Swedroe: Investing Uncomfortably

December 31, 2018

Earlier this week, I explored some historical data and relevant research in an attempt to help investors put recent stock market volatility into perspective. It’s easy to lose sight of the facts amid the stress and anxiety caused by potentially large dips in your portfolio’s value.

Because it’s human nature to seek to avoid pain, the pain of bear markets and underperformance unfortunately tend to cause investors to consider changing strategy. It’s an all-too-human trait to want to believe that someone out there can protect us from bad things happening to our portfolio—despite the fact that the evidence shows no such person exists.

However, before choosing a new strategy, you should be sure there is evidence to support your belief in why it will be more likely to help you achieve your goals. Consider the following evidence on three common alternative strategies: using actively managed funds, using hedge funds, and engaging in tactical asset allocation by managers/advisors.

  • While the evidence on active management overall paints an abysmal picture, perhaps it’s true that active managers can protect us from bear markets. To test this hypothesis, Vanguard studied the performance of active managers in bear markets, which they defined as a loss of at least 10%. The study, published in the Spring/Summer 2009 issue of Vanguard Investment Perspectives, covered the period from 1970 through 2008. The period included seven bear markets in the United States and six in Europe. Once adjusting for risk (exposure to different asset classes), Vanguard concluded that “whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term market cycles, the combination of cost, security selection, and market-timing proves a difficult hurdle to overcome.” The researchers also confirmed that past success in overcoming this hurdle does not ensure success in the future. Strike one.
  • Over the past 10 calendar years the HFRX Global Hedge Fund Index lost 0.4% per year, underperforming every single major equity and bond asset class. The underperformance ranged from 1.6 percentage points when compared to the MSCI EAFE Value Index to as much as 9.5 percentage points when compared to U.S small-cap stocks. Compared to a balanced portfolio allocated 60% to the S&P 500 Index and 40% to the Barclays Government/Credit Bond Index, it underperformed every single year. Strike two.
  • In his book “Investment Policy,” Charles Ellis discussed a study of the performance of 100 pension plans that engaged in tactical asset allocation. Not one single plan, he reported, benefited from the effort. If pension plans, with their advantages of scale and their use of highly paid consultants, are unable to win this game, why do you think that you, or some advisor you hire, would be likely to succeed? Strike three.

Playing The Winner’s Game
The evidence is clear that the strategy most likely to allow you to achieve your financial goals is one based on both:

  • Historical evidence demonstrating that active management is a loser’s game (it’s possible to win, but the odds of doing so are so poor that it’s not prudent to try).
  • Certain asset classes and factors have provided premiums meeting all of the following criteria. They are: 1) persistent over long periods of time; 2) pervasive across sectors, countries, regions and even asset classes; 3) robust to various definitions; 4) survive transaction costs; and 5) have risk-based or behavioral explanations for their persistence into the future.

Because the evidence is strong for each of the factors to which we seek exposure in portfolios (market beta, size, value, momentum and quality/profitability) we can have a high degree of confidence that the premiums are likely (but not certain) to persist in the future. (It’s uncertainty that leads one to conclude the prudent strategy is to diversify across as many factors as we can identify that meet all the criteria established.) However, risk aversion and the pain of losses leads to a problem known as myopic loss aversion—the tendency for even those with long investment horizons to focus on short-term results.

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