If you watch financial TV programs or read articles in the newspaper’s business section, you may notice an emphasis on “investment themes”. What investment themes will likely generate better portfolio returns? Will political themes outweigh economic themes? Will high corporate earnings boost investor sentiment; or, will high unemployment cast a dark shadow over investors?
Investment experts often interweave four or five themes into a narrative. The goal of the story is to justify specific investment recommendations – “buy oil but stay away from gold.” Often, however, the experts differ over which themes are important; or, if they cite common themes, they may draw differing conclusions from them. Although the narratives are usually compelling, logical, well-researched, and internally consistent, the end result is often to recommend a portfolio based on a single-perspective world view. Unfortunately, if the “theme” – read “investment story” – proves to be incorrect, a portfolio suffers greatly.
For example, suppose you hear an expert forecast that U.S. large stocks will earn 10% over the next year while the U.S. bond market will suffer a loss of 5%. Your investment portfolio is currently allocated 50% to stocks and 50% to bonds. What should you do? Should you dump the bonds?
You could decide to tilt more towards the stock market. However, before you do this it would be a good idea to determine how accurate past predictions have been. After all, you don’t want to change your portfolio merely because there is a good story (theme) behind it. An amusing example of such testing is a recent research study that concludes that investors would have fared better by selling all of the stocks recommended as buys on Jim Kramer’s popular Mad Money TV program.
A better approach considers the full range of possible future results as opposed to a forecast of the single “most likely” result. Let’s say we told you that we expect U.S. stocks to have an average return of 10% next year. You also should know that our analysis indicates a 30% probability of a gain of 40% for stocks, a 40% probability of a gain of 10%, and a 30% probability of a loss of 40%. Furthermore, in the lousy stock scenario, bonds will be up by 15%. Now what do you want to do with your bond position? If you sell the bonds that are expected to decrease in value slightly, you will leave your portfolio wide open to a catastrophic loss. It’s like getting rid of your auto insurance because you don’t “expect” any accidents. If you keep the bonds and they go down in value, as expected, you will suffer only a small loss – one from which you should be able to recover nicely.
Basing an investment strategy on forecasts of specific results [“I expect this stock to be up 10% in the next six months”] is a dangerous way to run an investment portfolio. Our suspicion is that some investors tend to follow advisors promoting investment themes that resonate with the investor’s subjective beliefs. For example, if an investor is pessimistic about a political outcome, he or she will be drawn to investment advice predicated on gloomy forecasts: “My candidate lost, therefore, everything is going to go to hell in a hand basket.”.
Bottom Line: enjoy the investment stories but don’t assume they promote a better portfolio strategy and better portfolio outcomes.