Swedroe: Difficulties Of Discipline

July 30, 2018

In a June 1999 interview with Businessweek, Warren Buffett is quoted as saying, “Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”

Michael Mauboussin, director of research at BlueMountain Capital Management (and prior to that, head of global financial strategies at Credit Suisse and chief investment strategist at Legg Mason Capital Management), seems to agree with Buffett. In his book, “More Than You Know,” Mauboussin wrote: “Investment philosophy is really about temperament, not raw intelligence. In fact, a proper temperament will beat high IQ all day long.”

Temperament is critical to successful investing because markets persistently test investor discipline with periods, often long ones, of volatile and/or poor performance. In my more than 20 years of counseling individual and institutional investors, I’ve learned that, when it comes to judging performance, most investors think three years is a long time (e.g., that’s the typical period over which institutional investors judge performance when considering whether to retain or fire a fund manager), five years is a very long time, and 10 years is an eternity.

On the other hand, financial economists know that when evaluating the performance of all risky assets, 10 years is likely nothing more than noise and, thus, should be ignored. Warren Buffett certainly appears to agree, as he stated in Berkshire Hathaway’s 1988 annual report that the company’s favorite holding time is forever. In the Berkshire Hathaway’s 1996 annual report, he added: “We continue to make more money when snoring than when active.”

It’s many investors’ inability to ignore market “noise” that leads to poor performance. The following example should make this point clear.

Underperformance Tests Discipline

It has long been known that small-cap and value stocks have provided higher returns than large-cap and growth stocks and the market overall. Shortly after Eugene Fama and Kenneth French published their 1992 paper, “The Cross-Section of Expected Stock Returns,” which showed the public that small-cap and value stocks had provided a large premium, Dimensional Fund Advisors launched the first small-cap value fund that did not engage in any individual stock selection or market timing (i.e., active management). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)

The inception date of Dimensional’s U.S. Small Cap Value Portfolio (DFSVX) is April 1993. (The first small-cap value index fund, Vanguard’s Small Cap Value Index Fund (VISVX), had its inception on May 20, 1998.) Note that my firm has used DFSVX in client portfolios almost from the very beginning. Almost immediately, investor discipline was severely tested. As you review the data, keep in mind my maxim about how long most investors believe is long enough to judge performance.

Over the more than seven-year period from inception in April 1993 through May 2000, Dimensional data shows that DFSVX fund underperformed the S&P 500 Index by 6 percentage points a year (19.8% versus 13.8%). Thanks to the power of compounding, that gap resulted in an underperformance in total return of 265% versus 153%.

That’s not the only long period of underperformance. Over the most recent 5 ½-year period, January 2014 through June 2018, DFSVX underperformed the S&P 500 Index by 3.8 percentage points a year, producing a total return difference of 61% versus 38%. Periods such as these test the patience of most investors.

Long-Term Payoff

Now, let’s look at the fund’s performance over the full period. Despite enduring those two long periods of underperformance, totaling more than 12½ years (virtually half the fund’s life), Dimensional data shows that, from inception through June 2018, DFSVX provided a total return of 1,642% versus the 893% total return for the S&P 500 Index. Annualized returns were 12.0% for DFSVX and 9.5% for the S&P 500 Index.

Investors who had faith in the size and value premiums, as well as the required discipline to stay the course, were rewarded well for their belief that capital markets work efficiently, and it’s likely that riskier assets will provide higher returns (the longer the time horizon, the more likely that will be case).

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