Best Of 2016: Swedroe On The Mystery Of Vanishing Premiums

February 16, 2016

  • Persistent—across long periods of time and various economic regimes.
  • Pervasive—holds across countries, regions, sectors and even asset classes.
  • Robust—holds for various definitions (for example, there’s a value premium whether we measure value by price-to-book, earnings, cash flow or sales).
  • Investable—holds up not just on paper, but also after considering trading costs.
  • Intuitive—there are logical risk-based (economic) or behavioral-based explanations for the premium and why it should continue to exist.
  • Not subsumed by other well-known factors.

My almost 20 years of experience as a financial advisor has taught me that even the most disciplined investors can have their patience sorely tested by as little as even a few years of underperformance, let alone a 10-year period without higher returns for value (or small, or international, or emerging market) stocks.

A dramatic example of the potential for underperformance, or what’s referred to as negative tracking error, is the five-year period ending in 1999. During that time, small value stocks underperformed the S&P 500 Index—which returned 28.6%—by 13.8 percentage points, as Fama-French small value stocks, ex-utilities, returned 14.8%. The longest period when small value stocks underperformed the S&P 500, at least based on calendar years, was the 19-year period 1984 through 2002, when small value stocks returned 12.1% versus the 12.2% return of S&P 500 Index.

No Regrets!

Given the above, those who know their investment history certainly shouldn’t then be surprised when we have a 10-year period without outperformance. Such periods, however, create risk for investors who fall prey to a dreaded disease known as “tracking error regret.” These are investors who regret their decision to maintain a portfolio that performs differently than the market. Tracking error regret causes many investors to abandon their well-thought-out, long-term plans.

As a footnote, for the 15-year period ending Feb. 11, 2016, the DFA Small Value Fund (DFSVX) returned 8.5% per year and outperformed the Vanguard 500 Index Fund (VFINX), which returned 4.2% per year, by 4.3 percentage points per year. That’s called positive tracking error. And I’ve yet to hear an investor complain about positive tracking error.

Of course, the likelihood of periods, even very long ones, of negative tracking error is the price you must pay to earn above-market returns in the long term. And that’s why so few individual investors actually earn the premiums available. They don’t have the discipline to stay the course. Their greatest enemy tends to be themselves.

One of my favorite expressions is that diversification is the only free lunch in investing, so you might as well eat as much of it as you can. But to enjoy the benefits of diversification, you must be patient. Warren Buffett, for instance, has stated his favorite time frame for investing is forever.

If you aren’t patient and disciplined, you are likely to catch that tracking error disease and abandon your plan. It’s that stop-and-start approach to investing that dooms many investors to poor returns. Though they own stocks, they often end up with bondlike returns.

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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