The protégé to Milton Friedman and great economist Thomas Sowell is a personal hero of mine. One of his books Economic Facts and Fallacies is the inspiration for a series of posts I will be writing on this blog titled Myths & Fallacies. My posts will be economically related, but will focus specifically on investing, financial planning, and capital markets as always.

Too often folks equate stocks with risk. This is a fallacy. The idea that more stocks equals more risk or that less stocks equals less risk is a myth. It is true that stocks are much more volatile than bonds over short-term periods. Volatility or short-term unpredictability should not be used interchangeably with risk.

Risk is the potential of gaining or losing something of value. Stocks and bonds both have the potential to lose value. Stocks have a much higher probability of losing value from day-to-day or even year-to-year than bonds have, and too often that leads folks to say things like “bonds are safer than stocks.”

Is that really true though, are bonds safer than stocks? If your definition of safe is a higher probability of lower long-term returns with less short-term volatility, then yes, bonds are safer.

That is not my definition of safe, and hopefully it is not your definition either. I think the safest investment is the one with the highest probabilities of success. There are no certainties when investing, only probabilities.

Think about this, over 20-year rolling periods stocks have outperformed bonds 97% of the time, and have an average a cumulative return of 908% vs. a cumulative return of 247% for bonds. Over 10-year rolling periods stocks have outperformed bonds 82% of the time and have a cumulative average return of 209% vs. 80% for bonds.

If you had two different options for placing a bet, and one had significantly higher probabilities of winning with a better payout; wouldn’t you do that one? Of course you would.

Many investors mistakenly invest too heavily in bonds, and not enough in stocks. They do this, because they think they are doing the safe and conservative thing.

The reality is that feeling safe and investing too conservatively, is often the riskiest thing an investor can do.

More stocks DO NOT equal more risk in a portfolio. The “risk” of the portfolio should be defined by its likelihood of meeting the objectives of the investor. Given the time horizon and goals of the investor there are many instances where adding more stocks to the portfolio will increase the probabilities of success and therefore actually reduce the “risk.”

Don’t you see what’s happening? Potter isn’t selling. Potter’s buying! And why? Because we’re panicking and he’s not. That’s why. He’s picking up some bargains. Now, we can get through this thing all right. We’ve got to stick together, though. We’ve got to have faith in each other.
George Bailey – It’s a Wonderful Life

That quote is from one of my favorite movies, and it is very appropriate given the current market environment. In this scenario the hero George Bailey and the bad guy old Mr. Potter prove to be strong investors. They both see the big picture, they see the long-term perspective, neither character panics, and both maintain faith in the future despite a murky present.

As of yesterday the Vanguard Total World Stock (VT) was at -10.33% for the year. Starting this week the S&P 500 was at -7.93% and the MSCI EAFE was at -8.79% for the year. Since the first trading week of 2016 markets have been dropping, and they have been dropping fast.

My recommendation is to be like Mr. Potter and George Bailey. Do not let the emotion of seeing account values fall dictate your actions. If for some reason you have extra cash within your portfolio, put it to work. Price movement alone should never dictate your investment actions.

The current market downswing is one of two things. It is either a correction within a continuing bull market, or it is part of a new bear market cycle. Neither is provable while occurring, we will not know which is occurring with certainty until we are able to look back.

If it is a correction, the play is simple. As investors we should hold our positions confident that our asset allocation is appropriate for our goals, time horizon, and cash flow needs. We should sit back and put our feet up, while the weaker investors weed themselves out and inevitably whipsaw their returns.

If it is part of a bear market cycle, the play to make is more complicated. If this was a bear market that was preceded by over enthusiastic market sentiment with wobbling economics/fundamentals (like what we see in China), then we would have considered going defensive prior to now.

Hundreds of years of market data have proven that an investor can achieve very strong returns while taking the full brunt of bear markets, as long as they do not miss out on the Bull market cycles. When an investor takes a defensive position or takes money out of stocks, they are betting against hundreds of years of data that says “when in doubt, hold and wait.” Investors can predict bear market cycles and position portfolios accordingly. Accurately predicting bear markets can help an investor achieve superior long-term returns, but it is very very difficult. It is also the most dangerous move an investor can make, because the investor risks being wrong and missing out on bull market returns.

I think that we are in a correction and not a bear market, because I do not see material change in the world from three weeks ago. I do not believe the global economy is threatened by slower growth in China or low oil prices. As I see things, the likelihood of a recession in the US or Europe is low.

The USA and international developed economies are still poised to grow at the low but steady level of 2-3%. Exports to China account for less than 1% of US GDP, and exports to China account for less than 1.5% of Eurozone GDP. Volatility and/or a bear market in Chinese equities could lead to a period of heightened volatility globally, but will not lead to a global bear. The equity prices in China were drastically overbought given the fundamentals of the underline companies, and they crashed much like tech stocks in 2000, or all stocks in 1929. There should not be any contagion for global developed stocks or their underline companies.

Low oil prices or low energy costs hit energy companies hard, because they are very price sensitive. Low energy/oil prices act almost as a tax cut for consumers though. Consumer spending is a much bigger portion of GDP among developed economies than energy is. Low oil prices are a wash economically, or perhaps even a net positive.

Of course the market is a master at humiliating investors and maybe I am its next victim. That is why asset allocation, the correct mix of stocks, bonds, and cash is so incredibly important.

I like to listen the sports radio show The Herd with Colin Cowherd. Colin makes a lot of observations and bold predictions on his show. He also does a segment called Where Colin was Right and Where Colin was Wrong in which he reviews how his predictions panned out.

I am going to do the same, regarding my take on the markets for 2015.

Where I was Right: While the global markets had very flat returns, the bull market continued. An investor should only take a defensive portfolio position if he/she is confident in the imminent oncoming bear market. Otherwise investors should remain fully equitized within the framework of their asset allocation. The dangers of missing out on potential positive returns are great than being hit with potential negative returns.
Where I was Wrong: I fell into the Fed “predicting game” trap. I thought the Fed would raise rates much sooner than they did. I thought we would have at least one rate hike by the end of summer, and the first rate hike did not come until December.
Where I was Right: Large-Cap Outperformance: From a size perspective large-cap, and more specifically large-cap growth outperformed the other size categories 2016. This was the overarching theme of my managed portfolios and it paid off. Large-cap stocks outperformed mid, and small caps. I had portfolios overweight to large and mega caps, and overweight towards growth which outperformed value in 2016.
Where I was Wrong: Financials were essentially flat relative the market in 2015. I expected the financial sector to benefit from rising interest rates and have outperformance which led me to position portfolios with a slight overweight relative to benchmark. The rising rates did not come until December and the outperformance never came.
Where I was Right: On August 21st I made a post advising investors not to panic sell their stock positions. I said that the market appeared to be going through a classic correction and that the right course of action was to hold. It turned out to be a classic correction, which was over with almost as quickly as it started.
Where I was Right: Greece was overblown. In the early part of 2015 there was great worry that the global economy and markets were vulnerable due to problems in Greece. The impact Greece has on the global economy/markets was always overblown, and I said just that.