Investing is a never-ending learning experience. I think that’s one of the things that makes the financial markets so fascinating. Just when you feel like you know everything, the markets and the economy will surprise you. For me, learning is largely about introspection of past actions. You have to learn to audit your past decisions to see where you went right and where you went wrong. That helps you build a little better foundation of understanding from which to make future decisions. The last few years have been a series of lessons for us all. Here are 3 things I learned in 2023 that I hope will help me formulate a better understanding of how to navigate the future.
1) Inflation is necessary to predict and very hard to predict. It’s impossible to put together a sound financial plan without predicting what future inflation might look like. The last few years have made that abundantly clear as high inflation has ravaged most of the global economy. I think we did a pretty good job forecasting the Covid inflation:
- In May 2020, I said inflation was likely to surprise everyone to the upside as the fiscal deficits we were running were likely to result in stronger-than-expected demand and high inflation.
- In May 2021, I said the Fed should be hinting at rate hikes and balance sheet reduction because the financial markets and economy seemed to be overheating.
- When the Fed started hiking I said that inflation was unlikely to be “transitory” in the way they expected and that the shelter lag could result in inflation remaining stickier than expected.
- In January 2022, I said that inflation had peaked, which happened to be a few months before the peak of 9% CPI.
- In January 2023, I predicted that this year would be the “year of disinflation” and that inflation would end the year above the Fed’s target but much lower than markets expected.
That all sounds pretty good, but I was still surprised by how sticky inflation has been. Even more important, I was surprised by how rapidly the Fed responded when they finally did.
The lesson here is that it’s necessary to make big macro predictions but to always remember that these things are so complex that you can’t get overly optimistic about your forecasts. That’s how you end up on the wrong side of big moves. And if you end up being all in on the wrong side of a big move, then you expose yourself to huge behavioral biases that can trip up your financial plan. In other words, diversify your portfolio even if you have tilts in favor of specific baseline forecasts. And yes, diversification still works. While many people said the 60/40 stock/bond portfolio was dead after 2022, it turned out to be about as alive as ever as the US 60/40 ended the year up 17.4%.
2) Stock picking is getting harder. 2023 was a crazy year for the stock market. The S&P 500 was massively skewed by the performance of the largest 7 companies in the index. While the equal weight index was up a healthy 13.7% the market cap index was up 26.2%. As I wrote earlier this year, this divergence is one of the largest in history. Now, we all know that stock picking is hard. The data on active management makes that abundantly clear as 80%+ of active managers consistently fail to beat a simple index fund. But I think stock picking is getting even harder.
I am not sure what’s causing this unusual concentration risk in the market cap index, but if this sort of thing continues, it will make it even more difficult to pick the outperforming stocks in the index. But there’s an interesting catch in there. If the index is becoming more concentrated, then that also means that the index, while superior to stock picking, is also exposing investors to more risk than they might expect from a diversified index fund. And that, ironically, means that it could make sense to diversify in other ways where the market cap-weighted index is tilted to reduce this risk.
The lesson here for me is that “factor tilting” might be a decent option in this environment. Or, rather, you need to understand your benchmarks and how they expose you to risk. For instance, the FTSE All World Stock Index has a 20% tech weighting, while the S&P 500 has a 30% tech weighting. So, if you are a “passive” US investor, you’re actually deviating quite a lot from a broader global market cap weighting. And that could mean that an “active” tilt towards a lower tech concentration could help you reduce some of that single entity risk from the S&P 500.
3) Time is all we have. I’ve focused a lot on time in the last few years. The death of my dog hit me really hard, and my young daughters have made me increasingly paranoid about longevity and the time management of my finances. I created the Defined Duration strategy because I am trying to better solve for time in asset management. I love the asset management business, but I also feel like the standard models for asset allocation often do people a disservice by failing to communicate time horizons to people.
You will hear an endless parade of 2024 forecasts in the coming weeks. Heck, I am working on one. But every forecast you read will treat every asset class like a one-year instrument that you have to try to navigate in 2024. I think this is deeply misleading, as it takes many assets that are inherently long-term (like stocks or long-term bonds) and tries to turn them into 1-year instruments. No one knows what these instruments will do in a 1-year period and I think we need to do a better job of matching time horizons with expectations for investors. After all, when people treat long-term assets like short-term assets, they’re creating behavioral biases that will likely result in excess stress and activity which could lead to worse performance.
You’re going to hear a lot more about time management from me in the coming years as my time here ticks lower. Time, after all, is all any of us have. When you squander it, you can’t get it back. I hope the time you spend in 2024 is productive, enjoyable, and filled with love.
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