Swedroe: 7 Investing Rules

November 16, 2018

5. Understand That Even Good Strategies Can Have Bad Outcomes

In his book, “Fooled by Randomness,” Nassim Nicholas Taleb noted: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., 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 people who fail (those who succeed attribute their success to the quality of their decision).”

He also cautioned investors that “History teaches us that things that never happened before do happen.” The following is a great example of the wisdom of Taleb’s advice.

Over the 40-year period ending in 2008, both U.S. large-cap and small-cap growth stocks, as measured by the Fama-French research indices, underperformed long-term U.S. Treasury bonds. Does this mean investing in U.S. large-cap and small-cap growth stocks in 1969 instead of 20-year Treasuries was a bad strategy? Or is it that the risks of equity investing just happened to show up over that particular 40-year period?

I would hope that investors didn’t abandon the idea that these risky equity assets should be expected to outperform in the future just because they had experienced a long period of underperformance. From January 2009 through August 2018, the Fama-French U.S. Large Growth and Small Growth Research Indices produced total returns of 378% and 374%, respectively, while 20-year Treasuries produced a total return of 40%. The per annum returns were 17.6%, 17.5% and 3.5%, respectively.

6. Minimize The Frequency Of Checking Your Portfolio’s Value

Nobel Prize winner in economics Richard Thaler, author of the book “Misbehaving,” has found we tend to feel the pain of a loss twice as much as we feel joy from an equal-sized gain. This tendency leads to the behavior known as “myopic loss aversion,” creating a problem for investors who check their portfolio values on a frequent basis.

Consider the following: Based on the historical evidence for the S&P 500 Index (1950–2014), investors who check their portfolios on a daily basis can expect to see losses 46% of the time and gains 54% of the time. However, while they see gains more frequently than losses, because we tend to feel the pain of loss with twice the intensity that we feel joy from an equal-sized gain, the more often we check the value of our portfolio, the more net pain we will feel because our pain/joy meter will be -38 ([-46 x 2] + [54 x 1]).

Over the period 1927–2014, investors who resisted checking their portfolio daily, and instead moved to a monthly check, experienced losses only 38% of the time. That reduced the net pain reading from -38 to -14 ([-38 x 2] – [62 x 1]).

Over the same 1927–2014 period, losses occurred only 32% of the time on a quarterly basis. Thus, investors who reviewed their values quarterly (like many who participate in 401(k) plans and receive quarterly statements) experienced a shift from net pain to net joy of +4 ([-32 x 2] + [68 x 1]).

Investors whose patience and discipline allowed them to check values only on an annual calendar year basis experienced losses just 27% of the time. That results in a big improvement in the net reading, from +4 to +19 ([-27 x 2] + [73 x 1]).

As you would expect, the frequency of losses continues to diminish over time. Using overlapping periods from 1927 through 2014, the frequency of losses at a five-year horizon falls to just 14%. That results in a pain/joy reading of +58. At a 10-year horizon, the frequency of losses falls to just 5%. That creates a pain/joy reading of +85 and will make for a happy (and more disciplined) investor.

If you’re a masochist, the implication for you is that you should check the value of your portfolio as frequently as humanly possible. For the rest of us, the implications are many.

First, the more frequently you check your portfolio, the less happy you are likely to be and the less able to enjoy your life. Second, all else equal, the less frequently you check the value of your portfolio, the more equity risk you should be able to take. Third, the more frequently you check your portfolio, the more tempted you will be to abandon your investment plan in order to avoid pain.

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