We could go a lot of different ways with the “lump of coal” theme. The most obvious is the performance of equities and bonds this year. 2022 goes down as one of the worst years for both equities and bonds combined in nearly 100 years. Typically bonds and equities don’t go down at the same time as they have this year. One will go up while the other goes down oftentimes. Of course, we could have also gone down the path of natural resources and how coal/natural gas/and oil have had a rebirth in popularity due to scarcity. You could argue that a lump of coal might be desired in certain areas of the world. However, the primary direction we desired for our theme was towards the concept of “lumpiness”. Lumpiness, or in this case volatility of returns, is one of the most important parts of the complexity of investing that many underestimate. Volatility in an up year seems great, but in a down year one realizes the amount of risk we can truly handle. The fallacy of linear returns with tiny ups and downs leads many to feel a false sense of security and then overreact to a down year. Keep in mind that market corrections have occurred on average once every 19 months since 1928. Simply put, down years are a natural occurrence. Of course, our portfolios were not immune to feeling the sting of negative returns. For example, a few of our large cap holdings experienced double-digit declines, as did our mid cap and small cap holdings and international stocks. That being said, lumpy returns, in our opinion, can be mitigated by two things: a patient mindset and diversification.
For instance, last year we were able to reduce downside by holdings asset classes like gold, commodities, long/short managers, cash, short duration fixed income and managed futures that provided minimal correlation to the standard 60/40 portfolio (60% equities/40% fixed income). Of course, we have also always made use of managers who are flexible and convicted enough in their discipline and philosophy to diversify from assets that are overpriced and hold noncorrelated, cheap assets if need be. So, of course, these managers held up very well last year. Even some of our more aggressive areas like smaller capitalization names did well compared to their indices. Thus, we are somewhat happy with our mitigation of lumpiness in returns last year. We say “somewhat” because no one ever likes being down.
That being said, in a perverse way as prices fall, one oftentimes improves future rates of return. However, the lumpiness of the experience is not pleasant. The famous saying “You make most of your money in a bear market. You just don’t realize it at the time” hints at this. With that in mind, by minimizing downside this year we have more money to put to work in assets that are attractively priced. We realize this is difficult to do with a “macro” backdrop that is not rosy. Trust us when we say that we are aware of the multitude of issues: wars, interest rates, inflation, and aggressive Federal Reserve governors to name a few. In fact, the last one, Federal Reserve governors, we harped on significantly in the last quarters missive as we continue to think they were slow to react to inflation and now feel forced to overreact.
However, we think Howard Marks of Oaktree Capital summed up the “macro” argument very well in his memos “What really Matters” and “The Illusion of Knowledge”. In the memos, Howard basically stated that no one can predictably tell the future well enough to repeatedly produce superior performance, yet we continue to do so to our detriment. Said differently by Daniel Boorstin, “The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge”. Details of the Dalbar Institute study of 2012 support this finding as it showed the average holding period for a typical investor is six months and they underperform the S&P 500 by three percentage points. More important than timing the market is time in the market, in our opinion. Since 1926 the S&P 500 (or its predecessors) have produced a nearly 10.5% yearly return through 16 recessions, several wars, one World War, a global pandemic and many instances of geopolitical turmoil. Identifying a diversified strategy to stay invested in the market will allow us to manage the lumpiness and is the best way we know how to position a portfolio for success; and that is what we think we have done throughout the years. We would encourage everyone to stick with their well-considered financial plan and investment strategy no matter the worries in the marketplace.
Given the setting of the season, we hope no one receives any lumps of coal this year, unless that is what they want (China has plans to build 43 new coal plants in the next several years so there may be some takers.). Keeping with the coal theme, however, we wanted to share some positive news with so many negative “macro” headlines. Kyle Bass, famous hedge manager living in Texas, has started a conservation fund buying up wetlands and forests in Texas with the goal to maximize the land and reduce carbon emissions at the same time. On his land, they have a vision for sustainable living and carbon capture underground in natural gas wells already present. We don’t completely understand the science, but we applaud the efforts by highly motivated, long-term investors. These are the types of examples of capitalism finding a way through the darkness (or maybe a coalmine in our example) to create progress for all of mankind. We hope these sparks of hope cascade throughout the holiday season for you and your family.
Finally, you will notice new performance reports this quarter. We hope you like them. They may be longer than the ones in the past and if it has created more paperwork than you would like, then you can log into your Wealthscape Investor Portal and update your preferences for E-delivery. If you need help recovering your Wealthscape information, please contact any member of your team. We will be happy to assist you.