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.

Investor Myopia
Over the almost 25 years that I have been an investment advisor, I’ve learned one of the greatest problems preventing so many investors from achieving their financial goals is that, when it comes to judging the performance of an investment strategy, they believe three years is a long time, five years is a very long time, and 10 years is an eternity.

That leads them to abandon even the most well-thought-out plans. We observe this even with supposedly more sophisticated institutional investors, including those who employ highly sophisticated consultants, as they typically hire and fire managers and advisors based on the last three years’ performance.

As Michael Mauboussin, director of research at BlueMountain Capital Management, noted, this tendency “causes investors to often make the critical mistake of assuming that good outcomes are the result of good process and bad outcomes imply a bad process.” On the other hand, financial economists know that for investment returns, 10 years can be nothing more than what they call “noise,” a random outcome.

In recent years, it has been the poor performance of international stocks and U.S. value stocks (though internationally value has outperformed growth). That underperformance has resulted in investors experiencing the dreaded psychological condition known as tracking error regret, which occurs when your portfolio underperforms a popular index, such as the S&P 500. Regrettably, the twin problems of “relativism” (how the performance of your portfolio compares to that of your friends’ and to popular benchmarks) and “recency” can conspire to lead investors to abandon even well-thought-out plans.

Relativism
Unfortunately, too many investors have entered what Vanguard founder John Bogle calls the “age of investment relativism.” Investors’ satisfaction or unhappiness (and by extension, the discipline required to stick with a strategy) is determined to a great degree by the performance of their portfolio relative to some index (an index that shouldn’t be relevant to an investor who accepts the wisdom of diversification).

Relativism, sadly, can best be described as the triumph of emotion over wisdom and experience. The history of financial markets has demonstrated that today’s trends are merely “noise” in the context of the long term. Bogle once quoted an anonymous portfolio manager, who warned: “Relativity worked well for Einstein, but it has no place in investing.”

Before you consider changing strategy based on the results of such periods, consider the following data from Ken French’s website.

  • 15 years (1929-1943) U.S. Market Beta: -0.5% annualized
  • 14 years (1969-1982) U.S. Market Beta: -0.8% annualized
  • 13 years (2000-2012) U.S. Market Beta: -0.2% annualized

As you can see, we had three long periods where the U.S. market beta premium (the excess return of the stock market compared to U.S Treasury bills) was negative—investors took all the risks of equities while earning lower returns than they could have earned on risk-free one-month Treasury bills. That is without even considering the costs of implementing an equity strategy. Thus, actual results would have been even worse. Note also that the three periods make up a 42 of the 90 years from 1929 through 2018—that’s 47% of the total period. Would you have abandoned your belief in equity investing after such a period and stuck with Treasury bills? You should not have, because equities are risky and investors require a large premium for taking that risk.

Again using Ken French’s data, let’s look at how the size and value premiums performed during those same three periods. Returns are annualized.

  • 15 years (1929-1943) U.S. Market Beta: -0.5%; Size: 4.9%; Value: 5.0%
  • 14 years (1969-1982) U.S. Market Beta: -0.8%; Size: 2.4%; Value: 5.5%
  • 13 years (2000-2012) U.S. Market Beta: -0.2%; Size: 4.4%; Value: 5.1%

In each case, the size and value factors (the excess return of small companies over large companies and the excess return of value companies over growth companies) provided large premiums during long periods when market beta was negative. Of course, that isn’t a guarantee this will always be the case. However, it does demonstrate the historical and potential benefits of diversifying across unique sources of risk. That is exactly why we diversify across asset classes/factors—our crystal ball, like all crystal balls, is always cloudy. And diversification is like insurance; insuring against having all our eggs in one risky basket.

Here’s another important point. When an asset class or factor has performed poorly, that generally means it has gotten cheaper and, thus, now has higher expected returns. It’s the reason why we tend to see reversion to the mean of long-term returns. Thus, before you abandon a well-thought-out plan due to poor recent performance, consider the following:

Cheap Or Expensive?
You have a choice to invest in asset class A, which has a one-year forward-looking price-to-earnings (P/E) ratio of 10.6, or asset class B, with a P/E of 15.7. The P/E of B is 48% higher than it is for A. You then look at another valuation metric, the price-to-book (P/B) ratio. You find that A has a P/B of 1.1 while B has a P/B of 2.5. The P/B of B is 2.3 times that of A. For investors focusing on dividend yields, the yield on A is 2.9% versus 1.9% for B.

A is cheaper by all three metrics. However, perhaps B has better growth prospects? The weighted average historic three-year earnings growth of A was 16.1%, 45% higher than the 11.1% growth for B. The weighted average estimated three-year to five-year growth of earnings for A is 15.7%, 21% higher than the 13.0% estimated growth for B.

Comparing the P/E relative to expected earnings growth (the PEG ratio), we find that the forward-looking PEG for A is 0.68 (10.6/15.7) versus 1.21 for B (15.7/13.0). Relative to forecasted growth in earnings, B is trading 1.78 times higher.

Here are some other interesting facts.

  • As a group, year-over-year growth in real gross domestic product (GDP) for the countries in A was 5% versus 3% for B.
  • The countries in asset class A make up about 28% of global GDP, higher than the 25% share for B. However, A makes up not much more than 10% of global market capitalization, while B makes up more than half.

By now you may have figured out that A is emerging market stocks, as represented by the S&P Emerging BMI, and B is the S&P 500 Index. All data is from S&P Dow Jones Indices’ Indexology® Blog.

We can add one more valuation metric, the cyclically adjusted price-to-earnings (CAPE 10) ratio, which is as good a predictor of long-term real returns as we have. CAPE 10 ratios as of the end of October 2018 for emerging markets and for the S&P 500 Index translate into forward-looking real-return forecasts of 6.8% and just 3.4%, respectively.

Additional Wrinkles
Unfortunately, investors are also subject to recency bias—allowing more recent returns to dominate their decision-making. From 2008 through November 2018, the S&P 500 Index returned 8.3% per year, providing a total return of 138%. During the same period, the MSCI Emerging Markets Index returned just 0.7% a year, providing a total return of just 8%. It managed to underperform the S&P 500 Index by 7.6 percentage points per year and posted a total return underperformance gap of 130 percentage points.

Compounding the problem was that not only were investors earning much lower returns from emerging market stocks, but also that they were experiencing much greater volatility. While the annual standard deviation of the S&P 500 Index was about 15% per year, the MSCI Emerging Markets Index’s standard deviation was about 22% per year. Not exactly a great combination—lower returns with 50% greater volatility. What’s to like?

Further compounding the problem is that investors tend to have short memories (especially after periods of losses). For example, it wasn’t long ago that investors were piling into emerging market equities due to their strong performance. For the five-year period from 2003 through 2007, while the S&P 500 Index provided a total return of 83% and the MSCI EAFE Index provided a total return of 171%, the MSCI Emerging Markets Index returned 391%. Emerging market value stocks did even better, as Dimensional data shows that its Emerging Market Value Index returned 521%. How quickly investors forget!

Before moving on, it’s worth noting the following forecast on international equities, which as we discussed have underperformed by a wide margin over the past decade, perhaps leading many investors to abandon them. Vanguard now expects international stocks to outperform U.S. stocks over the next 10 years by a margin of 3% to 3.5%.

Specifically, Vanguard expects a 4% annualized return for the U.S. stock market over the next decade, versus 7% to 7.5% for international equities. The expected performance gap is mainly driven by equity market valuations in the United States being much higher than for developed international markets (plus the U.S. economy being much further along in terms of its monetary tightening).

We have another important issue to discuss.

Diversification = Being Uncomfortable
Adam Butler of ReSolve Asset Management once offered the following observation: “Investing provides a premium because it is uncomfortable. The more experience I accumulate in this business, the more I have come to believe that the returns an investor can expect to achieve are directly proportional to the amount of discomfort that they are willing to tolerate.”

Investors face a choice. They can either own a traditional market-like portfolio, which has the vast majority of its risk concentrated in the single factor of market beta (for a typical 60% equity/40% bond portfolio, it’s almost 90%), or they can choose to diversify across as many unique sources of risk and return that have been identified and meet all the criteria we established earlier (persistence, pervasiveness, robustness, implementability and with intuitive explanations for their persistence).

The first path is the comfortable one in the sense that your portfolio will not cause any tracking error regret—you won’t be underperforming popular benchmarks that are reported on daily by the financial media. On the other hand, the traditional market-like strategy will likely be highly uncomfortable during periods like 1973-74, 2000-02 and 2008, when the single-factor (market beta) that dominates such portfolios’ risk suffers from severe bear markets.

Failing conventionally is always easier than failing unconventionally (misery loves company). Based on the historical mean and historical volatility, the market beta premium should be expected to be negative about 9% of the time over 10-year periods. However, we should expect more frequent failures in the future because current valuations are much higher than historical valuations.

Thus, we should expect a smaller premium. From 1927 through 2018, Ken French’s data shows the market beta premium was 8.5%. Most financial economists expect it to be much smaller going forward, perhaps half as much. A smaller premium with the same volatility means greater odds of negative returns.

The second path, diversification, is more likely to lead to successfully achieving goals. However, it does mean having to live with the fact that your portfolio will perform very differently than traditional portfolios, creating the risk of tracking error regret. In that sense, diversification is not a free lunch. It means living through uncomfortable periods, even long ones. And, during periods of failure, it means failing unconventionally, which is much harder to deal with.

Given that you must accept you will have to live through uncomfortable times whichever path you choose, it seems logical that you should pursue the path that gives you the highest odds of achieving your goals. And that is choosing the more efficient portfolio, the more diversified one, and saying, “I don’t give a damn about tracking error regret because relativism has no place in investing.”

Next week, I’ll discuss what happens if you do, in fact, decide to sell equities.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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