“Opportunity is missed by most people because it’s dressed in overalls and looks like work.” Anonymous (though often attributed to Thomas Edison)
2018 got off to a bit of a bumpy start – volatility returned to financial markets and most asset classes posted negative returns in the first quarter. In the second quarter, investors continued to be buffeted by strong cross currents in the news. On the positive side, U.S. companies grew earnings by 26% year-over-year in the first quarter, the highest growth rate in earnings in seven years. Offsetting that good news, investors continued to fret over a potential trade war and the potential for slower economic growth as a result. This was all against the backdrop of the Federal Reserve continuing to slowly reduce its balance sheet and raise interest rates. From a performance perspective, the second quarter offered investors a bit of a reprieve as several asset classes bounced back vigorously from first quarter losses, though fixed income markets had a rough quarter as interest rates continued to creep upwards.
MLPs and REITs are two asset classes that benefitted from dramatic rebounds in Q2. By way of example, following a dismal first quarter of -11.12%, the Alerian Energy MLP, a benchmark for MLP investments, roared back in Q2 posting an 11.80% return. Similarly, following a -7.48% first quarter, Wilshire U.S. REIT, a benchmark for REIT investments, finished with a strong 9.73% return in the second quarter. In a quarter where stocks offered a mixed bag of returns and bond markets struggled, maintaining exposure to diversifying asset classes such as MLPs and REITs paid off handsomely for investors.
Performance in stock markets varied greatly depending upon country, market capitalization, and sector. The best performing equity asset class in the second quarter was U.S. Small Cap (Russell 2000), which was up 7.75%. U.S. Large Cap (S&P 500 Composite) was also up for the quarter, but a more modest 3.43%. Foreign stocks, however, posted losses for the quarter. Some of this loss was due to the strengthening of the U.S. dollar, which had a negative impact on U.S. investors allocating capital in foreign markets. From a sector perspective, energy stocks were the best performers for the quarter, up 10.2%, and financial stocks were the laggards, down 5.6%.
In bond markets, rising rates continued to be an impediment to returns. The Federal Reserve raised rates another 0.25% in June, staying on target for an anticipated one or two more rate hikes this year. The broad U.S. bond market (Bloomberg Barclays U.S. Aggregate) fell -0.16% in the quarter. Short-to-intermediate-term municipal bonds (Bloomberg Barclays Municipal Bond 5Y) held up better in the quarter, posting gains of 0.87%.
We have previously commented in these commentaries that forecasting is hard, and that basing one’s financial decisions on the ability to foretell the future is an often futile pursuit ending in a disappointing result. As an illustration of this difficulty, let’s briefly consider the impact of a rising U.S. dollar and its implications for investors. The dollar strengthening has been driven by several factors. The strong U.S. economy makes the U.S. an attractive market in which to invest, which draws foreign investors and increases demand for dollars. In addition, rising interest rates also draw capital from overseas, further increasing the demand for dollars. The stronger dollar increases purchasing power for U.S. consumers, but it can cause U.S. exports to be less competitive on price hurting U.S. companies that are reliant on exports. So while stock market investors benefit from having foreign investors buying U.S. assets and driving up equity valuations, they also suffer as many U.S. companies lose revenue, either from falling exports or from cheaper competition from imports. Investors buying U.S. bonds due to rising rates in turn drive up bond prices, which mitigates further increases in bond yields. These buyers may be partially responsible for the flattening U.S. yield curve. And all of this is occurring against a back drop of escalating trade tensions and rising protectionism. For anyone trying to develop an investment strategy based upon how this all turns out – good luck.
We’ll continue to do the hard work. Diversifying exposures across a broad range of complementary asset classes. Rebalancing portfolios when needed to maintain appropriate exposures. And remaining as tax-aware and cost-conscious as possible. It’s not as exciting or glamorous as predicting the future. But sometimes boring and reliable, even when dressed in overalls, is best.
Traditional economic theory suggests human beings behave rationally when making decisions. In other words, humans, on average, act in such a way as to maximize fulfillment of their needs and desires. Since earning wealth is assumed to be a good thing, and more wealth is assumed to be better than less wealth, it is further assumed that people make rational decisions in order to maximize their wealth. This rationally acting person is sometimes referred to as Homo Economicus (Economic Man).
However, traditional economic theory often does not match how people make decisions in the real world. Research into Behavioral Finance, led by Nobel laureates Richard Thaler (for Economic Sciences in 2017) and Daniel Kahneman (for Economic Sciences in 2002) has revolutionized the way we think about how people make financial decisions. Instead of being purely rational humans that dwell exclusively in the minds and models of economists, behavioral economists have shown that mankind’s decision making is heavily influenced by emotion and irrationality. However, the real insight isn’t that people make decisions in an emotional and irrational manner, but rather we are all predictably irrational.
Human beings crave certainty and are comforted by feeling right. When we feel certain and right we feel a sense of security and comfort. In order to get this sensation, which is called cognitive ease, we seek out information that is familiar, easy to understand, and validates our pre-existing beliefs. Humans have developed a number of mental shortcuts that help us understand the world while maintaining as much cognitive ease as possible. These good enough mental shortcuts, or heuristics, while not optimal or perfect, are often sufficient to meet our immediate goals. While heuristics ease our cognitive load, they can also lead to cognitive biases that by their very nature are distortions or errors in thinking. Heuristics allow us to experience a sense of cognitive ease, which makes us feel good, but distortions and errors they cause can actually decrease our understanding of the world.
Nobel laureate Daniel Kahneman says our brain has two systems. The first utilizes heuristics and provides fast, intuitive responses that govern most of our daily lives. The second activates cognitive effort and is much more energy intensive. System one, the conscious part of the brain, is kind of lazy and doesn’t want to work more than it has to, so it is just fine with utilizing heuristics to make decisions and explain the world. It’s more than happy to let the unconscious part of the brain do all the work. Because these heuristics and the subsequent cognitive biases they engender operate at the unconscious level, we aren’t even aware of them unless we make a diligent effort to recognize them. In fact, even when confronted with the evidence, our first reaction is to deny that we have these biases. To be human is to have cognitive biases. In this year’s Investment Perspective, we will examine several types of cognitive biases, reflect on the errors they can potentially cause, and propose several methods of dealing with and overcoming these biases which affect us all.