[Note: This month's newsletter was prepared and authored by Dominic Corabi, one of our co-founders.]

Clients and friends, 

We hope this finds you and your families well as we approach the year end. 

As we reflect on 2024 from an investment market perspective, it is hard to complain. The markets have had an incredible run, with the S&P 500 up over25% year-to-date, international markets not far behind, and bond markets rallying after last year’s rapid rise in interest rates. The Federal Reserve has signaled that it expects to cut rates three times next year as inflation approaches the Fed’s long-term target of 2%. 2023 has been a welcome reprieve after the historically turbulent markets of 2022. At the beginning of the year hardly any of this seemed likely. 

We believe there is an important lesson here: predicting how the markets will perform over the short-term is akin to forecasting the weather 12 months in advance - as we attempt to show below - entirely futile.

Unfortunately, many investors believe otherwise, even when the evidence is so clear. Achieving investing success proves elusive for so many because they neglect the things that end up mattering a great deal, while trying to control the things that are, by definition, out of their control.  

So what matters a great deal? Selecting, monitoring, and maintaining an appropriate asset allocation that is informed by a robust financial plan; building, rebalancing, and drawing down that allocation tax-efficiently; aggressively harvesting losses; and keeping investment costs low. If you can get those things right, you have, more or less, maximized your chances of investment success. 

As we look forward to 2024, we will continue our focus on the principles that matter. And as always, if you need anything, please reach out to us at any time. 

Wishing you a Merry Christmas, happy holidays, and a joyful New Year. 

-Dom 

[Note: All market data is as of November 30, 2023. Special thanks to our colleagues at Avantis for compiling this data and allowing us to share it.]

As my kids are counting down the remaining days until Christmas, many market prognosticators are celebrating for a different reason: it’s market forecasting season! 

Every year around this time, we see “expert” forecasts on where the market will go next year. Many investors - both amateur and professional - rely on these predictions to inform their portfolio positioning. 

The problem? The experts aren’t very good at it… 

We looked back at past estimates from industry strategists to offer some perspective. As shown below, there tends to be a very wide range of projected outcomes across strategists. 

Figure 1 provides an example that plots 23 firms’ estimates of the S&P 500 Index level at the end of 2023. The results span a surprisingly wide 33% range and the majority of estimates have proven to be wrong in a dramatic fashion.

Figure 1 | Performance Estimates for the S&P 500 in 2023 Varied Widely

Look back further, we find this dynamic is not unique to 2023. In Figure 2, we show median, or, consensus, estimates from compiled industry strategist forecasts versus actual S&P 500 returns for year-to-date 2023 and the preceding five years. The results fall short of inspiring awe. For the five completed years, the estimation error ranged from 26% too low to 21% too high. On average, the median annual estimate was off by about 18 percentage points — nearly double the index’s long-term average annual return! 

Figure 2 | Consensus S&P 500 Estimates vs Actual Returns (2018 - 2023)

What we know is that stocks have positive expected returns, which are higher than what we should expect to achieve with bonds. But we also must recognize that this higher expected return is not a free lunch, and that the reason we are rewarded with better returns is because investing in stocks comes with significantly more volatility than investing in bonds. 

The long-term average returns and volatility (standard deviation) for stocks and various bond categories are presented in Figure 3.  

Figure 3 | Long-Term Average Returns and Volatility Across Asset Classes

Since 1928, stocks have had a positive annual price return (which does not include dividends and share buybacks) about 75% of the time, and the year-to-year performance of stocks has been uncorrelated, meaning that one year’s return can tell us nothing about the next year’s expected return, and vice versa. 

To put it in perspective, consider this analogy for the probability distribution of stock returns. Imagine a non-translucent bag with 15 green balls (positive market outcome) and 5 red balls (negative market outcome). Despite having a higher likelihood of picking a green ball than a red one, there is plenty of uncertainty about any individual draw. If you were playing a game of chance, the smart choice would be to guess that a green ball would be selected from the bag, assuming that the ball was replaced after every round (each outcome is independent of the last, similar to how you would expect the market to behave). 

It wouldn’t be that unusual to get 4 green balls in a row, but it also wouldn’t be that unlikely to pull 2 red balls in a row.  

Now imagine that a friend were to offer you this wager – if you pull a green ball out of the bag, she will give you $5. But if you pull a red ball out of the bag, you must give her $5. And after every round, the ball you just pulled gets put back into the bag, so at the beginning of every game, there are 20 balls in the bag, 15 greens and 5 reds. 

I suspect that the first thing you would do is to make sure your friend is feeling alright and doesn’t have to have her head checked, and the second thing you would do is try to raise the stakes. Both of these would be rationale decisions at this point. But she is not concussed and she doesn’t want to raise the stakes, so you play the game as she proposes. Before beginning, you verify that there are 20 balls in the bag, 15 greens and 5 reds. 

Right off the bat, you hit a streak of terrible luck, and pull 3 red balls in a row (this is an occurrence that should happen ~1.6% of the time). You look into the bag to make sure that your friend didn’t sneakily switch the balls while you weren’t looking, and you verify that there are still 15 green balls and 5 red balls. Should you stop playing the game? 

Unless you’re feeling bad in advance for taking your friend’s money, of course not! Regardless of what has happened in the past, nothing changes the odds in favor of green for the next draw. We know that if we look at a collection of many draws, greens will win about 75% of the time. It is almost certain that, if playing a large finite number of rounds of this game, a player will pull about 3 times as many green balls as red, even though there will also certainly be stretches where the unlucky player pulls a few red balls in a row. 

This game is not dissimilar to investing in the market. Figure 4 demonstrates that holding stocks for longer periods of time has historically resulted in a greater chance of realizing a positive return.  

Figure 4 | The Probability of Positive Returns Increases with Time

The game analogy has its limits, because investing in the market is subject to other variables that the game does not have to reckon with, such as drawdown risk, but we can derive certain lessons that apply to both. The most important is that the key to “winning” this game is to continue playing (e.g., staying invested in the market, even if you encounter a series of seemingly unlikely outcomes).  

You would have made a poor choice had you stopped playing the game after pulling 3 red balls in a row. Perhaps this would have been an understandable decision, because after all, how do you know that an invisible magician didn’t switch the balls while your friend was holding the bag, but it still would have been the wrong one. Likewise, trying to predict the market will almost certainly lead to worse outcomes than staying invested, even when it feels like “this time is different.” But don’t fret – it almost certainly isn’t. Just continue playing the game, all while knowing the odds are stacked in your favor.