The next book about money we plan to read is The Psychology of Money – Timeless lessons on wealth, greed, and happiness. It is scheduled to be released on September 8th and is getting the buzziest reviews we have heard about any finance book in 2020. It’s authored by Morgan Housel, who readers of this email will recognize. Housel uses 19 short stories to explore the way people make financial decisions. “Important decisions are often made at the dinner table, where personal history, your own unique view of the world, ego, pride, marketing, and odd incentives are scrambled together.”
“It’s one of the best and most original finance books in years.”
We’ve said it before and we’ll likely say it again: Investment risks and expected rewards are related, but disciplined diversification helps us reduce the risks.
Our friends at Dimensional Fund Advisors recently released an important report supporting this point.
In their report, they took a look at four sources of expected returns found in many evidence-based investment portfolios (market, size, value, and profitability).
Using U.S. stock market data stretching back more than 50 years, they found that, about half the time, one of the four premiums delivered negative returns for any rolling ten-year period across that time frame.
That sounds risky, doesn’t it? But consider this: Across the same time frame, at least one of the premiums delivered positive returns during every single 10-year rolling period. In fact, far more often than not, two of them delivered positive returns during each 10-year period. The premiums existed, they observed, but they “do not move in lockstep.”
Check out Dimensional’s report to see the data for yourself. It offers a strong, continued vote for depending on steadfast diversification across multiple risk premiums to help you manage your risks in pursuit of your expected rewards.
Did you know that December 11, 2018 marked the 10-year anniversary of the day Bernie Madoff was charged with securities fraud? His colossal $64 billion dollar scheme came crashing down.
While there is certainly nothing to celebrate about the anniversary, there are lessons to learn. Ranking toward the top of our priority list, we should do all we can to prevent history from repeating itself, at least to the same magnitude.
Madoff’s Manipulative Mind Games
One of the telltale signs of Madoff’s malfeasance is easy to describe, but treacherously tricky to catch when it’s happening to you. Madoff was famous (now infamous) for supposedly employing stock options to deliver unwavering returns, year after year after year, no matter what the market was doing.
Think Houdini. When a supposed gentleman with impeccable credentials is masterfully managing your money like none other, it becomes difficult to recognize what has to be a sleight of hand. A potent mix of your own behavioral biases sees to that. Plus, Madoff’s set-up lacked any of the checks and balances you should demand from your advisor. Without an independent third party custodian reporting directly to you (such as Schwab, for our clients), it’s too easy for a con artist to fabricate a reality that doesn’t exist.
Unfortunately, while magic is entertaining, losing your wealth to a deception is no fun at all.
Bottom line, if any money manager claims to be delivering constant, consistent stock market returns for years at a time while the markets swing up and down, you can almost certainly assume something’s amiss.
Back to Evidence-Based Reality
Unfortunately, these kinds of tricksters put us real advisors at a disadvantage. Unlike Madoff’s portfolios, ours won’t deliver magically positive percentages every month of every year – or even every year. Instead, we employ evidence-based investing to guide us through markets whose expected long-term returns are typically delivered in unpredictable fits and starts.
That means, as a realistic investor, you must be willing to tolerate the risks involved when you Take the Long View®. This does not mean you must accept excessive risk. There are a number of ways to manage the downturns while maximizing expected returns:
- Avoid concentrated risks by employing broad, global diversification instead of trying to pick individual stocks or time the market’s movements.
- Establish enough liquid (spendable) reserves to tide you through market downturns without being tempted or forced to unwind your long-term investments.
- Judiciously seek higher returns when warranted by tilting your equities toward expected sources of added risk and return – such as small-cap value stocks.
Likely vs. Certain = Reality vs. Fantasy
Are we SURE our approach is going to work? Do we KNOW, for example, that small-cap value stocks WILL provide premium returns over time?
We cannot be certain. After all, the value premium has disappointed during the past decade. Ten years might tempt even a resolute investor to waiver.
However, while we cannot be certain, we can shoot for most likely, based on the strongest, longest-term evidence we can find. In that context, the evidence clearly informs us that a decade of underperformance in any given asset class is not only possible but is periodically expected.
As this chart from Dimensional Fund Advisors demonstrates, since 1926, the value premium has outperformed growth 84% of the time across nearly 1,000 overlapping 10-year timespans. This means, 16% of the time (during around 160 decade-long periods), it has not.
If you’d like to ponder this phenomenon at greater length, here’s the Dimensional paper from which we extracted this chart.
We also encourage you to read “Factor Fimbulwinter” by Corey Hoffstein of Newfound Research. Admitting that the recently “disappearing” value factor (as measured by price-to-book) could well signify either the death of the premium, or simply a decade of expected variance, Hoffstein calculated how long it should take to be able to determine which conclusion was correct. The answer: 67 years.
He concludes (emphasis ours):
“The problem at hand is two-fold: (1) the statistical evidence supporting most factors is considerable and (2) the decade-to-decade variance in factor performance is substantial. Taken together, you run into a situation where a mere decade of underperformance likely cannot undue the previously established significance. … In investing, factor return variance is large enough that the proof is not in the eating of the short-term return pudding.”
Larry Swedroe also recently analyzed the durability of various investment factors and reached similar conclusions. In his article, he observed:
“[O]ne of the greatest problems preventing investors from achieving their financial goals is that, when it comes to judging the performance of an investment strategy, they believe that three years is a long time, five years is a very long time and 10 years is an eternity.”
Planning for Uncertainty
Of course most of us don’t have 67 years to wait before we decide whether a market factor is a sure winner or loser. Favoring reality over fantasy, here’s what we suggest:
- Incorporate the most robust academic evidence suggesting which risk/return factors to favor.
- Tilt your globally diversified portfolio toward those factors (as needed to reflect your unique goals).
- Stick to the plan for a long, long time; avoid acting on hopes or fears, favoring only judicious adjustments when warranted.
What’s the alternative? While Madoff is history, we can point to any number of unsavory schemes that continue to be perpetrated by a seemingly never-ending supply of similar scoundrels. So whatever you do and whoever’s advice you choose to take, here’s one tip worth taking to heart: Always be wary of a “sure bet.”