Swedroe: Know The Risks, Stick To The Plan

November 26, 2014

Sticking to your plan is the single biggest factor determining successful investing.

In my 20 years’ experience as a financial advisor, I’ve learned that even if there were such a thing as the “perfect portfolio,” choosing the asset allocation that’s most likely to allow you to adhere to your financial plan is even more important than the allocation itself.

Because adhering to your plan should give you the greatest chance of achieving your financial goals, it’s critical that your plan not assume more risk than you have the ability, willingness or need to take. It’s equally critical you don’t invest in any strategy that contains risks you don’t understand. The reason for this warning is because any asset class or strategy can experience very long periods of underperformance.

If you don’t understand that risk, you’ll likely make the mistake of confusing strategy with outcome. That could lead you to abandon your plan when a long period of underperformance occurs.

A Real-World Example

The following example makes this point crystal clear. From 1969 through 2008, U.S. large-cap growth stocks (specifically, Fama-French large growth stocks ex-utilities) returned 7.8 percent a year. Long-term (20-year) Treasury bonds returned 8.9 percent a year over that same period, meaning large-cap growth stocks underperformed for 40 years.

The question is: Would you have abandoned your plan if you had invested in these stocks? If so, consider this: From 2009 through 2013, the returns were 23.1 percent a year for large growth stocks and just 1.9 percent a year for 20-year Treasurys. This difference was so great that for the full 45-year period, large-growth stocks now outperformed 20-year Treasurys: 9.4 percent versus 8.1 percent. Of course, the only way you earned that higher return was to patiently wait out the 40-year period of underperformance.

This point holds just as true for the low-beta/high-tilt portfolios my colleague Kevin Grogan and I recommend investors consider in our book, “Reducing the Risk of Black Swans.” What the New York Times called the “Larry Portfolio” basically limits the equity portion of the overall portfolio to small value stocks.

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History Lesson

Think about the following historical scenario: For the period 1927-1979, small value stocks (Fama-French small value stocks ex-utilities) outperformed the total market portfolio at 13.2 percent a year versus 8.8 percent a year. As a result, you decide to load up your portfolio on small value stocks. For the next 20-year period, 1980-1999, small value stocks returned 16.6 percent a year, underperforming the total market portfolio by 0.9 percentage points a year.

Would you have had the discipline to stay the course?

I ask, because over the next four years, 2000-2003, small value stocks outperformed the total market by 25.1 percentage points a year, 20.4 percent a year versus -4.7 percent. Over the full 24-year period, small-value stocks outperformed the total market by 3.8 percentage points a year, 17.2 percent a year versus 13.4 percent. Again, the only way you earned that higher return was to patiently wait out the 20-year period of underperformance.

Understand The Risks

Hopefully, the above examples make clear that before you invest in any strategy (asset allocation), you should fully understand the nature of its risks and be prepared to experience long periods of underperformance. These examples should make it quite clear that it’s possible the period of underperformance might even last for the majority of your investment horizon (or all of it).

That doesn’t mean a strategy is a bad one. It just means the risks involved happened to show up during a period where it mattered to you. In other words, because none of us has a clear crystal ball, a strategy must be judged as the right one or the wrong one before we invest.

You shouldn’t judge strategies based on ex-post outcomes, as they can be the result of random (both good and bad) outcomes.

Don’t Be ‘Fooled By Randomness’

Nassim Nicholas Taleb, author of “Fooled by Randomness,” put it this way:

“Lucky fools do not bear the slightest suspicion that they may be lucky fools—by definition, they do not know that they belong to such a category. They will act as if they deserve the money. The lucky fool [is] defined as a person who benefited from a disproportionate share of luck but attributes his success to some other, generally very precise, reason.”


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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