Optimism is defined as the “hopefulness and confidence about the future or the successful outcome of something.”
Pessimism is defined as “a tendency to see the worst aspect of things or believe that the worst will happen; a lack of hope or confidence in the future.”
I think for most investors their degree of optimism and pessimism likely fluctuates with the performance of their investments and the overall market. When stocks are up, investors are generally happy and when stocks are down many get frustrated.
When Stocks Go Down, Expected Returns Go Up
But what many investors fail to realize is that future expected returns are actually better when prices go down. And so even though current portfolio values might be down, the expected future returns are higher.
Take 2022 and 2023 as an example. At the end of 2022, many investors were very negative on the markets as there were concerns of a hard landing, higher interest rates and inflation, global conflicts and cracks in the banking system. Even Wall Street strategists were forecasting muted returns for stocks in 2023. Fast forward to today, and the S&P 500 is up over 20% and the NASDAQ Composite is up over 37%, and even though these indexes are being driven by a handful of stocks there are plenty of stocks and strategies putting up double digit returns this year.
The chart below is a good example of the cost of bad timing. Isolating returns in 2023 alone, if an investor would have missed the five best trading days of the year, they’d be up 8% (vs. 19% if fully invested throughout the year). If you missed the 10 top performing days, you’d be down for the year. And the point JP Morgan made in this article, is the best days tend to cluster around the worst days, and so if you become pessimistic and move out of stocks you are likely hurting your returns.
The Cost of Pessimism
Popular financial podcaster and Canadian financial advisor, Ben Felix, recently posted an excellent video, “The (Expected) Cost of Pessimism”, where he walked through the research and evidence on why and how pessimism in investing can detract from long-term returns. There is a wide body of empirical finance research around this topic that investors can learn from.
Felix outlines a number of ways to combat the cost of pessimism, including checking your investments less frequently and finding ways to automate your investing contributions, among others.
Here are a few additional considerations that can help the long-term investor stay in the optimistic camp.
Understanding Markets: One of the reasons stocks reward long-term investors is because in the short term they are risky and unpredictable. Over the last 25 years, we have seen four bear markets (1999-2002, 2008-2009, 2020, 2022) and numerous market corrections (10% losses). And yet a $100,000 investment in the S&P would be worth just shy of $700,000 today. In order to make your money grow you have had to endure these types of drawdowns and those investors that maintained discipline and saw through to the other side were rewarded.
Independent & Balanced Thinking: Felix highlights how negative biases in the financial media have a larger impact on investors’ overall perception of market crashes and future declines. You don’t have to look much further than YouTube to see how videos about the end of America or why the stock market is going to collapse get tens of thousands of views. If you are seeking this type of information out, there is a good chance the algorithms are going to continue to feed you this information and you can get trapped in an echo chamber of bad news. This is why it’s important to maintain a balanced approach and look for independent sources of information that have a track record of success and talk in probabilities (vs. certainties).
Seek Out Feedback: Imagine if before every trade, you were able to call a financial advisor or get some outside perspective, just to make sure you were seeing things clearly and not making a poor, short-term decision. Some investors have access to advisors but many don’t or don’t choose to include advisors in those decisions. Well, what if before a any trade an A.I. chatbot could look at the trade and give you some feedback. Below is an example what this could look like – I asked ChatGPT the pluses and minuses of sell Berkshire Hathaway and moving into a tech-heavy mutual fund. It’s a pretty solid response. We may find that A.I. could be helpful in the investment decision making process by giving feedback on the pluses and minuses of a decision and highlighting pieces of information they we may not have thought about or through completely.
Lean Into Optimism
Understanding where you fall on the optimistic / pessimistic spectrum is important because this will help determine how much volatility you can withstand and how to position your portfolio in a way that delivers the best return for you. But if you’re an equity investor and have a long-term time frame, I would encourage you to lean into the optimistic side of things because the odds of building wealth and growing your portfolio are much better.
Here is how I prompted ChatGPT:
I own Berkshire Hathaway in my investment account. I am thinking about selling it and reinvesting the money in a tech heavy mutual fund. I am a long-term investor, with a 10+ year time horizon. I am disappointed in the returns of Berkshire and tech has been performing very well in this market. What are the pluses and minuses of this decision. Explain it to me in a way a financial advisor might explain it to a client.
As a financial advisor, it’s essential to consider both the advantages and disadvantages of shifting your investment from Berkshire Hathaway to a tech-heavy mutual fund, especially given your long-term investment horizon of over 10 years.
Advantages of Investing in a Tech-Heavy Mutual Fund:
- Higher Growth Potential: Technology stocks have demonstrated strong growth potential, particularly as technological innovation continues to accelerate. Investing in a tech-heavy mutual fund could expose you to companies at the forefront of trends like artificial intelligence, e-commerce, cloud computing, and more, which may offer higher returns.
- Sector Diversification: If your current portfolio is underexposed to the technology sector, this move can diversify your holdings, potentially reducing risk and enhancing returns.
- Alignment with Market Trends: The technology sector has been a major driver of market performance in recent years. If this trend continues, being invested in a tech-heavy fund could be beneficial.
Disadvantages of Investing in a Tech-Heavy Mutual Fund:
- Higher Volatility: Technology stocks can be more volatile than the broader market, including stocks like Berkshire Hathaway. This means you might experience more significant fluctuations in the value of your investment, which requires a higher risk tolerance.
- Sector Concentration Risk: Overexposure to one sector can increase risk. If the technology sector faces a downturn, your portfolio could suffer more than a diversified portfolio would.
- Valuation Concerns: Some technology stocks have high valuations, which means you could be buying at a high price, increasing the risk of a correction.
- Potential for Market Shifts: Market trends can shift, and sectors that have performed well historically are not guaranteed to continue doing so. It’s essential to consider whether the current success of tech stocks is sustainable over your investment horizon.
Regarding Berkshire Hathaway:
- Stability and Diversification: Berkshire Hathaway’s portfolio is diversified across various sectors, providing a more stable investment with lower volatility compared to a sector-specific fund.
- Proven Track Record: Led by Warren Buffett, Berkshire Hathaway has a long history of solid performance and value investing, which might align well with your long-term investment strategy.
- Recent Performance Not Indicative of Future Results: While you might be disappointed in its recent performance, it’s crucial to remember that past performance isn’t always indicative of future results. Berkshire’s conservative approach could be beneficial in market downturns.
- Opportunity Cost: Selling your shares in Berkshire Hathaway to reinvest in a tech fund also involves opportunity costs, especially if Berkshire’s diverse portfolio starts outperforming tech in the future.
Your decision should be based on your risk tolerance, investment goals, and belief in the future performance of the technology sector versus a diversified holding like Berkshire Hathaway. Diversification is key in any long-term investment strategy, so consider balancing your investment in both rather than moving entirely from one to the other. It’s also wise to consult with a financial advisor who can provide personalized advice based on your entire financial situation.