Richard Whitacre is living in a financial nightmare. As Jason Zweig’s latest Intelligent Investor column details, in 2023, Whitacre rolled his entire Fidelity 401(k), worth almost $800,000, to a firm called Yield Wealth. They were promising him a guaranteed yield of 15.25% annually. “I figured this was an amazing opportunity and I’d be set for life,” was Whitacre’s reasoning.
Even without reading the article, you probably know how this story ends. Not only did Whitacre not get the 15.25% guaranteed yield because nothing of the sort has ever existed, but he’s also not even sure where his money is or how much is left. It might all be gone. It could take years to sort all this out, and having been diagnosed with colon cancer last year, Whitacre might not even live to see it resolved.
You’re probably thinking to yourself, why would someone do this? You must know that there’s no such thing as a sure thing. Practically speaking, who would ever bother to own stocks or bonds, which have historically averaged only +10% or +5% per year and, of course, are not guaranteed, if you could get +15% per year with no risk? This free lunch would turn the investment world on its head. Every bank CD in the country would be redeemed virtually overnight. It makes no sense.
Of course, you would probably never make this mistake, right? Frankly, I’m not so sure. I talk to clients all the time, and I repeatedly hear about the things they’re thinking and reading about and how they often treat them as close to, if not actual, sure things.
For example, let’s switch gears to another article from this weekend, this time from the New York Times and a favorite journalist, Jeff Sommer, The High Risk, High Reward Trump Market. Jeff’s written extensively about the market and Trump’s influence over the last few months, almost always with some version of the near certainty that the new president’s proposed tariffs and immigration policy will result in slower economic growth, higher inflation, and rising interest rates. I bring this up because several clients have asked about these issues as if they’re a foregone conclusion. They’re not. Just as there are no investments with 15% yields that are safe or guaranteed, there are no sure things when it comes to macroeconomic forecasting based on political policies.
The problem for investors is that it’s a long way from campaign claims to economic and financial market outcomes. As you’ve seen countless times in just the last decade, the economy, interest rates, and the stock and bond markets can behave exactly the opposite of how you would expect them to, even if you knew the outcome of an event ahead of time.
Let’s take as just one example the absolute can’t-miss, lock prediction of 2024–that interest rates would finally go back down and bonds would go up. Forget that, coming into the year, experts were forecasting as many as a half-dozen interest rate cuts throughout the year, and we didn’t even see the first one until mid September. The Federal Funds interest rate set by the Federal Reserve has fallen by 0.75% in 2024. As we all know, when interest rates fall, bond prices go up (and vice versa). So, what do you think has happened to long-term bonds in 2024? Their prices have not gone up; they’ve gone down as long-term bond interest rates have risen! On the year through November 25th, the iShares 20-Year Treasury Bond ETF (TLT) dropped -6.2% (-3.1% including interest). Since the rate cuts began in mid September? TLT’s price is down -6.9%! You could have perfectly predicted when and by how much the Fed would cut interest rates, but you would still lose money as the bond market’s response was the opposite of expectations.
This example is an anecdote, for sure. And as statisticians remind us, the plural of anecdote is not data. Fortunately, we have plenty of evidence of the immense unpredictability of markets by even the most knowledgeable and informed investors. Managers of “actively managed” mutual funds are trying to forecast the impact of politics, interest rates, the economy, and individual company fortunes on stock and bond prices daily—buying undervalued and selling overvalued stocks and bonds in their portfolios. If investment forecasting worked, we’d see it show up as outperformance, compared to unmanaged indexes like the S&P 500, by professionally-managed, active mutual funds.
The graphic below shows this is not the case. Of the 2,860 actively managed stock mutual funds that existed in 2003, only 45% survived, meaning 55% did so badly they went out of business over the last two decades. Of the survivors, only 18% of these managers—less than one in five of the original group—outperformed their index. Active bond managers did worse, showing the difficulty of even getting the future direction of interest rates right.
But some people have made accurate forecasts, right? Sure, and a stopped clock is right twice a day, but it doesn’t tell time. So, let’s see what the actual data says.
If thousands of professionals make predictions all the time, you’d expect some of them to be right some of the time, just by chance. But do they continue to be right? To answer this, we can look at only the actively managed stock and bond funds that were the best performers, landing in the top 25% of their category over five years, and then track their results over the next five years. If these managers had genuine skill at forecasting the future, we’d see 70% or 80% of them remain in the top 25%. If, on the other hand, their success was random, we’d only expect about one in four (every fund has a one-in-four chance of being a top-25% performer) to continue to stay on top.
The graphic below is the final nail in the coffin for investment forecasting believers. Only a quarter of top-performing active stock and bond mutual fund managers remained in the top 25%. Most professionals can’t forecast, and the few who do owe their success to luck, not skill. The implication for us, obviously, is that we should not be playing this game. Your financial success is too important to leave it to speculation, educated guessing, forecasting, and random luck.
Does that mean we stick our heads in the sand, don’t pay any attention to what’s happening around us, and don’t react to what could happen? From time to time, I get a version of all these questions. My answer is no. Predicting what will happen isn’t our only option. On the other hand, we could prepare for what could happen and plan accordingly. Predicting and preparing are not the same thing.
Prediction is reactionary. Preparation is a strategic act that is well thought out and sensibly planned. As investors with critical long-term goals, we should understand what risks we face and how to handle them. When it comes to inflation, for example, that is a risk that we should address, no matter who is in office. If the prices of the things we spend money on go up faster than we expect, we will need a lot more money to pay for them.
A sensible investment plan takes into account higher-than-expected inflation. Our’s sure does. Fortunately, we don’t have to guess what would happen if we saw a surge in inflation because we already experienced one from the late 1960s to the early 1980s.
What happened? From 1966 to 1981, inflation (Consumer Price Index) went up 7% yearly. The worst-performing asset class was long-term bonds—their +2.5% per year gain was 4.5% less than inflation. Shorter-term, five-year bonds did better, but their +5.8% per year return still trailed inflation by over 1%. Higher-priced large growth stocks, represented by the S&P 500, didn’t do much better, returning +6% per year and 1% less than inflation. Only large and small value stocks managed to outpace inflation, with small value stocks, in particular, gaining +15% per year, more than double the inflation rate.
From this research, you can see the basis of an investment portfolio policy that could also handle a bout of hyperinflation whenever it materializes. Specifically, don’t own any long-term bonds, keep maturities short-term, and generally keep bond allocations to a minimum. Own more stocks than bonds, but not just larger, higher-priced companies; hold a meaningful allocation to large and small lower-priced value stocks, as they seem to perform best when inflation is at its worst. Finally, and in particular, dare to hold a higher-than-average allocation to small value stocks, which have the highest expected long-term returns and were the only asset class that overwhelmingly outpaced inflation.
I’ve always thought the quote attributed to Mark Twain applied to investing—history doesn’t repeat, but it does rhyme. Sure, investing and creating an investment policy isn’t as simple as studying historical data and “just doing what’s worked.” But I believe there are valuable lessons in understanding how stock and bond markets have behaved over the last century, during various never-seen-before world wars, presidential assassinations, economic calamities, terrorist attacks, and pandemics.
In the case of high inflation, understanding the past had us well prepared when we were caught off guard by 6.8% annual inflation from 2021 through 2022–bonds tanked, the S&P 500 only managed +2.7% per year returns, while the Dimensional US Large Value and Small Value Indexes again outpaced inflation, gaining +8.8% and +16.6% per year, respectively.
There is no such thing as a sure thing in investing. Following this logic can keep you out of a lot of trouble. Poor Richard Whitacre would have over $1,000,000 today had he avoided the too-good-to-be-true sure thing and instead invested in a diversified stock or stock and bond portfolio. Less obviously, the myth of the sure thing extends to our ability to predict the future and reposition our portfolios accordingly. Every year, we see can’t-miss economic and political predictions go astray, and investment portfolios managed to exploit the forecasts get crushed. This approach isn’t intelligent investing; it’s speculating.
You do not have to play this game. You can invest well without trying to forecast the future or react to every current event. How? By understanding the long-term rates of return and risks of core stock and bond asset classes, you can create an allocation that makes sense for your long-term financial goals. By thinking about the risks you face, such as higher inflation or a significant market decline, you can customize your portfolio to address these issues if they materialize without having to predict if or when they will happen. To keep you from pushing the panic button and bailing out when things get scary, you can partner with an independent financial advisor and fiduciary like Servo, who can give you the right advice when it really matters.
If you’re well prepared and disciplined, you can eventually be “set for life” without having to bet on sure things.
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Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or additional expenses except where noted. Indexes and mutual funds shown are for illustrative purposes only and may not be the only or any of the funds that Servo clients hold. Servo was not managing client portfolios over the entirety of the periods shown. This content is informational and should not be considered an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.