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How the Market Works, Semi-Retired, Retired

How the Market Works:  Rear Window Investing

Posted by kdadmin on March 24th, 2017.

How the Market Works:  Rear Window Investing

On March 1st, I had a conversation with a fellow who wanted me to get out of bonds and buy stocks. His sole rationale was that stocks had recently done better than bonds. Obviously, I refused. Looking at the chart above, I’m glad I did.

His rationale is called rear window investing. It’s the same as looking backwards while driving forwards. Everything is fine until the road curves …

The Backtesting Myth

One of the most obvious tells of a dubious investment strategy is its dependence on backtesting. The hard sell is usually for some investment subscription or newsletter that gives signs or signals or tips about when to buy or sell stocks based on some “unique system” that was backtested over the last 80 years and came out a winner.

The problem with this theory is that backtesting is itself devoid of any actual testing. All the variables are known. There is nothing to test. If the “unique system” has access to all the performance data over the last 80 years, for every investment option, don’t you think the programmer can build a “system” that somehow magically wins every time?

Now, the true challenge of investing is going forward. It’s a lot harder to succeed when you don’t have performance data for any of the investments. After all, nobody can predict the future.

Risk vs Reward

Let’s go back further. Over the last three months, the market has begun to digest the new administration, slowing GDP, rising interest rates, economic stimulus in Europe and near full employment. Notice how stocks did 3.69%, long term bonds did 1.97%, and aggregate bonds did 0.96%?

How the Market Works

Remember, however, that the worst one year loss in the stock market during the Great Recession was -67%. Whereas the worst one year loss in the long term bond market was roughly -22%, and in the aggregate bond market was -5%.

Though the past three months were better for stocks, it certainly wasn’t a smooth road. And the road ahead looks even bumpier. For the tiny improvement in return, and the monstrous increase in risk, wisdom still makes no argument for stocks. After all, rear window investing in October, 2007, would have indicated strong future stock performance, and nothing could have been further from the truth. This is how the market works.

To see how this concept develops over decades, try my recent article, Percentage Off High: Stocks vs Bonds.

Why You Care

Over the last three months, consensus estimates for stock market upside has been roughly 5.8%. But on March 1st, the market had surged past that. Since then, the stock market has retreated significantly. Buying on March 1st would have put you in line for the worst monthly performance since January 2015. Oops.

More importantly, investment choices must be based on today’s data and future expectations, not the fiction of backtested “strategies.” As always, economic research, discipline and a firm handle on investment theory are key to your financial success.

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