Broker Check

An Interesting Question...

August 02, 2023

A few weeks ago, a poll posed a fascinating question for investors: “Would you rather outperform during bull or bear markets?".  

To my shock and amazement, by a margin of nearly two to one (63% vs. 37%), respondents expressed that they would rather outperform in bear markets than bull markets. 

I simply cannot grasp that concept, although with what I know of the extreme irrationality of human nature, I really shouldn't be surprised. It only makes sense, especially with investors, given their propensity to panic. 

Imagine thinking, “I would rather see my portfolio decline less during the market’s frequent but relatively short and temporary declines, even though this may be significantly less profitable for me in the long term."  Investors willing to sacrifice long-term, superior, inflation-killing investment performance so as not to lose as much during temporary and brief declines might want to seek the guidance of a good financial professional. 

Imagine being so gripped with fear that this is their way of thinking and actually adopting it as part of their investment policy statement. 

Of course, maybe it's not their fault. Perhaps they have become so indoctrinated with fear from the bias of the financial media; after all, who wouldn't become fearful when there’s 24/7/365 reporting on the next crisis (real or imagined) and its effect on your retirement? 

The more significant issue for me is that when you look to minimize the temporary declines in your portfolio, that usually means adding bonds and adding bonds to your portfolio under the pretense of "outperforming in a bear market," which can be a fatal mistake to your financial plan. 

It begins when you change your portfolio strategy from owning enduringly successful companies. Instead, you lend to them (i.e., buying bonds, essentially loaning those successful companies your money in exchange for a fixed interest rate over a pre-determined time).   

What happens when you go from ownership of great companies to lending to them? Chiefly is the fact that, roughly over the past century, the average annual compound rate of total return from mainstream equities has been seven percent net of inflation. In contrast, at three percent, comparable bond returns have been less than half that. 

Take a look:



Why would anyone pay such a steep price to avoid a temporary decline? 

That's a tricky question to answer. 

Maybe human nature guilts us into avoiding the pain of temporary loss. Nobel laureate Richard Thaler says, "Losing money feels twice as bad as making money feels good.”  I have to think this quote alone gives the panicked investor reason to believe that in each succeeding bear market, "This time is different.” 

When in reality, it is not. Bonds are bonds, and equities are equities, no matter the environment.  

When investors buy bonds during a panic-driven temporary decline, an intriguing question arises: "Why do well-established, soundly financed, consistently profitable companies borrow money by issuing bonds?” 

I can only think of one answer: They're convinced they'll be able to invest borrowed money at a far greater return than what they pay in interest. No need to make it more complicated than that. 

The companies that comprise the S&P 500 index, whose market capitalization is currently in the neighborhood of $35 trillion, don't become members of that index without providing good stewardship of shareholder capital. They know and understand that they can provide greater value to their shareholders by borrowing money. 

And if they can’t earn a greater return on their borrowed capital than their borrowing costs? Simple, they don't borrow.  

It’s because of the simple principle that companies are and must be good stewards of their owner’s long-term capital – otherwise, they cease to exist.   Just ask Peabody Energy, JCPenney, Eastman Kodak, or Goodyear Tire, as these companies have all been removed from the S&P 500 Index because they failed to be good stewards of shareholder capital.  

I will gladly concede that bonds can be an essential part of a portfolio. The danger comes from simply adding them to avoid temporary declines. In these temporary declines, your investments are most susceptible to panic and fear, which may lead to making bad decisions at the worst possible moment. 

Avoiding those bad decisions when panic and fear are at their greatest might be the difference in getting you closer to the ultimate goal:  Spending time doing what you want, with who you want, when you want, and for as long as you want. 

Stay the course, my friends.