Long-Term Needs, Short-Term Focus

One of the emerging issues I see many investors grappling with is the short term/long term dichotomy. Right now, for instance, I am getting two sets of almost diametrically opposed questions from readers:

• First, why should we bother to invest outside the U.S., as it has been outperforming for years and (the thinking goes) is therefore likely to keep doing so?
• And second, with multiple metrics signaling high risk (as tracked in my market risk update), aren’t we bound to have a significant downturn?

The answer to both questions, of course, is yes.

U.S. markets—up or down? It depends on the time frame

Short term, the U.S. will likely continue to do well. Longer term, markets face real risks, and there will be a significant pullback at some point. The key to investing is to either (1) be diversified, so you can ride through the turbulence with the least possible damage, or (2) try to avoid the worst of the turmoil by reallocating away from the riskiest areas.

Both are hard to pull off, but in different ways. Diversification requires an almost manic focus on the long term. Selling winners and buying losers—which is what diversification and rebalancing amounts to—requires faith that, over time, the math will work out. Most people don’t really have a lot of faith in math, so this is difficult.

Trying to manage risk by reallocation is challenging in two ways. Finding a risk point to sell at is difficult, and buying back in when that risk point has proved out (or not) is even harder.

Which brings us back to the mismatched questions above. U.S. markets are likely to keep doing relatively well in the short term, based on the current trend, improving fundamentals such as earnings and confidence, and the real possibility of positive policy actions such as a tax cut. At the same time, U.S. markets are also more expensive than they have ever been, with the exception of 1929 and 2000. To me, that suggests a major pullback is very likely, if not immediate.

Appropriately aligning your strategy

The irony here is that the people asking “Why diversify, why not stay in the U.S.?” are typically those whose plans and needs are long term. In other words, the people who should not be focusing on the short term are doing exactly that. Those who are focused on the potential downturn have the same problem despite their opposite concern, in that their needs are long term but their focus is short term.

In the end, you have to match your investment strategy to your ability to focus and execute.

Worried about a downturn in the short term? Then look for ways to mitigate that risk without damaging your longer-term results. Going to cash and staying there is guaranteed failure over the long term for most people.

Looking to focus on the U.S. markets (or any other asset class), rather than diversifying? You’ll have to come up with a way to get that perceived advantage, short term, and avoid the risks of underperformance and volatility in the long term.

Problems arise when you make short-term observations and decisions that negatively affect your long-term results. This is certainly not a problem limited to investing (I, for one, am in the process of getting back in shape after too many short-term eating decisions), but it is one with potentially irreversible consequences. I can lose the weight again, but I may not be able to fund my retirement portfolio again after a certain point.