Research Director Monthly comment: January 2017

Fearless Forecasts and Financial Planning

 

This time of year in our industry, we get all the pundits out with their fearless forecasts for the financial markets for the coming year. After reading these for the past 30 years, I have come to learn that these forecasts have to be taken with a grain of salt. Why? Because statistics show that the pundits are correct about half the time, the statistical equivalent of a coin toss.

An interesting irony this year, and one thing that has been quite confounding to the pundit crowd of late, has been the recent Presidential election. Most pundits had assumed if Trump won, the stock market would tank. As the market usually does a good job confounding the consensus, it is up about 9% since the election and has been recently achieving new record highs.

What is behind the gain in the market that has confounded the experts? Primarily the belief the new administration will actually succeed in implementing several things that are favorable to business. This includes a reduction in corporate tax rates, potential for increased infrastructure spending, and potential for reduction in business regulations. All of this has positive implications for corporate profits, which is the primary driver of stock prices. And with a Republican majority in Congress, a lot of this may actually get done. Some people say it’s crazy, it’s not real. But the market is simply reacting logically to what it perceives may happen.

A corollary to this is while many pundits have been forecasting tepid gains for the stock market in 2017 (consensus is 5-7% total return), there is reasonable potential for the market to return more than this, perhaps significantly more, if these changes and legislation come to fruition. They would have a powerful effect on corporate profits, which may not be fully discounted yet by the market.

So what does all this have to do with financial planning? To be truthful, not much. We don’t put a lot of “stock” in the forecasts of the great “punditry”.  Similarly, when we put together a financial plan and set an investment policy, we don’t try to guess what the market is going to do (i.e., time the market); rather we look at long-term trends in returns in asset classes which we believe provide a better guide for estimating long-term growth in client assets. By diversifying portfolios across multiple asset classes, we capture growth in those asset classes while reducing portfolio volatility and delivering a more stable long-term return. True, while an all-stock portfolio may outperform a diversified portfolio in a strong equity market, an all-stock portfolio will most likely have materially greater downside than a diversified portfolio in a severe stock market decline. This is borne out in the long-term record of diversified portfolios, which have delivered superior risk-adjusted returns than an all-stock portfolio primarily because they are less volatile. We believe risk-adjusted return is arguably the most important measure of performance in wealth management.