Most people are only too ready to turn the page on 2020 and look forward to better times ahead. While that’s understandable, it’s worth taking a look back to draw some investment lessons from the difficult year we just lived through.
One major lesson investors should draw from 2020 is that risk is what you don’t see coming. Everyone naturally evaluates the risks of investing based on what they know but give far too little thought to what they don’t yet know or can’t know. The global pandemic was a perfect example of this.
We knew a pandemic was possible, but it was a low probability, high-impact event—a black swan in the words of author Nassim Nicholas Taleb. It didn’t figure into the risk scenarios of most analysts and market pundits.
In fact, we often treat the improbable as impossible. When we see 20% chance of rain, we tend to assume it won’t rain. However, if it rains 20% of the times the weather calls for 20% chance of rain, then the forecast is bang on.
A more impactful example was the high degree of confidence the U.S. media had that Hillary Clinton would defeat Donald Trump in the 2016 presidential election. In fact, “Clinton simply wasn’t all that much of a favorite,” says Nate Silver, head of the FiveThirtyEight website in an article titled The media has a probability problem. “She had about a 70 percent chance of winning according to FiveThirtyEight’s forecast, as compared to 30 percent for Trump.”
A low probability obviously doesn’t mean impossible, but our biases lead us to underestimate small probabilities. As fund manager Morgan Housel observes in this article, the biggest risks are the ones that no one expects because we aren’t prepared for them, and that lack of preparation amplifies the damage when they come, often in a climate of panic.
In recognition of this cognitive bias, our portfolios are designed to not only take advantage of market gains, but also prudently protect against the permanent loss of capital by broadly diversifying across asset classes and geographies. This is also why, despite very low interest rates, bonds remain a relevant asset class in all portfolios.
A related lesson to take from 2020 is to ignore the market pundits. This is good advice every year, but particularly in 2020. None of the major forecasts for 2020 released in late 2019 predicted a global pandemic. Yet, again at this time of year, all the major banks and investment houses are coming out with their predictions for the year to come. They are largely useless.
That said, while annual fluctuations are like Sea-Doos darting back and forth, some long-term trends are more like ocean liners, steaming ahead and changing course only slowly. It’s on the basis of these long-term trends that we base our return expectations for financial planning.
We don’t expect returns over the next 10 years to be stellar because both inflation and interest rates are so low today. Indeed, both Vanguard and PWL’s own research show long-term return expectations that are similarly modest.
Nevertheless, while keeping in mind the difficulties, and in some cases tragedy, so many have experienced in 2020, we look forward to the new year with optimism and wish everyone a healthy and prosperous 2021.