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.


Another example is that, for the same 40-year period, U.S. small-cap growth stocks returned just 5.1 percent, underperforming long-term Treasury bonds by 3.9 percentage points a year. Let's look at one more example where investors confuse strategy with outcome.

Consider an investor who begins in 2007. Having reviewed the data on various asset classes, he observes that from 1927 through 2006, value stocks have provided an annual average premium over growth stocks of 5.3 percentage points. So he decides upon a significant allocation to value stocks. Over the next five calendar years, the value premium is negative in four of them. It was negative through July 2012 as well. The total return underperformance was almost 17 percent.

Confusing strategy with outcome, the investor abandons his plan and sells his value stocks. The problem occurs because the investor did not understand that, while there has indeed been a large value premium, the premium has been highly volatile. The annual standard deviation has been 12.3 percent. That means there can be long periods when the premium can be negative.

To help you better understand of the persistence of risk premiums, my colleague and co-author, Jared Kizer, took a look at the issue. He explored the consistency of the market, size, value and momentum premiums using U.S. stock market data from the Fama-French data series for the period from 1927 through June 2014.

Consistency is important because it gives you a sense of how frequently the unexpected happens; for example, bonds outperforming stocks or growth outperforming value.


The table below shows the consistency of each return premium over monthly, annual and independent five-year periods.

Market Size Value Momentum
Positive Months (%) 60 51 55 64
Positive Years (%) 69 56 63 84
Positive 5-Year Periods (%) 88 65 76 94


These data illustrate a number of points. First, over monthly periods, all of the return premiums are positive more often than they are negative. But it's not much better than a coin flip for the size and value premiums. Note that the highest persistence is for the momentum premium.

Second, as we lengthen the time frame, the expected result begins to more clearly emerge. Over independent five-year periods, three of the four premiums are positive at least three-quarters of the time. We shouldn't interpret these numbers with too much precision, however, because there are only 17 independent five-year periods over this sample.

Nevertheless, directionally, we see that time horizon matters. Finally, the table gives one an appreciation of the tracking error, relative to the stock market, associated with the size and value premiums. For instance, 65 percent and 76 percent of five-year periods result in positive size and value premiums, which means that large stocks outperform small stocks 35 percent of the time, and growth stocks outperform value stocks 24 percent of the time.


Another insight we can collect from the data set is just how frequently one of the four premiums was positive over monthly periods, and how frequently all were positive. This gives you a sense of the diversification benefits of having exposure to all four premiums instead of focusing on a single one, such as the market premium.

At Least 1 Premium All 4 Premiums
Positive Months 1,007 109
Positive Months (%) 96 10




This second table shows that at least one premium was positive in 96 percent of the months. All four were positive in 10 percent of the months. Remember that the best consistency result we found in the first table was momentum, which was positive in only 64 percent of monthly periods. All else being equal, this indicates you should consider having exposure to a bit of each of these premiums for diversification purposes.

These examples demonstrate why I believe that knowledge is the armor necessary to protect you from confusing strategy with outcome. As Benjamin Franklin said, "An investment in knowledge pays the best interest."

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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