As we head into 2025, investors are giddy over the market returns of the last two years. As shown, the annual returns, while elevated, have come with only average volatility along the way.
However, while most analysts and investors expect 2025 to be another bullish year, there is always a risk of a more disappointing outcome. This is because unexpected, exogenous events can cause a reversal in earnings expectations. Note the words "unexpected" and "exogenous." It is often stated that "markets climb a wall of worry" because markets "price in" concerns such as geopolitical, monetary, fiscal, or economic concerns. However, when an event occurs that is entirely unexpected, the markets can rapidly reprice. This is particularly an issue when investors take on excessive portfolio risk due to increased overconfidence from a running bull market.
Such was the topic of an article from ARS Technica:
"There's extensive academic literature on the risks faced by investors who are overly confident of their ability to beat the market. They tend to trade more often, even if they're losing money doing so. They take on too much debt and don't diversify their holdings. When the market makes a sudden lurch, they tend to overreact to it. Yet, despite all that evidence, there's no hard data on what makes investors overconfident in the first place."
As we discussed in "Bull Markets & Why We Repeat Our Mistakes:"
"Behavioral biases that lead to poor investment decision-making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases specifically:"
"During bull market advances, 'herding,' 'lack of diversification,' and 'anchoring' are the most common problems. These behaviors tend to function together and compound investor mistakes.
'Bull markets hide investment mistakes. Bear markets expose them.'"
As shown, "reversions to mean" remain one of the most powerful forces in investing.
Such is why our "gardening guide" has more to do with managing your portfolio than you imagine. Over the last decade, behavioral finance has studied investor psychology and identified the repeated behaviors investors make throughout market cycles. As you can probably surmise, investors tend to develop many "bad" behaviors during bull markets, which are the most significant reasons for underperformance over time.
Over the long term, investors' most prominent mistake is failing to manage investment risk.
Individuals tend to do an excellent job of "buying" stocks. However, they are terrible at "selling" them. Of course, since the media only tells you to "buy," such should not be surprising. However, "buying stocks" is only one-half of the investment transaction. Unfortunately, individuals tend to "sell stocks" only after accumulating significant losses. Such is the very nature of the "buy high, sell low" syndrome.
Over the years, I have found that our "gardening guide" resonates with individuals in managing their portfolio and investment risks.
In the "Spring," it is time to till the soil and plant your seeds for your summer crops. Of course, one must water, fertilize, and pull the weeds; otherwise, the garden won't grow. As the "Spring turns into Summer," it's time to harvest the garden's bounty and rotate crops for the "Fall" cycle. Eventually, even those crops must be harvested before the "Winter" snows set in.
While many investors are skilled at planting gardens, they often forget to harvest the "bounty" they produce. Of course, if the garden's production is not harvested, it will rot on the vine. Being a good gardener, or "having a green thumb," is not a function of "luck," but rather carefully planned actions to ensure the garden grows, the bounty gets harvested, and the garden is replanted.
Therefore, to have a successful and bountiful garden, we must:
So, what actions should you take to prepare your garden for 2025?
As noted above, the first step in preparing your portfolio for what happens in 2025 is to clean up the things hindering you.
The next step is to rebalance your portfolio to the allocation that will most likely weather a "cold snap." In other words, consider what sectors and markets will improve in whatever economic environment you believe we will experience in 2025.
Step 2) Compare Your Portfolio Allocation To The Model Allocation.
(Note: the primary rule of investing that should NEVER be broken is: "Never invest money without knowing where you are going to sell if you are wrong, and if you are right.")
Lastly, with a game plan, it is time to pull the weeds, till the soil, plant seeds, and water it.
Step 3) Have positions ready to execute accordingly, given the proper market set-up. In this case, we are looking for positions that have either a "value" tilt or have pulled back to support and provide a lower-risk entry opportunity.
These actions have TWO specific benefits depending on what happens in the market next year.
As discussed in "Predictions For 2025 Using Valuations," there is a wide range of potential outcomes for next year. Much will depend on the Fed's monetary policy changes and economic and earnings growth rates. In that article, we provide several scenarios, but most importantly, two sets of ranges. The first set of forecasts assumes that Wall Street analysts are correct about forward earnings of $251/share.
"The chart below combines the four potential predictions to show the possible market range for next year. Of course, you can analyze, make valuation assumptions, and derive your targets for next year based on your views. This analysis is an exercise in logic to develop a range of possibilities and probabilities over the next 12 months."
The second option is based on the understanding that Wall Street analysts always overstate earnings growth, which is revised lower over time.
"While the bullish prediction is possible, that outcome faces many challenges in 2025, given the market already trades at fairly lofty valuations. Even in a "soft landing" environment, earnings should weaken, which makes current valuations at 27x earnings more challenging to sustain. Therefore, assuming earnings decline toward their long-term trend, that would suggest current estimates fall to $220/share by the end of 2025. This substantially changes the outlook for stocks, with the most bullish case being 6380, assuming a roughly 4.5% gain versus every other outcome, providing losses ranging from a 2.6% loss to a 20.6% decline."
No one knows with any certainty how the markets will perform next week, much less over the next several months or an entire year. However, we DO know that not managing "risk" to hedge against a decline is more detrimental to achieving long-term investment goals.
Tending to your portfolio doesn't take tremendous effort, and I hope our "Gardening guide" can help. The mistake investors make is assuming that planting a garden today will produce its bounty tomorrow. That is not how portfolio management works. Taking action in your portfolio today may lead to short-term underperformance. However, in the long term, managing the portfolio to mitigate the risk of catastrophic losses will lead to a bountiful garden to support you in retirement.
In the short term, managing risk will provide some drag between your portfolio and the major market index if the market rallies. However, when winter's next "cold snap" sweeps the markets, preparation should protect your garden from "frostbite."