Quarterly Client Letter – Q4 2019
- January 17, 2020
- Investment Insight
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Dear O’Brien Wealth Partners Investor,
The holiday season brings with it time for reflection. As we pause to express our appreciation for our colleagues and our clients, and to gather with family and friends, we also take time to look back on what 2019 meant for financial markets and ponder what may come in 2020.
Perhaps the most notable dynamic in 2019 was the unusually strong – and almost universally positive – returns across both stock and bond markets. The S&P 500 was up a hefty 32%, international stocks jumped 22%, and even U.S. Treasuries were up 7%. These returns represent a sharp reversal from 2018 – where cash was the best performing asset class.
Renewed Federal Reserve (Fed) and other major central bank easing was the primary driver behind these gains. At the same time, actual economic activity slowed both in the U.S. and globally. Geopolitical uncertainty reasserted itself as well: be it in the form of U.S.-China trade tensions, Brexit uncertainty, riots in Hong Kong and elsewhere, the impeachment trial of President Trump, and the start of the 2020 U.S. election cycle.
As a result, we enter 2020 with the U.S. economy in a mature stage of expansion with swirling geopolitical uncertainty and generally elevated asset market valuations. Looking ahead, there is some potential for growth to improve as last year’s monetary stimulus continues to flow through the global economy, but the upside may be capped as long as business sentiment remains subdued. At the same time, the odds of imminent U.S. recession are likely to remain low as long as hiring and consumer spending remain strong.
Put together, another year of moderate growth in 2020 appears to be a reasonable base case.
This macro outlook implies there may well be additional asset market gains in 2020, and continued outperformance of risk assets – such as stocks – vis-à-vis more defensive assets – such as bonds. However, the magnitude of returns will likely be more subdued in the absence of additional Fed easing.
A key risk to monitor given this backdrop is the potential for renewed market volatility if something happens to unexpectedly disappoint markets. Volatility can be a nerve-wracking experience for investors. As such, we would like to share with you a behavioral finance concept known as myopic loss aversion that may help provide a framework for dealing with volatility when it inevitably reappears.
Behavioral finance is the study of why people make less than optimal decisions. For example, say you inherit $100,000 and you are talking with a friend over lunch about what to do with the money before going out of town. They mention there is a bank around the corner offering a 2% interest rate on new savings accounts. Two percent beats what you would get putting the money in your checking account, so you decide to swing by the bank and open up the savings account on your way to the airport.
All else equal, choosing a 2% return over basically nothing in a checking account is a good decision. But that doesn’t mean it was necessarily the optimal decision (hint: that would involve talking to us). You could have invested that money in stocks or bonds and in all likelihood earned more than 2% if you had more time to examine your options. This idea of choosing something that is good enough, rather than optimal, is known as satisficing and is at the heart of behavioral finance.
Behavioral finance can be further broken down into cognitive and emotional biases. Cognitive biases examine shortcuts we take when doing mental calculations. Emotional biases occur when our feelings and biases drive our decision making. Myopic loss aversion falls into the latter category.
Loss aversion is the idea that we feel the pain of losing a dollar twice as hard as we enjoy the pleasure of making a dollar. This results in investors having a tendency to sell winning investments too soon (over fear of them becoming losers) and holding losing investments too long (hoping they will bounce back).
[As an aside, we think loss aversion is also relevant outside of investing. For example, it is probably fair to say that Red Sox fans hate losing to the Yankees twice as much as they enjoy watching the Red Sox beat them. But we digress…]
Myopic loss aversion, in turn, occurs when loss aversion is compounded by the frequency at which portfolios are examined. Put differently, the more frequently investors look at portfolios the more likely they are to see those nasty negative red returns we all hate. In response, they tend to become more conservative in allocations over time – potentially preventing them from achieving their long-term investment goals.
These biases are inherent in all of us, and part of our value proposition to you is to help you identify them in advance and mitigate the adverse impacts they can create. Given the elevated potential for renewed volatility, consider this a call to action to take a step back and not let short-term movements cause you to lose sight of those long-term goals. Stocks, by their nature, are both volatile assets and key to long-term wealth creation.
If you have any questions or would like to discuss the specifics of your portfolio, please contact your O’Brien Advisor.
Your O’Brien Wealth Partners LLC Investment Team
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