On April 12, 2001, Donald Rumsfeld sent an email to President George W. Bush with the subject line “Predicting the Future.” Attached was a brief memo written by Lin Wells, an analyst on Rumsfeld’s staff at the Pentagon. It has since been declassified, and it is worth the read:
That last bullet point nailed it.
Imagine it’s April of 2011 – ten years following the date Wells’ memo crossed President Bush’s desk. What would hindsight reveal as the driving forces of the preceding ten years?
- 9/11 may turn out to be a defining moment of the 21st century, let alone the first decade. It is eerie to think the towers fell just five months less one day from the date Wells wrote this note.
- That of course launched the War on Terror, one of the defining geopolitical events of the decade with repercussions still reverberating two decades later.
- America endured her worst economic contraction since the Great Depression centered on what was previously thought the most stable of financial assets: housing.
- The advent of quantitative easing amidst the Great Financial Crisis changed the Federal Reserve’s relationship with the financial markets.
- China rapidly developed into the globe’s second largest economy.
- The smartphone and mobile internet remade… everything?
- Social media began reshaping society in ways we’re still trying to comprehend.
- The shale boom transformed the global energy landscape, vaulting the US to first place amongst the world’s oil producers.
How many of those do you suppose Rumsfeld, Bush, or anyone predicted in 2001? None.
Bank of America publishes a monthly fund manager survey in which they survey a group of fund managers’ analysis of the greatest risks facing the market. It serves as a barometer of the known unknowns:
It is, in my opinion, completely useless. The known unknowns will not shape geopolitics, financial markets, and human society looking back ten years from now. Every bullet point in the Wells memo was an unknown unknown at the time. None were expected. The same goes for the events that shaped the first decade of the 2000s - 9/11, the Great Financial Crisis, social media, shale, the smartphone – all unknown unknowns in 2001 that shaped humanity’s future.
Of course, the same will be true for the next ten years.
Think of all the brainpower spent evaluating, measuring, and projecting known unknowns. World leaders, politicians, corporate boardrooms, the entire news industry, probably more than half of the finance industry, every other person’s post you see on your social media feed… Then we’ll look back in ten years and see it was only the unknown unknowns that had any lasting impact.
We often talk about risk in investing. “Risk” calls to mind known unknowns (see the fund manager survey above). But we live in a world – and invest in financial markets – shaped by the unknown unknowns. The events and inventions no one predicts before they occur. This dynamic makes investors nervous. If the markets turn on the unknown unknowns, how do we build a multi-decade portfolio?
Diversification.
The ten years on either side of the April 2001 Wells memo proved to be very different markets for investors. The 90s were a booming bull market, while the aughts are known as the lost decade. Here’s how the S&P 500 performed compared to a diversified portfolio* during the ten years preceding and the ten years following the date the Wells memo crossed the President’s desk:
April 12, 1991 – April 12, 2001:
- S&P 500: +286.8% (14.5%/yr.)
- Diversified Portfolio: +179.3% (10.8%/yr.)
April 12, 2001 – April 12, 2011:
- S&P 500: +34.4% (3.0%/yr.)
- Diversified Portfolio: +78.7% (5.9%/yr.)
What if we zoom out and compare the two over the full twenty years?
- S&P 500: +419.9% (8.6%/yr.)
- Diversified Portfolio: +399.0% (8.4%/yr.)
Diversification didn’t generate excess returns over this twenty-year period, but it allowed investors to handily outpace inflation during the Lost Decade. Diversification compresses a portfolio’s range of possible outcomes – underperformance in a raging bull market and outperformance during weaker markets.
If the world and the markets turned on the known unknowns, eschewing diversification makes sense.
Diversification is a hedge against the unknown unknowns.
And in the long run, the unknown unknowns are all that matter.
Sean Cawley, CFP®
*The diversified portfolio here is modelled roughly as 25% large cap US, 25% mid cap US, 25% small cap US, and 25% international holdings. Diversified portfolio example shown is hypothetical and provided for illustrative purposes only. It does not represent an actual account or investor experience. Past performance does not guarantee future results. Diversification and asset allocation do not ensure a profit or protect against loss in declining markets.
Sources
YCharts
BofA Global Fund Manager Survey
Neither asset allocation nor diversification guarantee against investment loss. All investments and investment strategies involve risk, including loss of principal.
Content here is for illustrative and educational purposes only. It is not legal, tax, or individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy. Results will vary. Past performance is no indication of future results or success. Market conditions change continuously.
This commentary reflects the personal opinions, viewpoints, and analyses of Resolute Wealth Management. It does not necessarily represent those of RFG Advisory, clients, or employees. This commentary should be regarded as a description of advisory services provided by Resolute Wealth Management or RFG Advisory, or performance returns of any client. The views reflected in the commentary are subject to change at any time without notice.