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Why Comparing Returns Is A Bad Way To Choose An Investment Manager

Summary Short-term or recent returns give little information about future returns, and they increase the odds you’ll make a bad decision. Far too often, investors put significant weight on short-term performance, in many cases by choosing the investment with the highest recent investment return. This tends to actually produce future underperformance. The better way to choose an investment manager is to look at service, fit, and investor returns. The greatest trick the stock market ever pulled was convincing investors that historical returns are predictive. They aren’t. In fact, historical returns not only give you very little information about future returns, but they can also increase the odds you’ll make a bad decision. We often see this bias in investors. Both reporters and prospective customers often ask us, “What are your returns?” I cringe when I hear this. Out of all the questions you should be asking, this one should be low on the list. There are far more informative and useful questions to ask, once you know what’s in our portfolio . To be fair, there are aspects of the answer that can be helpful. Returns can give you an idea of the size of upswings and drawdowns, and how the portfolio relates to other asset classes. But in a passive, index-tracking portfolio, such as Betterment’s, you shouldn’t expect to see market alpha in our performance. When properly benchmarked, we are the benchmark. The other common mistake people make is comparing our portfolio to another over a short period of time. If, after six months, our portfolio has a lower return, they’ll often ask, “Why should I use you if your returns are worse?” Far too often, investors put too much weight on small sample, recent historical performance, choosing the investment with the highest investment return. How deceptive can this be? Our interactive tool below shows that this method leads to astonishingly high odds that they’ll underperform both in absolute and risk-adjusted terms in the future. How the Data Deceives You might not realize it, but when you look at historical returns, you’re doing a statistical analysis. Any set of historical returns comprises a sample of behavior over a certain period. Any inferences you make about what they tell you of the future should be balanced by placing them into context of how variable they are. And when you do that, two clear issues arise. Fooled by Randomness The first is being “fooled by randomness,” a phrase coined by Nicholas Nassim Taleb, a risk analyst and statistician. When you choose the highest returning of two correlated investments using a small sample of historical data, the odds are incredibly high that you picked the wrong fund. The randomness of small samples overwhelms the truth. Let’s work through some examples. We’ll use hypothetical portfolios with return probabilities we know for certain, because we’ve created them through simulation, and see how well the short-term data mimics the long-term truth. These are not Betterment portfolios. Portfolio A will have a mean annual return of 6% and a volatility of 14%. Portfolio B has a mean return of 6.5% and annual volatility of 13%. The portfolios will also have a 0.90 correlation to each other-most stock funds have higher correlations. By both measures of absolute return and risk-adjusted return, Portfolio B is better. Yet over the first randomly simulated six-month period, Portfolio A came out ahead. One 6-Month Simulation (click to enlarge) How often does the worse portfolio come out ahead over a short time period? In this case, we’ll call them C and D, with the same parameters. Let’s look at running 1,000 of such simulations over a six-month period. How often does Portfolio D, who should be the winner, come out ahead? Many Simulations Over 6 Months (click to enlarge) The answer is so close to 50% as to be indistinguishable from it. In fact, we can increase the differences in expected returns and this remains true. Let’s give Portfolio D a mean return of 8% and Portfolio C a mean return of 6%. Both have 14% volatility. The significantly higher return Portfolio D will still lose over 40% of the time over a six-month period. Many Simulations Over 6 Months (click to enlarge) While the odds are just better than 50/50 in the short term, they have big consequences in the long term. Here are the distributions of 20-year outcomes for those same portfolios: Many Simulations Over 20 Years (click to enlarge) The randomness in half-year returns results in choosing the wrong portfolio about half the time, even with large difference in return. You might as well save yourself the time and expense and flip a coin. Over long periods of time (20 years), and with large differences in average returns, the odds of picking the correct choice do increase. But you may be surprised how long it can take. For portfolios with a 1% return difference, by 20 years you still have about a one-in-four chance of picking the portfolio that will have worse underlying returns over even longer periods of time. Chance of Choosing Worse Portfolio Based on Performance Return Difference 3 months 6 months 1 Year 5 Years 10 Years 20 Years 0.50% 49% 48% 48% 42% 40% 37% 1.0% 47% 46% 44% 36% 32% 26% 2.0% 44% 43% 37% 26% 16% 9% Each cell based on 3,000 simulated cumulative returns of better portfolio (8% return) versus a benchmark portfolio with a mean return of 6% and 14% volatility. Correlation of 0.90 between portfolios. To be clear, there are statistical tools you can use to improve your odds of picking the right portfolio, but most investors aren’t professional statisticians. They just go by the cumulative returns over a short period of time. Performance Chasing Is Worse Than Random If the low odds of correctly choosing a better portfolio above didn’t convince you, it’s even worse than that. Empirically, choosing the best funds, a strategy called performance chasing, is likely to reduce your returns. The graph below comes from an excellent research paper from Vanguard. It shows the returns achieved by investing in the best fund in each asset class, compared to a buy-and-hold strategy. Performance chasing-picking investment based on recent performance-produced worse returns of about -2% to -3.5%. Buy-and-Hold Superior to Performance Chasing, 2004-2013 (click to enlarge) If every year, you picked the investment manager with above average returns over the past 12 months, you’d end up underperforming an investor who stuck with the passive index-tracking manager. The Right Things to Consider If recent investment performance is such a poor way to choose an investment manager, how should you select one? Use a set of clear principles that are likely to be true in the future: Monetary Cost: A certain drag on returns, if the service doesn’t deliver value above cost. Consider commissions, trade fees, and assets under management (AUM) fees. Non-Money Costs: How much time and and effort does it take for you to use it well? Does it have a high time or stress cost for you to get the most out of it? Services Offered: Do the services offered make you better off? Does it do things for you which you wouldn’t do yourself? Does it help you make better decisions? Does it make some of those decisions for you, automatically? Experience: Is it easy to use? Do you enjoy using it? Philosophy Fit: Consider its investment philosophy, and if it is parallel to yours. Some funds seek to deviate from the index and cost more, some seek to track it passively. Tax Management: Returns will likely not take into account actual value-adds , such as tax loss harvesting. You won’t have received a comparison tax bill that allows you to compare after-tax returns across services; it will be up to you to compare them. Behavior Management: Does the service have a proven track record of reducing the behavior gap? When choosing an investment manager, the key isn’t to focus on investment performance; it’s to focus on service, fit, and investor returns. Information in this article represents the opinion of the author. No statement in this article should be construed as advice to buy or sell a security. The author does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision.

Price And Return Study On Class I Railroads

Summary In our ongoing efforts to point out the value of buying the least expensive stock, we have reviewed the price performance of the Class I railroads over fifteen years. We found that the most expensive stock outperforms about 50% of the time. The more relevant finding, though, is the powerful relative performance of the “cheap group” versus the “expensive group.” We offer this (non-scientific) study as the basis for discussion. We thought we’d take a break from talking about operating yields, the value of avoiding optimism and the fact that most expensive stocks disappoint over time to talk about the value of cheap investing as it relates to railroad investing. Although this short study was in the aid of our railroad obsession, we believe the findings are relevant to many sectors and stocks. We decided to review the price performance of the six Class I railroads for which we have data available for the period 2000-2014. We looked at which company was the least and most expensive on a PE basis at the beginning of each year from 2000 to 2014 inclusive. We then calculated the subsequent yearly returns for the cheapest and the most expensive railroads. The results are interesting (to us, anyway….we know…get a hobby). Results We found that “buying expensive” in some sense beat “buying cheap.” Specifically, buying the most expensive railroad at the beginning of the year was as likely as not to generate higher returns than the cheapest railroad over that year. Before concluding that there’s no value in buying cheap, though, consider that the mean return for cheap was much greater than buying expensive. Over the past fifteen years, on average, buying the cheapest railroad has produced a return of 23.56%, while the return for buying the most expensive railroad generated only an 18.25% return on average. We include the raw data at the end of this document. Source: Gurufocus Although buying expensive may beat buying cheap in any given year, over time, buying cheap has crushed the returns of the positive railroads. In our view, there was less risk associated with these cheaper stock returns also. We acknowledge that this is not a scientifically sound study. We will expand the study to include total returns from dividends. In future, we’ll review the tax consequences of this approach relative to a buy and hold approach. We will compare these returns to a benchmark (perhaps the transportation index). Before that, though, we believe that something need not be scientifically robust to be true. Although we’ll refine the work, this is sufficient evidence that buying cheaper railroads produces higher returns at lower risk than the alternative. Conclusion Although this short study looked only at the Class I railroads, we believe there’s a wider lesson here. Although expensively priced stocks may outperform in a given year, they will perform less well over time. Given that they’re coming from a much less expensive base, cheaper stocks almost inevitably outperform over time. (click to enlarge) Source: Gurufocus Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Balanced Investing For Balanced Living

In the market’s never-ending story, we never know how its most recent action will play out. One thing we do know is that when the market is more volatile than usual, investors who lack a personalized, long-term plan to guide their way are far more likely to make the wrong moves by the time the cycle is complete. In our opinion, every investor’s long-term plan should include embracing a buy, hold and rebalance approach to investing. This is one of the simplest and most effective ways to diversify, and it may help you prosper in various financial markets over the long term. To achieve this goal, a portfolio is initially allocated based on each investor’s needs across different asset classes, such as stocks, bonds and real estate. The portfolio mix is then maintained by periodically rebalancing. Winning investments are pared back, and underperforming investments are increased during a rebalancing. A rebalancing can occur on a specific date, such as a birthday or anniversary, or it can be done using a percentage of asset method. See my book All About Asset Allocation for a detailed discussion of rebalancing techniques. Figure 1 is an illustration of rebalancing using a 50% stock and 50% bond allocation. When stocks gain versus bonds, their percentage or allocation becomes too large. Shares of the stock investment are sold, and the proceeds are reallocated to bonds. This serves as a risk control mechanism for the portfolio. Another effective way to rebalance is to employ new dollars when they are available. For example, if you were to receive a modest lump sum of cash , you could use it to “feed” the portion of your portfolio that requires additional assets. If you were underweighted in bonds, for example, you could apply the new dollars there. This helps you rebalance, while minimizing the transaction costs involved. Figure 1: Rebalancing a 50% stock and 50% bond portfolio (click to enlarge) (Chart by R. Ferri) Some financial pundits criticize a balanced approach. They say a buy, hold and rebalance strategy is simple-minded and a relic of the past. Often, their solution is to be tactical, meaning they suggest that investors aggressively move in and out of the markets in an attempt to avoid the worst returns and capture the best ones. As it turns out, the data suggests that more than half the experts fail to time the markets correctly ; their portfolios are expected to fall short of the simple strategy they mock so much. Consider Figure 2, which illustrates the returns of a portfolio initially allocated to 50 percent in stocks and 50 percent in bonds from January 1, 2007 through August 31, 2015. The period begins just prior to the worst bear market in recent memory, and includes a surge in stock prices that occurred in the years thereafter. The proxy for stocks was the CRSP Total Stock Market Index, and the proxy for bonds was the Barclays Capital US Aggregate Bond Index. Both indexes hold broad representations in their respective markets. The 50/50 portfolio was rebalanced monthly; annual rebalancing works just as well. Figure 2: Comparing a 50/50 Bond/Stock Portfolio to Each Index (click to enlarge) (Source: CRSP and Barclays Capital data from DFA Returns Program, chart by R. Ferri) At least on paper, every stock investor lost portfolio value during the crushing bear market that began in October 2007. Prices were down nearly 60 percent from peak to trough. A 50 percent stock and 50 percent bond portfolio was down about 20 percent from the peak. Even a portfolio holding only 20 percent in stocks didn’t escape the bear, and was down about 5 percent by the time the market hit bottom in March 2009. Still, Figure 2 shows that the 50/50 diversified, rebalanced portfolio fared quite well during the bear market and the recovery that followed. The return hasn’t matched a 100 percent stock portfolio over the entire period, but the volatility was considerably lower – and volatility matters! Investors who assume the party will never end and take on too much equity risk when the markets are surging upward over extended periods run the risk of capitulating in the next bear market. They often lack a disciplined plan to see their way through, and may never fully recover the realized losses they incur after selling. Lower volatility created by a disciplined allocation to stocks and bonds helps keep you invested during all market conditions. Ideally, our crystal ball could tell us to get out of stocks before the crisis, but realistically, no one knows what the market is going to do in the future. We invest in stocks because in the long term, the returns are expected to be substantially better than those from bonds. We need this growth just to stay ahead of inflation and taxes. Patience is a virtue, though. Bear markets occur without warning; bull markets often follow on their heels with equal unpredictability. And so on, and so forth. Only those with discipline throughout can expect to build wealth according to a rational course, rather than depending on random and very fickle fortune to be their “guide.” Balanced investing is part of balanced living. A buy, hold and rebalance strategy using broad market index funds is one of the simplest and most effective ways to diversify and prosper over the long term. It helps keep us sane and our portfolios more reliably on track during good times and bad. Disclosure: Author’s positions can be viewed here .