Arty put up two especially important comments to a blog entry from last week. I am using his two comments as today’s blog entry to be sure that all visitors to the blog see his words and are able to profit from his insights.
The comments were put to the blog entry entitled Passive Investing Is For Extemists: The Critique.
Here are Arty’s words:
These are all important comments. John’s comments suggest to me the aim of avoiding big losses in down years.
I infer from Rob’s comment (whether he intends so or not) what I see as most important consideration to successful (long-term) investing: commitment to a “strategy.”
The opposite of commitment is selling-out, (usually low and usually at the time of low market valuations but high *perceived* risk, like last November). The issue for me, is that a good strategy has to be one in which you have conviction. The biggest threat to conviction, in my observation, is sustaining big losses. And I think most investors are indeed risk-averse, regardless of the silly little test they take in initial consults with an advisor when designing a portfolio strategy.
So, a successful strategy—whatever it is—has to be one that reduces the far left fat tail—dampens the big loss. Absent that, most investors are going to be tested—likely to their limit. Recognizing this changes the relative experience of *living with* a particular strategy even as two strategies may produce similar returns.
After playing with your calculator, I did some detailed observations using specific asset classes (funds that many individuals could have invested in). Here’s a specific example (using specific stocks and bonds) that embraces several valuation periods:
Portfolio 1 (1972-2008)
Cost adjusted Gross Return: 9.39%
Best year (among other similar): 1975 38.7%
Biggest losing years:
Portfolio 2 (1972-2008)
Cost adjusted Gross Return: 9.6%
Best Year (by far): 1985 22.8%
Biggest losing years:
(small gains in 2001 and 2002)
Similar returns between the two strategies over the same long time period. Now, which strategy would you rather have lived through? Which strategy would an investor have been likely to adhere to?
Keep in mind John’s point:
“Waiting 30 years will work well enough if you can stand what happens in the meantime.”
Yes. I think our discussion locates the crux of the matter, and it is indeed found at the emotional. But is has taken me some added work to understand the real threats, vice the lesser order issues that tend to dominate most discussions.
A successful, long-term investor must have a belief system and be committed to a strategy that avoids the great risk of “bailing-out” (which includes either performance chasing or outright going to cash).
Now, here is where it gets interesting, because there are very different ways to accomplish this, but to me, they usually share the common feature of Fat Tail reduction (an often used Larry Swedroe term, actually). And it might be accomplished with a valuations-based strategy, as you have endeavored to discover, which, not surprisingly, requires low beta exposure—but at high valuation periods and not necessarily throughout.
The two examples I provided, above, were buy and hold portfolios across a 37-year period using funds that many investors could access.
The first portfolio was obviously a TSM fund—100% stocks! Clearly, if you held that portfolio your returns were nice, but you were tested—and I wonder how many could have held it 37 years.
The second portfolio, while returning about the same, did not compete in bulls, but hardly suffered much in bears, even last year, and not at all in ‘01-’02. It was a strategy whereby the equities were “Tilted” to small value and emerging markets (risky asset classes) but dampened by 70% Short-term Treasuries, thus accomplishing a low beta exposure and fat tail reduction. It is unlikely this investor was severly tested in any downturn. That is good.
Low beta being the key to reducing the big losses, and, in my view, staying committed for that long.
The portfolio below (#3) also reduces fat tail risk, uses TSM as its sole stock allocation and adds 2 low-correlating asset classes to it (Gold and LT Treasuries), and has a similar return to the other two portfolios, while being *very* different:
Portfolio 3 (1972-2008)
Cost adjusted Gross Return: 9.79%
Best Year (by far, the rest much lower): 1979 42.1%
Biggest losing years:
(small gain in 2008!)
This is the Permanent Portfolio and someone using a buy and hold strategy with it would have earned those returns across 37 years.
I’m not recommending any of these portfolios/strategies just making an observation on why they work.
So buy and hold can work over the a long term, and stay protected in the short term, and return well over time. But there is a catch.
The portfolios that I presented (#2 and #3) carry a risk—not surprisingly, an emotional one—that is their greatest threat; it is called “tracking error regret”. That means, they may perform very differently than “the market”. That means in bull markets, these portfolios will still make some money but be outperformed, badly, by traditional portfolios. (But, recall, these are the same traditional portfolios that then get crushed in the bears!)
But, the smart investor who respects the greatest threat of all, “bailing-out” in a big downturn, *must* be willing to trade-off not doing well as his friends in bull markets. He must be willing to make much less in boom cycles to lose far less in bust cycles. That is how one can actually “stay the course” with a single allocation. But the tradeoffs must be fully understood.
A valuations-based strategy also carries this risk. For if you were worried in 1993 at P/E 20, you may have reduced too much and missed 7 great years, making far less than your friends. Here too, tracking error regret is the emotional threat that must be understood to profit.
As evidenced by famous “Plan B” options, even veteran investors don’t know this, probably because they were advised, outright or subtly, to hold more beta exposure than they should (for all sorts of reasons like fear of inflation or blatant optimism or whatever). And they did not envision just how tough the tests were or how easy it would be to quit. But it takes education on the matters that truly *matter most*, and then belief in one’s implementation of that education.