An Annual Return is Short-Term Noise

S&P 500 finished the year up 18.3%, Small caps were up 20%, and Bitcoin finished up 304%. This was after drawdowns of -33.9% for the S&P 500, -41.1% for small caps, and -52.4% for Bitcoin.

Why is there such an incredible focus on the annual return? As with investors gravitating to round numbers, the annual return is such an easily relatable period of time to measure something. Financial media focuses on annual returns or year to date but it is also standard practice in finance to annualize whether that's interest rates or income statements. As with the over-emphasis over quarterly earnings reports in corporate finance, is a 2020 annual return even worth your time to review? Would allocating to evidence-based sources of return with high amounts of confidence in expected returns over 20-30 year time frames make more sense? It does to me and the reduced uncertainty of anchoring to 1 or 3-year returns is now just noise that offers little value to my financial plan. Every year since I finished my finance degree, I enter the annual return of the different asset classes into an excel spreadsheet. Each year I am surprised at how little the geometric rate of return also called compound annual growth rate, is affected by a single annual return. Long-term focused investors know this and ignore the short-term noise.  

Because of 2020 should I do X, Y, or Z?

“It shouldn’t impact what you’re doing at all. Really, there is no correlation with what markets did in a previous year with the new year” Justin Dyer is explaining what they call “serial correlation of returns” in finance. Previous year market returns are uncorrelated to the current years return. This means that investing based on what last year did is completely pointless. The data shows no edge or advantage that can be gained from extrapolating strong performance or expecting mean reversion and weak performance. Justin finishes it with: “Whatever happened in 2020 is gone, markets don’t really care about nice neat periods of 12 months of time.”

But Valuations are High?

Yes, valuations are high relative to their historical average. But, does that mean they are overvalued? Interest rates are also historically low with Fed guidance that they will continue to stay low. There are valid rationalizations for the higher valuations. Justin delivers: “You just never know how markets are going to react, even if they are overvalued, how long will they remain overvalued. Timing these things is incredibly difficult. And getting it right on both when to sell and when to buy back in. That's almost impossible from a probability standpoint.” If you sell and bail on the market you have to be right on the timing of getting back in. In taxable accounts there is also the tax impact which many advisors don’t take into account because they don’t want to do the work. Have you done a tax projection to see if you will come out ahead with selling your entire portfolio and then buying back in hopefully lower?  

Small Cap Outperformance

It is important to maintain exposure to drivers of return like the small cap premium. Because it is impossible to predict when that outperformance will come. The outperformance from these small caps comes on such few days and if you miss any of those days you do not get that small cap excess return. “We expect a higher return because they are a riskier asset class… It turns fast, the amount it did appreciate from trough to peak, close to 100%.” These factors are impossible to time and the key is to stay allocated and invested in them.

Bitcoin

Erik and Brandon discuss Bitcoin again to “Be ready for the volatility.” Brandon sums up the allure of Bitcoin once again with “This isn’t really an investment, this is a speculation. It doesn’t mean you shouldn’t go buy some Bitcoin, you need to understand why you're buying it.” If you must scratch that FOMO itch, just buy a little because there is no need to jeopardize your wealth on this kind of speculation. Cryptocurrency was discussed in greater depth on the last podcast.

“Our jobs as your fiduciary is to say what are your priorities and based on that here is the historical evidence that lays out - based on how much risk you are going to take - here is the return that should be compensated that should move you to achieve those goals. I think it's vitally important, you have to clarify what your priorities are and not invest in the exciting trends going on in culture.” -Erik Averill

If your portfolio is not diversified you are not being properly compensated for that risk. A good advisor helps you reach the outcomes you want and uses money as a tool to accomplish that task. Relying on an independent family-office, in which compensation is the same no matter what you are invested in, is not a bad idea. Not taking action can cost you a lot of money each year you accept inferior advice.