Reflecting on a year gone by is often, at least to some extent, an exercise in revisionist history. This isn’t necessarily a bad thing; many of the differences between our memories and experiences are minor and inconsequential. In some cases, the variations in these realities can help us persevere and move out of the past and into future endeavors. But as investors, revising the memories of the past can be problematic and potentially hinder future success.
Behavioral finance is the study of how psychology influences our actions as investors. Within it, there is a specific phenomenon known as the hindsight bias, which describes the propensity of investors to look back and “see the obvious” only after it has occurred. In a year like 2020, with every unprecedented and unpredictable event that unfolded in our collective experience, it’s important not to forget the lessons from the events as they actually were and not as we may want them to have been.
Here are five lessons that we learned, once again, in 2020.
Markets Are Forward-Looking and Tend to Change Quickly
The U.S. stock market started 2020 with strong performance. The S&P 500 rose by 5% through mid-February, peaking on February 19. Throughout the beginning of the year, investors started pricing in the growing risk of COVID-19 by selling stocks with exposure to China, but by late February it became clear that no country would be immune to the evolving pandemic. In just a few weeks, from February 20 through March 23, the S&P 500 fell 33.8%. Performance was even worse for the companies that would be most affected, such as airlines, cruise lines, and hospitality-oriented businesses. Small companies (-40.7%) and real estate (-42.2%) were also hit hard. 1
Applying lessons learned from the 2008 global financial crisis, the Federal Reserve stepped in quickly, with the objective of preventing the economic and health care crisis from becoming a financial liquidity crisis. The strength and breadth of the Federal Reserve’s response, along with subsequent fiscal stimulus programs and continued progress on vaccine development, allowed for a strong recovery. From the market close on March 23 through December 31, the S&P 500 rallied an incredible 70.2%, while small U.S. companies rallied 99.1%, leaving investors who were sitting on the sidelines regretting their decision. 1
The Stock Market Is Not the Economy
An additional lesson from the wild swings of the first part of the year is that in the short-term, the stock market is not the economy. At the end of March, when the market bottomed and began recovering, the unemployment rate stood at 4.4%, higher than the 3.5% recorded the month prior. By the end of April, that number stood at 14.7%, the largest number outside of the Great Depression and significantly higher than what was experienced in the 2008 global financial crisis. The stock market sometimes reacts to daily headlines and may seem short-sighted, but this is simply the mechanism of pricing in new information to future, forward-looking expectations and anticipating the multitude of risks and policy reactions that might be on the horizon. As a result, market activity was even more noticeably divergent from economic reporting this year. 2
Risk Is Real (Risky Assets Behave Like Risky Assets)
Stocks are risky—that is a constant in investing. However, it’s important to understand that other assets can be just as risky, even if they’re called bonds. Knowing the risk associated with fixed-income investments is incredibly important. Although the bonds that CCM owns in our managed allocations weathered the storms of March with stability and protection, many other investors were rudely reminded that some bonds, like corporate high-yield bonds, can be as risky as stocks. So, what should have been the “safe” part of their portfolio, in the grips of the bear market, was down 10% to 20%. 3
With interest rates likely to remain low in the near future, it’s important to remember that stretching for higher yields typically means taking higher risks, which can be costly when risk is repriced. 4
Market Timing Is A Risky Endeavor
With the volatility of the year, it’s easy to look back and see when an investor could have sold to avoid the drawdown and bought to ride the recovery. But don’t be tempted into succumbing to the siren song of the hindsight market timer. The reality is that timing these moments with accuracy or repeatability is nearly impossible. Even if you were the hypothetical investor who “saw it coming” and sold to cash in February, do you think that you would have bought in March? April? At all? With markets recovering so fast, it’s most likely that the perfect market seller was worse off than the buy, hold, and rebalance investor. And for the imperfect market timer who sold too late, the outcomes were likely even worse.
Diversification Works
Even with all of the attention being focused on U.S. stocks, and often just a handful of them, the experience of 2020 illustrates that the benefits of diversification are alive and well. In Q1, investors who had a balanced portfolio fared better than those only holding stocks. As the recovery pushed forward, U.S. large cap growth stocks provided the strongest returns, while in Q4, U.S. small value stocks stole the show with returns almost 25% higher than their large growth counterparts. 5
We saw U.S. small stocks outperform the S&P 500 for the first year in many and saw emerging markets stocks match the returns of their U.S. counterparts. 6
Over the past few years it’s been easy to be lulled into thinking that owning a handful of the largest stocks in the world is all that’s needed to be a successful investor. As investors, it’s prudent to consider this quote from George Orwell, “Whoever is winning at the moment will always seem to be invincible.” By spreading out risk across markets and asset classes, a more stable path forward is often the result.
- Morningstar; S&P 500 TR USD; Russell 2000 TR USD; Wilshire Global REIT TR USD
- https://data.bls.gov/timeseries/LNS14000000
- https://carlsoncap.com/articles/fixed-income-the-optimal-shock-absorber/
- https://www.wsj.com/articles/fed-signals-interest-rates-to-stay-near-zero-through-2023-11600279214
- Morningstar US Large Growth TR USD; Morningstar US Small Val TR USD
- S&P 500 TR; Russell 2000 TR; MSCI EM NR