“It’s Different This Time”
These are four words that should be banned from the investment lexicon. We heard it in the late nineties when the “new economy” was predicted to lay waste to the old model that solid fundamentals and profits were necessary components for growth in stock valuations. The bursting of the Tech Bubble in early 2000 showed that it was, much to the surprise of the vox populi, not different that time.
Over and over again, the financial media is replete with articles and interviews that profess that the current situation – a snapshot in time – is the new constant. To support the message they cite an unremitting string of experts all confirming that the world has changed, the old theories are banal and that “it is different this time”. Don’t be fooled.
The financial markets are a complex, dynamic organism. The averages are never the actual result and any one of a series of exogenous events can cause the markets to surge forward or retreat as the case may be. That said, the Law of Large Numbers tells us that markets – however volatile they may be right now – will perform in a certain way over a longer period of time. Moreover, it is statistically important that we have had these tumultuous markets to provide additional support for more stable markets going forward.
The current debate is whether the tried-and-true asset allocation philosophy is somehow passé. Again, I would caution you against falling for this specious argument. Harry Markowitz, who won a Nobel Prize for his work on Modern Portfolio Theory (MPT), established mathematical certainty for the need to diversify. One of the major tenets of MPT is that an efficient portfolio is one that is diversified among different asset classes. The concept of diversification is that these various assets classes will not go up in tandem nor will the go down in tandem, thereby smoothing out the returns of the collective portfolio. In other words, don’t put all of your eggs in one basket; sound advice in any environment. Yet, the new argument that you will be hearing is that this strategy will no longer work. The major claim against traditional asset allocation is that, with a global marketplace, correlations have converged to the point that the strategy of diversification has lost its effectiveness. Said another way, the asset classes (foreign and domestic, big companies and little companies, traditional and non-traditional asset classes) now move together so closely that the value of having one investment zig while the other is zagging is no longer possible. While it is true that the benefits of multi-asset class investing have been muted in recent years, it is nonetheless a cornerstone of intelligent investing and will remain so. Studies show that the correlations between asset classes are very dynamic; they change from year to year for a litany of reasons. One thing is clear, in periods of high volatility – such as we are presently experiencing – correlations converge. So the current behavior of asset classes to move together is not anomalous but rather is it quite consistent with empirical evidence that these interactions are very fluid and will change from market to market, economic cycle to economic cycle, etc.
Another controversial theory that is gaining attention is that it is bonds, rather than stocks, that will perform the best over the long run. Again, much of the support for this argument depends on the aphorism that “it’s different this time”. As support for this argument the pundits are showing that, for the past 40 years, the relative return of bonds has beaten those of stocks. Why 40 years instead of 50 years? What if we would have run those calculations last year, or the year before? Is the result the same or is it only during certain 40 year periods? The convenient part of the last 40 years is that it ended with an equity market that had one of its worst years on record. Furthermore, within that period of time, runaway inflation resulted in interest rates at levels we will likely not see again in our lifetime. Notwithstanding, it is because of the poor performance of stocks over the past 18 months that investors should consider them in their portfolio today. It was the low of 1932 that formed the foundation of the tremendous returns earned over the following five, ten, twenty and thirty years.
The vicissitudes of the stock market require a watchful eye. It is not enough to just buy a collection of stocks and hold them for the long term. You must be diligent in your approach, mindful of your exposures and strategic in your asset class decisions. And take heart; the principles of successful investing are not that transitory. It is NOT different this time.
Originally published in the Orange County Business Journal April 13, 2009
