An article in Advisor Perspectives, BAM Alliance research director Larry Swedroe discusses how to deal with underperforming investments, offering data to support the idea that an investment strategy should be built around the notion that: (1) all risky assets have similar risk-adjusted returns; and (2) you should diversify your portfolio across as many unique sources of risk that meet the criteria you have established for investment (e.g. persistence, pervasiveness, robustness, and intuitiveness).
Swedroe notes that when evaluating the performance of a strategy, investors tend to believe that “three years is a long time, five years is a very long time and 10 years is an eternity,” adding that even sophisticated institutional investors will hire (and fire) managers based on the last three years’ worth of performance. He offers data that showing that no matter how long the time horizon, investors will experience periods of underperformance, but asserts that the longer the horizon, the lower the odds of underperformance.
The article also cites the danger of confusing strategy with outcome, citing comments by author Nassim Nicholas Taleb: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (that is, if history played out in a different way.)” Swedroe also discusses the concept of relativism—when investor satisfaction is determined by performance relative to an index, describing the notion as “the triumph of emotion over wisdom and experience.” He asserts, “Relativity worked well for Einstein, but it has no place in investing.” He also addresses the repercussions of recency bias—a cognitive bias in which recent observations have the most significant impact on an individual’s memory and perception. According to Swedroe, “this is a very common mistake, leading investors to buy what has done well recently (at high prices, when expected returns are now lower) and sell what has done poorly recently (at low prices, when expected returns are now higher).
Swedroe cites Warren Buffett’s belief that Investor 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.”
The article includes a discussion of how to determine the strength of an investment strategy: “You need evidence that it has been not only persistent over very long periods of time and across economic regimes but also pervasive across sectors, countries, geographic regions and even asset classes,” adding that “even good investments can become bad if valuations become excessive.” It concludes that, while diversification “has been called the ‘only free lunch in investing,’ it doesn’t eliminate the risk of losses. And diversification does require accepting the fact that parts of your portfolio may behave entirely differently than the portfolio itself and underperform a broad market index for a very long time.”