As Romney and Santorum jockey for position in the Republican primaries, the stock market continues to roll, with the S&P 500 setting a multi-year high last week. Neither rising gas prices nor the prospect of the umpteen Greek bailout has roiled upbeat markets so far this month.
Market Future Ultimately Unknowable
Stock markets have risen despite reporters and financial gurus predicting calamities from a collapsing dollar to an imploding Europe. What gives?
The future direction of a particular asset class -- a group of securities such as stocks, bonds, or cash -- can't be forecast with any certainty. Years of research tells us that asset classes behave unpredictably. No guru, however well credentialed, knows what will happen in the markets this or any other year.
"For decades, top economists and scientists have been carefully studying ways to predict the movement of the public markets," notes the MarketRiders blog. "Their conclusion "“ it can't be done."
The take away? The future is not knowable. Rather than pin everything on stocks, bonds, or cash, it's better to own a combination of asset classes. Broad diversification works better over the long run.
Economic Forecasters Court Folly
Here's another case in point: as the architect of monetary policy, you would think that the Federal Reserve Board would know where the economy was headed. That's because the Federal Reserve sets interest rates, which affect everything from mortgage rates to yield on certificates of deposit.
But that's not the case, according to Larry Swedroe, who cites William Sherden's book, The Fortune Sellers, on the folly of heeding economic forecasters. It not productive and dangerous, because it can lead investors to believe they know more than they do. Such folly produces investment bubbles such as the Tech Stock Bubble of the 1990s and can lead to major investment losses.
"Among Sherden's findings was that economists forecasting skills are about as good as guessing," Swedroe notes. "It didn't even matter if the forecasts were coming from those directly or indirectly involved in running the economy."
Last Year's Losers are Winning this Year
NaÃ¯ve investors tend to chase performance by betting heavily on the sectors of the stock market that have performed well recently. That's a mistake. A phenomenon known as reversion to the mean tells us that any given asset class tends to provide returns at or near their long-term average. So recent, hot performance is usually followed by cold performance, and vice versa.
While there is no way to know how long a particular asset class will perform better or worse than average, we do know that markets eventually self-correct. Tech related stocks went on a tear in the late 1990s; that bubble ended abruptly and badly for investors in 2000.
This column points out that last year's stock losers haveso farbecome this year's winners.
Chasing Yield May Be Tempting, But The Hazards Are Real
Interest rates are very, very low. That's bad news for investors who rely on bonds, CDs and other fixed income investments for income.
That income -- or yield "“ is the amount of interest a bond, CD or dividend stock returns in a given year. This income, in combination with the gain or loss an bond, stock or mutual fund returns during a period of time is that investment's total return.
To achieve a better yield or total return, you need to take more risk. There is no reward without additional risk. It's a zero sum game as this article from Vanguard points out.
The Bottom Line
You can't know where to invest by looking at past performance, and you can't know where to invest based on what the gurus tell you about the future. The only thing you can do is determine how much risk is right for you, then diversify broadly and be patient.
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