December 11, 2020 – Featuring Larry Swedroe
“The stock market is a device for transferring money from the impatient to the patient.”
– Warren Buffett
While having a well-thought-out investment plan is a necessary ingredient for a successful outcome (while one can get lucky, the odds are against it), it’s not a sufficient one. The sufficient ingredient is having the patience and discipline to adhere to that plan. And that’s much harder than most believe.
One reason why is that an all-too-human trait is overconfidence. Thus, it’s no surprise that investors tend to be overconfident of their ability to stay the course during the inevitable periods when their strategy underperforms. Over 25 years as an adviser, I’ve observed that living through periods of bear markets and underperformance is much more difficult for most investors than observing them in backtests.
A second reason is unrelated to behaviour. It’s a lack of knowledge of financial history, the risks of maximum drawdowns (periods of underperformance) and their lengths, for all risk assets.
It’s been my experience that one of the greatest problems preventing investors from achieving their financial goals is that when it comes to judging the performance of an investment strategy, they believe that three years is a long time, five years is a very long time, and ten years is an eternity. Even supposedly more sophisticated institutional investors, including those who employ highly paid consultants, typically hire and fire managers based on the last few years’ performance.
Given that they are supposedly more sophisticated investors who often hire consultants to advise them, I was shocked to learn that a 2016 survey of large institutional investors by State Street Global Advisors found that 89 percent would not tolerate underperformance of more than two years before seeking a replacement.
This tendency causes investors to make the critical mistake of assuming that good outcomes are the result of a good process and bad outcomes imply a bad process. It also shows an incredible lack of knowledge of financial history. And it shows that they seem never to learn from their own experiences. Consider the following evidence.
The 2008 study The Selection and Termination of Investment Management Firms by Plan Sponsors by Amit Goyal and Sunil Wahal found that while plan sponsors hire investment managers after those managers earn large positive excess returns up to three years prior to hiring, post-hiring excess returns are indistinguishable from zero. They also found that if plan sponsors had stayed with the fired investment managers, their returns would have improved. I guess these supposedly sophisticated investors have never heard that the definition of insanity is doing the same thing over and over again and expecting a different outcome.
On the other hand, financial economists know that when it comes to risk assets, 10 years of underperformance can be nothing more than “noise,” a random outcome. For example, we have had three periods of at least 13 years during which the S&P 500 underperformed totally riskless one-month Treasury bills: 1929-43, 1966-82 and 2000-12.
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Thanks to the research team at Dimensional, we can examine the historical evidence demonstrating that all risk factors go through long periods of underperformance, unfortunately, that are much longer than many investors are able to endure.
For example, covering overlapping one-, five- and 10-years periods from July 1926 through December 2019, U.S. stocks underperformed totally riskless Treasury bills 30, 22 and 15 percent of the time, respectively. Similarly, small stocks underperformed large stocks 44, 38 and 28 percent of the time, while value stocks underperformed growth stocks 41, 27 and 18 percent of the time. And over the period July 1963 through 2019, high profitability stocks underperformed low profitability stocks 36, 19 and 9 percent of the time.
Although the time frames are shorter due to data availability, Dimensional found very similar results when examining factor returns in international developed and emerging markets. All factors and risk assets must be expected to experience long periods of underperformance. Thus, when they do, it should not be a surprise.
It’s important for investors to understand that the expected long periods of underperformance are not a reason to run away from risk. Rather, diversification across multiple unique sources of risk is the prudent strategy.
Vanguard’s research team also looked at the issue of patience with underperformance. The following is a summary of the findings from their October 2020 study, which looked at the persistence of performance and periods of maximum drawdowns, as well as the maximum lengths of underperformance and drawdowns, for both factors and actively managed funds.
The factors they examined were value, momentum, low volatility, size and multi-factor (equal weighted). Their analysis was for long-only factor portfolios. Note that their data sample, 1995-2019, was much shorter than Dimensional’s.
This is what the researchers found regarding the performance of different risk factors over time:
— All factors experienced drawdowns across all evaluation periods. While the magnitudes of underperformance were similar over the worst one-year period, there was a wide range of magnitudes over longer periods.
— Factor drawdowns ranged from 19 percent for momentum to 38 percent for both low volatility and size. (Note: Value’s maximum drawdown of 29 percent has increased greatly due to its underperformance in 2020.)
— The maximum length of the drawdown ranged from about six years for size to more than 11 years for value.
— Showing the benefits of diversification, multi-factor portfolios have significantly less risk of drawdowns than single-factor strategies in terms of likelihood, length and maximum drawdown.
Regarding the performance of active equity managers, these were Vanguard’s findings:
— Investors who select an outperforming manager or use factor-based strategies can expect to experience a drawdown between 40 percent and 60 percent of all one-year periods.
— Close to 100 percent of outperforming funds experienced a drawdown relative to their style and median peer benchmarks over one-, three- and five-year periods.
— 80 percent of outperforming funds had at least one five-year period where they were in the bottom quartile. Recall that almost 90 percent of institutional investors would fire a manager after just two years of underperformance.
— 50 to 80 percent of outperforming active equity funds underperformed their peer and style benchmarks by 20 percent or more.
— The average maximum drawdown magnitude and length of outperforming funds was 24 percent and 5.5 years.
— Of the active funds that outperformed, more than one-quarter did so after seven or more years of underperformance. Another quarter recovered after three years of underperformance.
— In terms of drawdown magnitude, a quarter of the funds that outperformed recovered from maximum drawdowns greater than 30 percent.
— As the time horizon increased, the median manager’s worst performance increased, as did the dispersion of individual manager drawdowns, which increased dramatically (a risk of active management).
Vanguard’s findings led them to conclude: “As with most things in life, success in investing requires patience; investing, in fact, probably requires more patience than most endeavours. You need patience when what you are invested in is performing poorly — and you need it when what you haven’t invested in is performing well.”
Quoting legendary investor Ben Graham, the researchers stated: “The investor’s chief problem — even his worst enemy — is likely to be himself.”
The reason why a lack of patience ultimately leads to bad decision-making is that you give in to anxiety and stray from your well-thought-out plan. The surest way to overcome this problem is to become educated on the risks of underperformance and make sure you don’t take more risk than you can tolerate.
In other words, successful investing requires conviction of belief in a positive risk-adjusted expected (but not guaranteed) return so that you are able to stay the course during the inevitable long periods of underperformance.
Warren Buffett believes that when it comes to investing, temperament (which provides the discipline to ignore what financial economists know are random periods of underperformance and adhere to a well-thought-out plan) is far more important than intelligence. He understands that all risk assets, and strategies that invest in risk assets, are prone to long periods of underperformance. If that were not the case, for long-term investors (and there should be no other kind), there would be no risk.
If you are not yet convinced of this, consider the following examples:
— Over the nine-year period March 2000 through February 2009, the S&P 500 lost 36.9 percent and underperformed totally riskless one-month Treasury bills, which returned 30 percent, by 66.9 percent.
— Over the 40-year period 1969-2008, U.S. large growth stocks (the current favorite equity asset) returned 8.5 percent per year and underperformed the long-term 20-year Treasury bond (the riskless investment for U.S. pension plans with nominal obligation), which returned 8.9 percent per year. U.S. small growth stocks performed even worse, returning just 4.7 percent per year.
— Over the more than 30-year period from January 1990 through October 2020, Japanese Large Stocks (MSCI/Nomura Index) lost 15 percent, while the FTSE Japanese 1-3 Year Government Bond Index returned 121 percent. That’s a drawdown of 136 percent.
— On January 21, 1980, the price of gold reached a then-record high of $850. On March 19, 2002, gold was trading at $293. The inflation rate for the period 1980 through 2001 was 3.9 percent. Thus, gold’s loss in real purchasing power was about 85 percent.
These examples demonstrate that successful investing means accepting the risk of long periods of underperformance and having the discipline to stay the course, treating them as nothing more than noise. The problem is that three years of losses often turn investors with 30-year horizons into investors with three-year, or even three-month, horizons.
The fact that all risk assets are prone to long periods of underperformance is why broad diversification across unique sources of risk and return is the prudent strategy, avoiding concentrating your investments in one unique source of risk such as market beta.
But while diversification has been called the “only free lunch in investing”, it doesn’t eliminate the risk of losses. It requires accepting the fact that parts of your portfolio will behave entirely differently than the portfolio itself, and it will likely underperform a broad market index for some long periods of time. In fact, a wise person once said that if some part of your portfolio isn’t performing well, you are not properly diversified.
The result is that diversification is hard. And because misery loves company, losing unconventionally by having a portfolio that doesn’t look like the broad U.S. market, which the media reports on daily, is harder than losing conventionally. In addition, living through hard times is harder than observing them in backtests. That difficulty helps explain why it’s so hard to be a successful investor.
While achieving diversification is simple, living with it isn’t, which is why Warren Buffett noted that “Investing is simple, but not easy.” That’s because a quality investment strategy is like a good diet; it only works if you have the patience and discipline to stick to it.
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