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bonds, business, cnbc, currency, education, EM, emerging markets, finance, financial planning, forex, fx, individual investing, interest rate risk, interest rates, investing, personal finance, rising interest rates, stocks, thought experiment, volatility
Sometimes the most important lessons in the individual investing sphere are complicated and simple at the same time. At the very beginning of January, I recommended a little experiment that related to the financial market coverage on CNBC. The specific details of this “thought experiment” can be found in the original blog post from January 1st:
The brief version of the exercise related to watching Monday and Friday coverage of the current events in the global financial markets during the month. The simple exercise was to watch CNBC’s Squwak Box every Monday during the course of the month. The second part was to watch the last hour of the Closing Bell segment. What was the logic? The Monday show is a three-hour program, and there are many current issues considered and opinions from various market participants (e.g. traders, money managers, economists, investment strategists, research analysts, etc.). Monday is critical due to the fact that the market participants cannot trade on Saturday and Sunday. You might think of it as “forced” time to think and/or reflect about how current events are affecting investment opportunities and risks. Friday’s reflections from the same market participants is focused more on trying to explain the “vagaries and vicissitudes” (i.e. volatility of the stock market and changing opinions) of the markets ups and downs over the course of the week. Furthermore, many commentators and guests try to explain why the predictions on Monday did not or did match up with the ideas expressed at the beginning of the week.
The overall point of this experiment was to “drive home” the fact that trying to time the market or predict its direction over the short term is extremely challenging and can seem hopeless. Toward the end of December, the general investment thesis for the majority of money managers was that the stock market was poised to have a very positive January due to the fact that the financial markets did not really dive after the Federal Reserve announced the reduction of the tapering program, commonly referred to as QE (quantitative easing). Additionally, the main belief was that bonds were one of the least attractive investments to own. Most people assumed that the 10-year US Treasury Note was headed up to the 3.0% level. Things seemed pretty simple and not too many headwinds in the near future. So what happened during January?
The main event that most people remember was the currency difficulties of a number of emerging market countries. The financial media focused a lot on the Turkish lira (TRY) and the Argentine peso (ARS). Turkey had political problems, and Argentina has a huge problem as it relates to political leadership (or the absence thereof) and dwindling currency reserves. There were other currencies that experienced trouble as well like the South African rand (ZAR). The other important development was that the Japanese yen (JPY) reversed its direction and strengthen versus the US dollar (USD). Oddly enough, the Argentine Merval stock index was one of the best performers over the course of the month. No one saw this coming to such an extent. You might term this an exogenous event as anything that occurs outside of your current model to build a portfolio or invest in individual stocks/bonds. It is largely unknown and hard to predict. (As an aside, this is NOT the same thing as a “black swan”. That term is overused and conflated with many other things. Refer to Dr. Nassim Taleb for a further definition of the termed that he famously coined years ago). These events tend to be unknowns and have a greater impact because the general level of the perception of risk changes almost instantly and affect market sentiment and momentum. Market participants need to alter their models rather quickly in order to account for the occurrence of these events.
The other big event was the movement of the yield on the 10-year US Treasury note. Instead of following a general path of rising, the interest rate actually fell. The yield on this instrument drifted down roughly 40 basis points (0.4%) from the 3.0% level. What most people fail to realize is that interest rates go down if economic data turns out to be worse than expected normally (e.g. December jobs of 70,000 and the lowest labor force participation rate since the 1980s), but, more importantly, there is a “flight to quality” phenomenon that occurs over and over again. There tends to be a bit of a “mini panic” when unexpected and impactful events occur. If all else fails, institutional investors like hedge fund managers tend to buy US Treasury bills, notes, and bonds for safety. The additional demand causes bond prices to go up and, by definition, yields will go down.
The combination of bad economic data and dealing with the currency woes in the emerging markets causes many short-term traders and speculators to buy these risk-free assets and figure out how to trade later. It is sort of an example of reflexivity. The bottom line for individual investors is that many sold bonds and purchased dividend stocks instead. The exact opposite happened: bond yields went down and dividend stocks sold off. The worst short-term investing strategy was to search for yield in the stock market rather than the bond market due to rising interest rates. For more information you can refer to one of my former posts on how to look at the various risk factors associated with bonds. Trust me, there is a lot more to bonds than simply interest rate risk. Here is the link to a former blog post that addresses this very issue:
There were many other smaller events that happened over the course of the month that affected the general volatility experience in the financial markets. At the end of the day, even the “experts” had a monumental task trying to explain all the macroeconomic events, currency movements, and interest rate implications throughout January. If the task was so difficult for them, it is normally advisable for individual investors to not follow the market daily and get caught up in temporary “greed and fear” of traders and speculators. Investment ideas and predications can change from day to day and even minute to minute in the short term. It is much more important for individual investors to develop a long-term financial plan that will allow them to reach future financial goals. You then blend that with your risk tolerance. For example, how likely would you have been to sell the positions in your portfolio given the volatility experienced during the course of January? An outlook of five years is normally a great start for that plan. If you look out into the future with a longer timeframe like an annual basis in terms of adjusting the components of your asset allocation, you are less likely to constantly trade the securities in your personal portfolio. The frenetic pace of traders/speculators and the volatility of the stock and bonds markets makes it seem that you MUST do something, anything!
If you would like to learn a bit more about behavioral finance, you can refer to this blog post from last year (note context of examples referred to is from August 2013 when the piece was published):
One of the most important things to learn in investing is how to control your emotions. It is easy to map out your investment strategy and risk tolerance on paper. Many asset managers who have experienced a multitude of secular bull and bear markets refer to this phenomenon as your EQ versus your IQ. Thus, when actual “money” is involved, volatility and uncertainty in the financial markets brings forth challenges that even the best money managers have a hard time keeping up their nerve. The other takeaway is that people’s investment recommendations can change on a dime. Market participants can be very hopeful on one day and think the sky is falling the next day. Trying to time the market is so difficult that you end up developing a portfolio allocation for your investments that assumes that general events with transpire. All the planning in the world cannot account for all possibilities of geopolitical and global events that might really cause the market to go down more than normal in a short time period.
The whole point of this “thought experiment” was to encourage you to take a long-term view of investing in the financial markets. It is a lot less stressful, less complicated, and tends to lead to better overall investment returns (i.e. you do not “sell low and buy high” as much because everyone tells you to). For more information on stepping back and thinking about the long term, I have included a final blog post. You always need to remember that your financial professional (or yourself if you manage your own investments) who advises you about investment decisions is forever impacted by the start of their investment career. They tend to be biased and make investment recommendations based upon how things used to be when they started in the business. It is very hard to separate your “biases” from the present day. Here is the link:
https://latticeworkwealth.com/2013/08/18/before-you-take-any-investment-advice-consider-the-source/
Well, I hope you learned a few things by participating in my experiment and maybe even had a little bit of fun. Please feel free to leave a comment or send me an email directly at latticeworkwealth@gmail.com with more specific feedback and/or questions. Sometimes you can learn a great deal just by being an observer of financial market volatility. What is the nothing part of this learning journey? The moral of the story is that everyday guests appearing on CNBC or other commentators will let you know that the stock market with either go up, go down, or stay unchanged. Obviously everyone knows that simple concept to begin with. Thus, it is hard to choose who to listen too because of so many divergent opinions. Lastly, you should realize that this same experiment would have worked with the other business networks and large financial news publications like the Wall Street Journal, Financial Times, Barron’s.
