ReSolve’s 2016 Year End Review, Why Playing the Lottery is a Terrible Investment Strategy

Editor’s Note: Advisors and Individual Investors who subscribe to our email list received the full version of ReSolve’s 2016 Year End Review a week ago.  If you want early access to our research, first notice of future (free!) continuing education courses, and of course, the full 2016 Year End Review report, click here.

2016 was a year that rewarded passive risk takers and not active risk managers. In fact, the past two years have been characterized by a lack of direction and low returns for most asset classes. While the US and Canadian equity markets may seem like “winners” in calendar 2016, their success comes with some important caveats. In our report, we address three important concepts all investors need to keep in mind – and that we find particularly encouraging for global asset allocators – as we move into 2017:

  • 2016 was a particularly unstable year for global politics;
  • North American stock valuations remain extremely elevated; and,
  • Stock picking cannot overcome challenges from asset allocation.

We don’t often comment on political or monetary matters, because it’s tough to quantify how social instability impacts investing decisions. Moreover, markets typically position appropriately in anticipation of political outcomes. But it’s fair to say that there was no shortage of unforeseeable events last year. From Brexit to Trump’s election, it was a year with many unexpected twists and turns made more challenging by the fact that markets were repeatedly caught wrong-footed.  It turns out, policy and sentiment risks are very difficult to diversify away. Political shocks have the effect of unsettling investors by confusing their expectations about the future.  This in turn creates a volatile, consolidating environment that undermines the benefits of diversification, and rewards investors who happen to concentrate in “winning” asset classes. In addition to the social environment investors endured, it’s also important to remember that valuations remain extremely elevated. According to data from Leuthold, the U.S. stock market is currently the third most expensive in the world, as measured by the cyclically-adjust price-to-earnings ratio, or CAPE.  Canadian stocks rank eighth, putting both in the top quartile. We’ve written many times that valuations are a terrible market-timing tool, and have little to say about what might happen over the next few years.  However, for investors who think over more appropriate time horizons (such as a 7-10 year business cycle), it’s fair to say that current valuations pose a serious headwind to future North American equity returns. Over the past year, North American equities performed admirably despite the environment.  But is it a prudent long-term strategy to wager a significant portion of your retirement funds on the lottery-like odds of a repeat performance? Of course not.  It is much better to diversify.  Unfortunately, rather than addressing these potential risks through diversification, many investors attempt to overcome the problem posed by valuations via security selection (or stock-picking).  This is a fool’s errand and the data backs that up. For the three years ending December 31st, 2016, the most skilled (95th percentile) international and emerging market equity managers trailed the least skilled (5th percentile) U.S. equity managers by 1.5%.  This is because the U.S. market outperformed international and emerging markets by such a large margin in this period.  That the best pickers of overseas stocks couldn’t beat the worst the U.S. stock pickers, makes a very clear and compelling point about stock-picking in general:

It’s about where you invest, not which stocks you invest in.

Even superb stock-picking cannot overcome challenges from wrong-footed asset allocation.

Finally, to leave you on a positive note, the report covers why we expect a reversal of fortune for globally diversified strategies in 2017 and beyond. After seeing similarly troubling circumstances in 1994 and 2004, globally-diversified tactical strategies had excellent rebounds in both 1995-6 and 2005-6.  Assuming a slightly calmer and more stable political and economic environment in the coming year, we expect that investors who focus on global diversification and real-time adaptation stand a very good chance of being rewarded for their thoughtful commitment. Get the full ReSolve 2016 Year End Review here.