If investors were asked, “Who do you think is the greatest investor of our generation?” I’d bet an overwhelming majority would answer, “Warren Buffett.” If they were then asked, “Do you think you should follow his advice?” you might think that they would say, “Yes!”
The sad truth is that while Buffett is widely admired, a majority of investors not only fail to consider his advice, but tend to do exactly the opposite of what he recommends.
Buffett has said that “investing is simple, but not easy.” He has also said that “the most important quality for an investor is temperament, not intellect.” By that he meant the ability to stay disciplined, ignore recent events and returns, and adhere to your well-thought-out plan. He explained: “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
While financial economists consider 10 years of data as nothing more than “noise,” my more than 20 years of work as an investment advisor have taught me that, when contemplating investment returns, the typical investor considers three years a long time, five years a very long time and 10 years an eternity. (What inspired me to write this piece was a new record set when an investor expressed concern over the fact that a fund had underperformed in the 11 weeks he owned it.)
10 Years Is Not A Long Time
For investors to be successful, they must understand that, in the market, even 10 years is a relatively brief period. No more proof is required than the -1.0% per year return to the S&P 500 Index over the first decade of this century.
That’s an underperformance of 3.8% a year relative to riskless one-month Treasury bills and a total return underperformance in excess of 40%. Investors in stocks shouldn’t have lost faith in their belief that stocks should no longer be expected to outperform safe Treasury bills due to the experience of that decade.
The following table shows the annual premium, Sharpe ratio (a measure of risk-adjusted returns) and the odds of outperformance for the six equity factors (beta, size, value, momentum, profitability and quality) that have provided persistent premiums, not only in the U.S. but around the globe.
Note that these six factors also explain almost all of the variation in returns between diversified equity portfolios. With a single exception, what the table shows is that, no matter the investment horizon, there is always some probability that the factor will deliver a negative return. The sole exception was the momentum premium, which was positive during each of the 20-year periods. Of course, even this is not a guarantee that it will be positive over all future 20-year periods.
There are two other important takeaways. The first is that, no matter what the investment horizon may be, you are putting the odds into your favor by gaining exposure to these different factors. The second takeaway is that, as demonstrated in Table 2 below, the factors all have low-to-negative correlations to each other, resulting in a diversification benefit.
Benefits Of Diversification
The diversification benefits can be seen in Table 3. This table shows the mean premium for each of the factors, the volatility of the factor and its Sharpe ratio. It also provides the same information for three portfolios.
Portfolio 1 (P1) is allocated 25% to each of four factors (beta, size, value and momentum). Portfolio 2 (P2) is allocated 20% to each of the same four factors and adds an allocation to the profitability factor. Portfolio 3 (P3) is allocated the same way, substituting the quality factor for the profitability factor.
The low correlations among the factors resulted in each of the three portfolios producing higher Sharpe ratios than any of the individual factors. Furthermore, we can see the benefits of diversifying across factors in the table below, which shows the odds of underperformance over various time horizons.
As you can observe, no matter the horizon, the odds of underperformance are lower for each of the three portfolios than for any of the individual factors.
Playing The Odds
There is one other important takeaway that relates to an issue I am often asked to address. Some investors will see this data and say: “But I don’t have 20 years to wait for a premium to be realized.” The best way to think about this, however, is relatively simple.
Unfortunately, there are no clear crystal balls in investing. Thus, the best we can do is to put the odds of success in our favor as much as possible. As the above tables show, regardless of your investment horizon, be it one year or 20, you are always putting the odds in your favor by gaining exposure to any of these factors. It’s just that the odds grow increasingly in your favor the longer the horizon.
Because any factor can deliver a negative premium over even long horizons, the prudent strategy is obvious: Diversify across factors and don’t put too many of your investment eggs in any one of them. But, as Buffett said, while investing really can be that simple, it’s not easy to ignore what feels like long periods of underperformance. And that leads to impatience and the loss of discipline.
The bottom line is that an investor’s worst enemy is staring right back at him when he looks in the mirror. One of my favorite expressions is that knowledge is the armor that can protect you from making bad decisions. You have the knowledge. Now all you need is the discipline.
This commentary originally appeared June 10 on ETF.com
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