Forecasting is overrated. How many events that seem inevitable in retrospect took people completely by surprise when they actually happened? From its low of 676.53 on March 9, 2009 through the end of this past quarter, the S&P 500 has gained 137.63 percent. Now that it has hit new record highs, the 12.63 percent it’s gained this year is generating a lot of attention and excitement. But four years ago, with the economy battling recession, housing collapsing, and the S&P 500 down nearly 60 percent in the span of a few months, how many people were forecasting economic recovery, predicting a big rebound in home prices, or enthusiastically pouring money into stocks because they thought the S&P 500 was about to nearly triple in value?
If forecasting isn’t reliable, how should investors figure out what they should be doing with their money? Over the years, we have shared our belief that the best way to invest is through a disciplined, responsive, rules-based approach, rather than relying on forecasts and predictions, or emotional responses to the market’s ups and downs. Of course, simply having rules isn’t enough – they have to be the right rules.
Imagine you have a car trip you take routinely. Since it’s Summer, let’s make it a trip to the beach. Along your route you travel through 7 traffic lights. Over time, you notice that on average you have to stop for 2 red lights along the way, and that each red light adds about 3 minutes to your trip. Which of the following rules would be a good plan for efficiently getting to your fun in the sun?
Stop at every intersection at which the traffic light is red, and allow enough time for the trip based on the likelihood that you’ll be waiting at traffic lights for approximately 6 minutes.
Stop at every third intersection, wait 3 minutes, then proceed.
Clearly Plan 1 makes sense. Plan 2, on the other hand, significantly increases the probability that you won’t make it to your destination at all.
What are the properties of an effective rules-based approach?
It should be based not simply on facts, but on the facts that matter. Plan 2 may be based on research and a study of the facts – an average of 2 red lights per trip – but not the facts that matter: which 2 lights are red.
- It should recognize and accommodate the uncertainty of future events. Maybe 4 lights will be red.
- It should balance risk and reward. The risk of a dangerous collision is wildly disproportionate to the reward of saving a few minutes of travel time.
- It should allow for the possibility that risks may be present even if disaster doesn’t strike. The light you didn’t notice just happened to be green when you barreled through the intersection.
- It should relate to reality as it actually exists, rather than some theoretical condition not found in the real world. Once you’re at the beach the waves and tide make it impossible to draw one line in the sand that exactly defines the shoreline.
- It should produce enough information to allow for good decision-making, taking risk into account. If you decide to try a bit of rock climbing instead of hitting the beach, you’ll probably want more instruction than “Find a big cliff – go up.”
To be effective, a good rules-based system will require the discipline and patience to actually follow the rules, even when they seem inconvenient or unnecessary – stopping at the red light, even if we don’t see anyone coming.
How do the properties of our investment process stack up to these standards for a rules-based approach?
Our investment process features: