#IWMC 2022 – The Returns Conundrum: Is your Strategy, Right? By Larry Swedroe

The 7th India Wealth Management Conference was held on 9th August 2022 in Mumbai by CFA Society India in association with CFA Institute, USA. The conference had a session by Mr. Larry Swedroe from Buckingham Partners, a famous author of many books, and his last book was on sustainable investing.

He started by discussing the value of patience and behavioral biases- which makes even one of the best investment managers abandon well-thought-out plans. During such times of crisis, the benefits of diversification also seem to be insignificant.

His firm Buckingham Partners has investment strategies to navigate stress full times by following 3 principles. First, markets are highly efficient; second, all risky assets have the same Sharpe ratios. And thirdly, portfolios must be well diversified across unique risks as against a single risk seen in traditional portfolios.

He then talked about his concerns regarding Beta being the most prominent risk factor during portfolio construction. He suggests diversifying across risk factors as well as diversifying across asset classes.  Diversification also leads to the problem of tracking variance regret, which leads to the mistake of resulting.  

Larry opined that risky assets experience long periods of poor performance. According to him, successful investing means accepting the risk of long periods of underperformance and having the discipline to stay on course, treating periods even as long as 15-20 years as noise.  The problem is that three years of losses often turn investors with 30-year horizons into investors with three-year or even three months horizons. People who don’t have patience end up buying stocks when they are doing good and sell when they are doing bad. This results in buying high and selling low. The best way to navigate during such periods is through diversification than by avoiding the investment opportunity.

He then showed the benefits of diversification and discipline of investing by analyzing the data for returns from 1927 onwards. Firstly, each factor, such as beta, size, value, momentum, quality, and profitability, individually exhibits very high odds of underperformance over a shorter period. It becomes lesser for 10 years and even lesser over 20 years. Secondly, however long the horizon is, each of the individual factors experiences underperformance, even at 20 years of the investment horizon.  The sole exception is momentum at 20 years. However, this doesn’t guarantee future success for momentum at 20-year horizons. Thirdly, in a portfolio that diversifies across these factors, no matter the horizon, the odds of underperformance are lower for a diversified portfolio than for a portfolio that has a concentration on any of the individual factors. The bottom line is that Diversification can reduce the risk of investing in risky assets, but it cannot eliminate them.

He then talked about most investment managers make the mistake of resulting. Resulting means judging a strategy’s performance based on the outcome instead of the quality of the decision-making process. He then spoke about hindsight bias which makes people do the mistake of resulting. Hindsight bias makes people feel the outcome was inevitable. The bottom line is you must accept that you can neither know the future nor control it.  Good investing means making a series of good decisions. Making many good decisions, over time, should compound into a better outcome than making a series of bad decisions.

The speaker drew insights from the period from 2008 to 2021, when investors were tested on their ability to ignore tracking-variance regret. During this period, Major US Equity Asset Classes provided somewhat similar returns. The S&P 500 index outperformed developed and emerging markets, which disappointed investors who diversified globally. Also, from 2017 to 2020, value stocks produced their worst return. Such returns led investors to consider abandoning their strategies of global diversification.

Now the question arises should we judge the strategy to have been a poor one based on the outcome?

Any investor planning to invest at the start of 2008 would have seen the returns from 2000 to 2007. Small and small value stocks outperformed the S&P 500 by wide margins, as did developed international markets and emerging markets dramatically outperformed. Investors would have liked building a globally diversified portfolio, with exposure to small and value stocks. Now you see, tracking variance works both ways. You have to take the positive tracking variance with the negative.

However, the investment world looked different in the new millennium. S&P 500 outperformed value and small stocks. US Stocks outperformed international and emerging market stocks. 

Performance between 1995-99 was very similar to the period after 2007 with growth stocks outperforming value stocks and US Stocks outperforming international stocks. Having experienced far superior performance of US Large cap stocks over this five-year period, it’s likely that many investors would have lost discipline, having lost faith in the benefits of building a globally diversified portfolio with small and value stocks. Thus, they would have missed the benefits that a more diversified portfolio provided over the next eight years. They would have had the worst of both worlds, having missed out on the superior performance from 1995 through 1999, and then earned far lower returns from 2000 to 2007. And perhaps, after those eight great years for the more diversified portfolio, they might have switched back, recognizing their mistake.

He then moved on to the twin problems of Relativism & Recency, which lead investors to abandon their well-thought-out plans. Relativism is when Investors compare their portfolio performance with a benchmark or peer. In today`s time, wisdom for diversification is the need of the hour and relativism shouldn’t affect portfolio decisions. Then there is another cognitive bias called recency where investors minds get maximum impact by the most recent observations and project them into the future.

Per Larry, Shiller cyclically adjusted earnings-to-price ratio which is the best estimate for future earnings. As of Dec 2021, this ratio was 2.5 for US, 4.8 for the MSCI EAFE Index, and 6.2 for the MSCI emerging markets index. The PE ratios were 50% higher in US markets in comparison to other developed markets and up to 90% in comparison to other emerging markets. Investors who avoid global diversification due to recency bias would miss the gains from other developed countries and emerging markets.

He then moved on to discuss the problem of impatience. When it comes to investing, temperament, which provides the discipline to ignore what economists know are random periods of underperformance and adhere to a well-thought-out plan, is far more important than intelligence.

During long period of underperformance S&P 500, value stocks, emerging markets makes investors abandon their plans to invest in them, this makes them miss the opportunity to experience high returns when things turn good for these investments.

The he talked about to have confidence that a factor premium, or strategy, wasn’t just the result of data mining, a lucky/random outcome, you need evidence that it has been not only persistent over long periods of time and across economic regimes, but also pervasive across sectors, countries, geographic regions and even asset classes. There is one other thing to consider: valuations. Even good investments can become bad if valuations become excessive. In other words, we need to ask, has a strategy become too expensive? That’s always possible, as bubbles have occurred in several different asset classes. The underlying premise of an investment strategy should be that the market is highly, though not perfectly, efficient. Diversification has been called the “only free lunch in investing,” it doesn’t eliminate the risk of losses.

Towards the end he said good advisors educate investors about tracking-variance, diversification, twin problems of relativism and recency. Along with discipline investors can expect a good portfolio return even though this isn`t guaranteed.