Swedroe: Don’t Invest Without Discipline

September 08, 2014

As an investor, having discipline means not confusing strategy with outcome.

A well-thought-out financial plan is necessary for successful investing, but even the greatest plan won't bear fruit if an investor doesn't have the discipline required to stay the course, rebalancing and tax-loss-harvesting as needed.

Unfortunately, even thorough and intelligent plans will sometimes end up in the trash heap because investors lose heart when their strategy appears to not be working. One of the keys to disciplined investing is acquiring a strong understanding of sound investment principles.

Investors who do so won't make the mistake I refer to as confusing strategy with outcome. In a world where there are no clear crystal balls—just uncertainty—a strategy is actually either right or wrong even before we know the outcome.

Nassim Nicholas Taleb, author of "Fooled by Randomness," explains: "One cannot judge a performance in any given field by the results, but by the costs of the alternative (such as if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by the people who fail (those who succeed attribute their success to the quality of their decision)."

My favorite example of investors who confuse strategy with outcome occurs in the following scenario. The stock risk premium has been very large, just more than 8 percent a year. However, it's highly volatile, with an annual standard deviation in excess of 20 percent. Thus, the premium is large, and for the very reason that there's a large amount of risk involved in equity investing.

In short, investors demand to be highly compensated for accepting the risk that they may experience very long periods of underperformance. In fact, that premium may never be realized.

As proof, consider that from 1969 through 2008, U.S. large-cap growth stocks returned 7.8 percent and underperformed 20-year Treasury bonds, which returned 8.9 percent. That's a 40-year period where investors took all the risks associated with owning stocks and then still had to swallow underperforming long-term Treasurys.

Does that mean investors should be convinced that the strategy of pursuing a stock risk premium is wrong? Of course not. The logic is still the same, despite the drought.

Stocks are riskier and so must have higher expected returns. Those who abandoned their plans and sold stocks over that period, because they confused strategy with outcome, may have missed out on the greatest bull market since the 1930s.


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