a glimpse into the future, and we see that a global pandemic hits, and that unemployment soars and GDP sinks.  We see that now 8 months into the year, there is no vaccine on the near-term horizon and that partial lockdowns will seem to persist indefinitely.  What would an investor do with this information?  They would thank their lucky stars that they got this info before it happened, and they’d move all of their money out of the stock market as fast as they could.  So what happened to this investor who basically won the lottery and got a crystal ball view of the most volatile year in generations before it happened?  Let’s assume he was invested in a total stock market fund and just moved his assets to a total bond market fund and see how he fared.

It’s been a bumpy ride, but somehow despite everything endured this year a portfolio invested in a basic total stock market index fund still managed to generate a positive return on the year in excess of the bond portfolio.  If we hadn’t just lived through it, no one would believe it.  Our hypothetical investor couldn’t believe it.  He had been given the gift of seeing the future and he still managed to underperform the market. Let’s expand this idea even further.  In our example, let’s assume not only did he know that these events would occur, but exactly when.  The below chart can provide some insight on these specifics.

This shows the 10 year numbers on unemployment and GDP growth.  This highlights two things:

  1. These were not small moves. These were huge spikes of measures directly tied to economic health
  2. These occurred very sharply, right near the end of March.

Now our hypothetical investor has even more information to go on.  He knows that the economy was largely unaffected for Q1, but the 1st of April, growth fell off a cliff and unemployment skyrocketed.  So what if he had just switched out of equity into bonds at that time?

This result would have been catastrophic.  Over these last 5 months, the total stock index fund outperformed the bond portfolio by 42%.  Unfortunately, although this story was hypothetical, this was the reality for many investors during this time period.  Even though the market was down, given the state of the economy many assumed that it was destined to decline substantially more and sold off their equities, only to miss out on this bounce back.  This is an all too common story, and one that is more damaging than most people realize.  The vast majority of investors I speak with have differing levels of fear of principal loss (losing money when the market goes down) but very few have a similar fear of opportunity cost (missing out when the market goes up).  However, the latter can often times be much more damaging.  Consider an investor who panicked and sold at the bottom, and thus missed out on the last 5 months, and compare that to an investor who stayed invested.  If they both stay invested exactly the same for the next 20 years and receive average long-term rates of return, the difference is astounding.  Using a starting amount of $100K, this one misstep would result in $283,000 less at the end of the 20 years.

In summary, there are 3 main takeaways:

1.) It is really difficult to predict the future. It may seem easy to think we may know where the economy is headed, but there are a lot of unknowns out there that can derail even the most well thought out analysis.

2.) Even if you do “know” what the future holds for the global economy, this does not always (or even usually) translate to the market behaving as one would expect.  If the market hitting all-time highs right now in 2020 isn’t convincing that predicting the market is really difficult, then there is no convincing.

3.) Missing on a prediction can be very costly.  The market is volatile in the short run but has consistently provided solid long-term rates of return for those that stay invested.  Being uninvested during a big upswing can be much more damaging than enduring the short-term volatility.

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