The world of investing is a complex one to say the least. As an investor, you’re constantly challenged to make sense of global economies, corporate financial statements, and geopolitics (among other factors) while trying to form an educated opinion about where to invest your money.
Based on this reality, it seems like superior intelligence would help you on your way to investment success. And yet Warren Buffett, one of the most legendary and successful investors of our time, once said, “The most important quality for an investor is temperament, not intellect.”
In the intricate, complex world of investing, how is it possible that anything other than intellect could be the most important quality of a good investor?
As it turns out, looking at the past 12 months might give us a good idea of what Buffett meant.
When “Average” Feels Like Anything But
Through the end of the first quarter, the S&P 500 was up 7% over the past year. While slightly lower than the index’s long-term average, that performance is in line with what an investor might expect in any given year. But how we got this result felt anything but normal.
Combining the 2nd and 3rd quarter of 2018, the S&P 500 was up more than 10%. The index produced a 6-month return that exceeded historical 1-year average returns. The market then promptly took a nosedive in the 4th quarter, declining almost 20% at its low point before lifting slightly to finish the quarter down 14%.1
This was the S&P’s largest intra-year decline since 2009.2 It spurred many investors to stick their heads out their windows to check the sky to see if it was falling. But that was 2018; this is 2019 — and the market came storming back to finish the 1st quarter of the new year up 13%, the best quarterly performance in nearly a decade.
Put all that volatility and tumult together and what do you have? Intellectually, it resulted in a very average 12 months as measured by the 1-year return. Despite that, most investors wouldn’t use the word “average” to describe their feelings about the past year.
It Just Won’t Go Away: US & China
The ongoing trade dispute between the U.S. & China contributed to the rough patch to close out 2018 as well as the market bounce in the 1st quarter. As previously discussed in past commentaries, the ongoing conflict has put pressure on the world’s two largest economies and been a drag on global growth due to the uncertainty it has created.
The biggest change in this situation since the end of the 4th quarter has been the market’s perception of the proximity of a resolution, shifting from skeptical to optimistic. However, it would be premature to suggest the worst is over despite promising news headlines. Investors should brace for continued market fluctuations until the US and China officially come to an agreement.
A Flip-Flopping Fed Created Unease (Even As It Contributed to a Market Upswing)
The Fed’s interest rate policy has come under increased scrutiny over the past year. In 2018, the Fed raised their short-term rate four times as the unemployment rate fell, wage growth increased, and overall economic conditions improved.
On the heels of a nearly 20% drawdown in the S&P 500 in the 4th quarter, lower economic growth projections, and declining consumer confidence, the Fed recently announced they would be patient with future rate hikes.
The change in Fed policy has left the market expecting no further rate hikes for 2019. The expectation of lower short-term rates for longer, which incentivizes consumers to borrow and spend, was another catalyst for the market bounce in the 1st quarter.
Is an Inverted Yield Curve the Death of Economic Expansion?
As the current market expansion turns 10 years old, investors are starting to ask the question, “When will the music stop?” Some have pointed to the risk of a yield curve inversion, which occurred in March.
A yield curve inversion occurs when short-term interest rates are higher than long-term rates. Investors view this as a bearish sign for the economy given its reasonable (though not perfect) accuracy in the past in predicting economic downturns.
We caution investors from jumping to broad conclusions based on one economic data point. A preferred tool for many economists for gauging possible downturns is the Conference Board Leading Economic Index.
The index includes 10 economic indicators (not just one) that evaluate the health of the economy. While the index declined in recent months, its current level does not indicate an imminent recession — especially when you consider we’re seeing a low unemployment rate, solid wage growth, low inflation, and positive corporate earnings growth, too.
Regardless of what economic tool one chooses, recessions are incredibly difficult to predict. Even after past yield curve inversions, the economy and stock market performed well for some time. We would strongly caution long-term investors against trying to time the next market downturn as doing so is likely to cause more harm than good to one’s financial plan.
Temperament Over Intellect
If you had done your best Rip Van Winkle impersonation for the past year, you’d have woken to find the S&P 500 to be up just below its annual average, which is barely news. If you had only taken a 6-month cat-nap, you’d see the market basically unchanged.
What you would have missed, however, were two of the most volatile quarters in a decade that saw a double-digit decline followed by a double-digit rally.
And if you had stayed awake over the past 6 months (as most of us presumably have), watching your portfolio would have felt like riding a roller coaster complete with big plunges and huge climbs. That feeling can be difficult to stomach, often causing investors to hop off the ride at the bottom and get back on at the next peak.
This is what Buffett meant in suggesting that temperament matters more than intellect. Most of us know, intellectually, that investors can combat that stomach-churning feeling by owning the right mix of stocks and bonds relevant to one’s risk tolerance and time horizon. Yet most people allow their emotions to drive their investment decisions especially during rocky times like the past 6 months, leading them to buy when they feel good and sell when they feel bad.
The success of the long-term investor is predicated on one’s ability to display a disposition that doesn’t get too low at market bottoms nor too high at market peaks. By focusing on their tolerance for risk and time horizon of their financial goals, investors can avoid letting short-term market gyrations alter their long-term financial goals. It’s this type of investor temperament that will succeed over intellect each and every time.
Source: 1,2 Morningstar
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