Hi Guys,
Earlier this week the WSJ published its quarterly mutual funds and ETFs review that incorporated 2013 data.
Overall, it’s a comprehensive summary in a concise, useful format. But I do take issue with part of their winners and losers page. I like the 5-year and 10-year listings since these provide some performance persistence insights. I believe their last quarter and 1-year winners and losers listings are a disservice to many individual investors. It invites
hot-hand thinking. It energizes herding instincts.
These short-term listings that emphasize ephemeral success stories encourage putting outcomes over process.
Consider a two-by-two matrix with good (GP) and bad (BP) processes in the horizontal direction, and good (GO) and bad (BO) outcomes in the vertical direction.
The upper left GP-GO box reflects just rewards. The mixed BP-GO illustrates a lucky happening. The mixed GP-BO demonstrates an unlucky event. The BP-BO box might well be interpreted as poetic justice.
As investors we can only control process. Outcomes are always uncertain, and we are subject to the whims of the financial Gods. So we should focus our resources at developing and persistently deploying a carefully constructed investment process.
For a passive investor that’s simply assembling a low-cost composite total market Index fund array.
For the active mutual fund proponent, it means cobbling together a portfolio with the following characteristics: low cost, low turnover, long tenured management arguably with financial degrees from Ivy league schools, and with investment philosophies and preferences similar to the clients.
The active route is more challenging with a likelihood of Index out-performance that is in the 10 % to 30 % range depending on time horizon and number of active funds within the portfolio.
Annual returns behave in a helter-skelter manner. If there is some order to annual rewards, it surely has escaped me. Patience is a prized virtue for successful investing.
Asset Allocation quilts offer a great way to illustrate the year-by-year chaos of investment category return disorder. I particularly like the report issued by the RBC Wealth Management outfit in Texas. Here is a Link to their “Market Cycle Quilts”.
https://www.rbcwmfa.com/File/Featured Reports/marketcycles.pdfThe Market Cycle Quilts document the separate and rapid elevator rides that various classes experienced since 1999 for the following clusters of investments: Asset Classes, Indices, US Economic Sectors, Developed Countries, US Stocks, US Bonds, Income Focused, and Alternate Investment groupings.
This is a huge body of data displayed in an attractive format. It is the most complete set of charts I’ve ever seen within the Quilt or Periodic Tables presentations. All these tables vividly demonstrate the volatility in annual returns; the first shall be last in short order.
One of the main themes that the marketplace constantly exhibits is a reversion-to-the-mean. The S&P Persistency and the SPIVA Scorecard reports demonstrate the fragility of superior above average performance among the professional class of investment wizards. The DALBAR studies show that individual investors do even poorer when contrasted against market averages.
I hope the Market Cycle Quilts will provide some guidance to MFOers when developing their investment philosophy and processes. Outcomes are forever uncertain. Good luck and good judgment to all you folks.
Best Regards.
Comments
In my haste to post I omitted to document what I feel is the single most important ingredient to good investing process=full portfolio diversification.
Returns volatility is a killer in terms of “staying the course”. It is the primary cause for buying high and selling low. Diversification can cut volatility in half without seriously compromising expected returns. It just might be the only free lunch in the investment world.
The excellent Asset Quilt returns tables that I included in the original post illustrate the wild volatility of candidate asset category returns. They show the temporal nature of any ordering. I submitted these Quilt tables to aid investors in designing a good investment process. That’s not an easy task, and is quite different for each investor. No single portfolio serves investors equally well.
Many options exist. Some investors might be tempted to reallocate resources using last year’s winning class. Yet another investor might be a regression-to-the-mean zealot and reallocate according to that principle by buying last year’s losing class. Neither works well.
There are numerous academic studies that demonstrate the poor performance when selecting extreme positions. But here is a Link to a simple industry study that serves the same purpose:
https://www.franklintempleton.com/forms-literature/download/ALLOC-G
Sorry for referencing this Franklin Templeton (FT) Guide booklet since about half of it is a selling pitch. But the meaningful material illustrates the risks of buying past winners, and the presentation explains the basics in terms that neophyte investors will understand.
An Asset Allocation Quilt is shown in the FT document. But I elected to reference this booklet because of the brief study reported on Page 6. FT examined 3 scenarios from the Quilt data summarized earlier.
They proposed a process that: (1) selected past winners, (2) selected past losers, and (3) an asset allocation strategy. Contributing a constant amount annually for a recent 20-year period, the study calculated that the average annual total returns for the 3 scenarios were 6.12 %, 6.79 %, and 6.90 %, respectively. The past losers strategy outperformed the past winners strategy, and the asset allocation policy outdid the two extreme processes.
I apologize for omitting this closure section in my initial posting. Either I was in too much of a hurry, or perhaps, I was subconsciously worried about the length of the full submittal.
Best Wishes.