Investing is never easy, but there’s no denying that the last 10 years in U.S. equities have been a far smoother ride than most of history.
How do we define “smoother”? In layman’s terms: higher returns with lower risk.
In technical terms, we can look at things like the Sharpe Ratio, which measures risk-adjusted performance. The Sharpe of 1.18 over the last 10 years exceeds 95% of other periods and is more than double the historic average of 0.48.
What, if anything, should an investor to do with this information?
That depends on their time frame, their tolerance for risk, and their temperament…
Time Frame
Like high valuations (see here and here), high Sharpe Ratios tell you next to nothing about what will happen over the next week, month, or year.
But looking out longer-term, we do find an inverse relationship between the past and the future, with higher Sharpe Ratios exhibiting lower future returns on average (and vice versa).
Tolerance for Risk
If an investor has a low tolerance for risk, this is important, as the future is likely to feature more volatility and drawdowns than the past.
Temperament
A more volatile future will be more challenging for all investors, but especially those who are inclined to sell in the face of adversity.
And that is not a small group. Over the last 10 years, Morningstar found annualized investor returns that were 1.7% below fund returns.
The reason? Bad behavior. Investors exhibited a tendency to chase on the upside (buy high) and panic on the downside (sell low). And this gap existed in spite of the tranquility in markets.
In a more volatile environment, one would assume the temptation to buy high and sell low would only increase, thereby increasing the gap in performance.
A Time for Prudence?
No one knows the future, but history has shown that the time to be prudent is when the crowd is throwing caution to the wind. Are they doing that today? It certainly appears so. In everything from the reach for yield (junk bond yields at record lows) to the reach for higher and higher returns (High Growth Stocks → IPOs → SPACs → Bitcoin → Meme Stocks → Dogecoin), risk has become an afterthought. When everything seems to be going in only one direction (up), potential reward is the only thing that seems to matter.
If you still have a respect for risk, the only way to counteract this thinking is with prudence. What that means will be different for everyone. It could mean increasing diversification in terms of asset class or style, reducing beta in your portfolio, holding more cash, or simply resisting the urge to chase the latest fad. None of this caution seems necessary today and indeed it may not even prove to be necessary in the years to come. But on the non-zero chance that it is, a little bit of prudence will go a long way.
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