Swedroe: Patience & Diversification Crucial

January 03, 2018

“Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”

—Warren Buffett

 

In my more than 20 years as the director of research for Buckingham Strategic Wealth and The BAM Alliance, I’ve learned that, while financial economists understand that even 10 or 20 years of investment performance can be nothing more than “noise,” the vast majority of investors believe three years is a long time, five years is a really long time and 10 years is an eternity.

This is true even for institutional investors—who should know better—as evidenced by the fact that the typical horizon over which investment managers are judged is three years.

The lesson I’ve taken from this knowledge is that investment discipline—the ability to adhere to a well-thought-out strategy (asset allocation)—is likely to prove far more important for helping investors meet their goals than the specific asset allocation decision itself.

The reason is the well-documented tendency for individual investors to chase performance, buying what has done well recently (buying relatively high) and selling what has done poorly (selling relatively low)—not exactly a recipe for successful investing.

In addition, once investors remove assets from the equity markets, it’s difficult to get back in, because there’s never a green flag letting them know it’s once again safe to enter.

Odds Of Negative Premiums

In our book, “Your Complete Guide to Factor-Based Investing,” my co-author Andrew Berkin and I present the following table, which provides the historical odds of underperformance for six factors that have provided equity premiums.

These premiums have been persistent over long periods of time and across economic regimes, pervasive around the globe (and even across asset classes), robust to various definitions, implementable (meaning they survive transaction costs), and have intuitive risk-based or behavioral explanations that afford confidence the premium will persist.

 

 

No matter how long the horizon, each of the individual factors have experienced some periods of negative performance, even at long horizons. Even the equity premium, market beta, was negative in 10% of 10-year periods and in 3% of 20-year periods. As you can see, the sole exception is momentum at 20 years. However, that, of course, doesn’t guarantee future success for momentum at 20-year horizons.

In my book, “Think, Act, and Invest Like Warren Buffett,” I note the great irony that, while investors idolize the “Oracle of Omaha,” they not only tend to ignore his advice, they then tend to do precisely the opposite of what he recommends.

For instance, we know that Buffett did not abandon his belief in value investing during the growth bubble of the late 1990s (when the value premium was highly negative). And we know he hasn’t abandoned it yet (despite the value premium now having been negative for more than 10 years). However, many investors will begin questioning the value premium’s existence after even just a few years of negative performance.

The evidence in the following table, which presents the historical premiums and standard deviations of the various equity premiums, offers important insights into why long horizons, and thus discipline, are the key to successful investing—and why Buffett has been so successful (his favorite time frame is forever). It shows that the volatility of each of the annual premiums has been a multiple (ranging from 1.7x to 4.1x) of the premiums themselves. 

 

 

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