Special to the Financial Independence Hub
The vast majority of today’s portfolios represent a Pavlovian response to the obliging nature of markets over the past several decades. The unprecedented increase in the value of risk assets coupled with low volatility have lulled investors into a false sense of security accompanied by an “if it ain’t broke, don’t fix it” approach to portfolio construction and risk management.
Most portfolios are dependent on the next few decades mimicking the last few. Specifically, they are over-allocated towards assets that have performed well during the secular (yet unusual) goldilocks environment of the past 40 years. As is typical of human behaviour, investors are looking in a 40-year rear-view mirror to avoid hitting something that may be in front of them.
What is Normal?
The past four decades have been unusually kind to investors. Strong tailwinds of favourable demographics, low inflation, falling rates and globalization have fueled an unprecedented rise in stocks, bonds, real estate, and almost every other major asset class. While it would be nice if these conditions were the norm, the fact is that they are unique from a long-term historical perspective.
An astounding 91% of the total price appreciation of a classic 60/40 equity/bond portfolio over the past 90 years is attributable to 22 years between 1984 and 2007. This period was also an atypically strong period for real estate, representing 72% of total appreciation over the past 90 years.
Notwithstanding some painful bumps along the way, including the tech wreck of 2000-2002 and the global financial crisis of 2008, the investing experience of most people today has been a proverbial walk in the park. An entire generation of investors has never experienced anything like the 86% peak-trough decline in equities of the 1930s which resulted in two decades of lost performance. Nor has it faced anything remotely like the 25% decline in U.S. Treasury Bonds during the stagflation-plagued 1970s.
What If?
Nobody (including us) can know for sure what the future holds. However, there are strong reasons to suspect that the road ahead will be drastically different than the unusually smooth path we have been on for the past several decades. Historically high asset valuations, record corporate and sovereign debt levels, $17 trillion in negative yielding debt, the lowest capital gains taxes in U.S. history, historically high income disparity across the developed world, and a global rise in populism and protectionism all suggest that, as Dorothy stated in The Wizard of Oz, “We’re not in Kansas anymore.” Continue Reading…