In a world beset by uncertainty, how do we cope? How do we help ourselves sleep at night?
I love this question, because it’s so important. First, you’re right, the world is beset by terrible uncertainty today. However, it always has been and always will be that way. That’s the default setting. You have to start at that point—start by recognizing that simple truth, which can be very humbling.
Given this uncertainty, what do we tell ourselves, to allow us to sleep at night? Well, there are a few things. First, we really need to understand what is and is not within our control. Stressing out about the things that are out of our control is a total waste of time, effort, and energy. Its psychologically debilitating, and is not how we should be using our finite amount of intellectual capacity and brain power. So, look, we can’t control if it’s going to rain tomorrow, but we can get up each morning, check the weather report, and decide whether to take an umbrella or not. That’s a better approach than stressing about the weather. It’s a simple form of risk management.
The questions we hear all the time goes back to that uncertainty issue: What’s the Federal Reserve going to do? How many rate hikes this year? Where’s the Dow going to be in 12 months? What’s your favorite stock pick?
All those questions are things that you as an investor simply are not going to be able to answer with any degree of accuracy—it’s really a crapshoot. And so, rather than guessing, wasting a whole lot of psychological emotion and energy on it, why not just recognize—and, again, it’s with great humility—recognize what we do know and what we can’t know—and try to adjust accordingly. This leads quite naturally to a portfolio that is balanced and robust enough to withstand the regular market turmoil.
Over the past 20 years, how many market booms and busts have we seen? There was the dot-com boom and bust; the 2008–2009 financial crisis. There have been several 20% pullbacks over the past few years. That is simply the normal state of affairs for U.S. markets. Investors must understand that volatility is part of investing; if you learn that truth about markets, it won’t surprise you when it finally arrives and it shouldn’t disrupt your sleep too much.
What’s the biggest worry for people near retirement or in retirement?
The biggest issue we hear from clients the past few years is a concern with outliving their money. By the time many of our clients retire—we have a huge age range among clients but I would guess the median is mid-50s—by the time these folks retire, human life spans will be closer to 90 than to 70. People have to plan for much longer retirements. Some folks are having trouble wrapping their heads around it, but that’s the overall trend.
What’s a potential answer? Although the traditional 60/40 portfolio is lagging somewhat because of the ultra-low-rate environment we’ve been in for the past decade, maintaining a fairly robust equity exposure that is global and intelligent in its construction really seems to be the best choice for most people. A conservative 50/50 model when you retire no longer makes a lot of sense.
We’ve seen active managers face a lot of questions and challenges in recent years. How do you think active management is going to evolve?
In any one year, 30%, 40%, even 50% of managers might beat their benchmark, but doing so consistently over time has proved quite elusive. That said, some people have demonstrated an ability, which is obvious after the fact, to select stocks or sectors or asset classes that have outperformed their benchmark.
If people want to take a percentage of their portfolio and put it in some form of active management, we don’t tell them that’s the worst idea, but we do want people to recognize the uphill challenge. Active managers tend to have much higher fees than you’d find with passively managed index funds. Be aware of the effect of fees, and the drag they put on returns.
I think the entire active space wildly overexpanded in the postwar period. They pay big salaries, charge big fees, attract a lot of the best and brightest, and suddenly it’s really hard to beat the market because 10,000 other people are doing exactly what you’re doing. There just isn’t that much outperformance to go around.
Bottom line, the shift to indexing is far from over, but I also don’t think active management is going away.
What’s your best advice for a millennial who is just starting out as an investor?
You have a time horizon of 40 to 50 years before you’re going to draw that money down. I would say start investing early, with a heavy emphasis on equities. Root for a market crash, which will let you buy stocks at a 30% or better discount. The reason people have a 60/40 or a 70/30 mix of stocks and bonds is that the bonds offset the volatility of the stocks. As you get closer and closer to retirement, you want to see less and less volatility.
Young investors don’t really need much of a bond portfolio. They should look at it as something that they’re not going to touch for decades. The ups and downs should be irrelevant. Don’t be afraid of crashes. When you’re young, they’re your best friend because they allow you to buy at sales prices. Learn to embrace volatility.
Stocks can be highly volatile and some investors wonder why they should take the risk. In your view, what makes stocks a good long-term investment?
Essentially, you’re betting on human ingenuity. Stop and think about how humans progress and how technology and societies move forward. One of the main purposes of Wall Street is to bring together the people who create new inventions and have new ideas with the people who have the capital. The stock market is essentially the place where ideas get funded, and those ideas subsequently change the world.
When you think about the standard of living that has consistently risen over the past century and a half, that typically takes place because some idea is funded and that funded idea becomes a company, and that company continues accessing the capital markets to grow. Its how prices for food and manufactured goods have fallen so significantly over the past century. And the pace of this is accelerating.
The stock market reflects all of the various growth engines of the economy of the country and of the world, and it’s most likely to generate the highest return relative to the risk investors assume over the course of their lifetime.
We live in an age of wonders. I love the idea that capital plus invention equals a raised standard of living with a side dish of dividends and economic growth.
When it comes to investing, most of us are naturally focused on getting the highest returns, but what do you think is really important?
You know, a lot of this goes back to the question: “What is money?” And I think a lot of people really misunderstand that very basic, very simple question. I look at money as a tool. Money exists; people accumulate money or work for money in order to exchange it for certain goods and services. Included in the list of goods and services are things like health care, security, education, experiences, etc. And so to just pursue returns for their own sake, while it’s fun and exciting and certainly entertaining for the people who engage in that, the question is what purpose does that serve for the average investor? And at what cost?
In the pursuit of outperformance, the typical investor underperforms. It seems like a kind of wasted effort with real negative ramifications for most people.
Putting returns aside for a moment, the reality is that most people need to start saving more. And depending on your situation, you may have to ratchet down your expectations of where you’re going to be at the end of a 20-year period.
But again, the relentless pursuit of outperformance, as we’ve seen in so many studies, as so much academic data has shown us, typically generates less returns than merely accepting the overall average market returns.
All investments are subject to risk, including the possible loss of the money you invest.
Diversification does not ensure a profit or protect against a loss.
Opinions expressed by Mr. Ritholtz are not necessarily those of Vanguard.