Imagine that you’re the marketing director for MegaAlpha Investments and you want to advertise two of your mutual funds. In the September 2011 issue of Performance Chaser magazine, you place the following ad:
Are stocks still worth the risk? Not anymore. Over the last three years, the S&P/TSX Composite Index delivered an annualized return of just 0.2%. Meanwhile, the MegaAlpha Awesome Income Fund earned 6.4% a year. Rather than relying on a disappearing equity premium, our managers delivered reliable yield and significant growth with a portfolio of the highest quality government and corporate bonds.
Three months later, in the December issue, you run a different ad:
Are stocks still worth the risk? You bet. Over the last three years, the MegaAlpha Awesome Equity Fund delivered an annualized return of 12.5%, dramatically outperforming the DEX Universe Bond Index, which returned just 7.7%. Rather than relying on the perceived safety of bonds, our managers took advantage of generous dividends and capital growth in a portfolio of leading Canadian companies.
Do you think I made those numbers up? Nope. Both the index returns and the funds’ performance are real—except the “MegaAlpha Awesome Income Fund” is actually the iShares DEX Universe Bond Index Fund (XBB), while my bogus equity fund is the iShares S&P/TSX Capped Composite Index Fund (XIC).
All I did here was change the start and end dates for the three-year performance data. The first ad uses numbers as of August 31, while the second example ends on November 30. By shifting these dates just 91 days, the entire argument gets flipped on its head. One ad makes stocks look pathetic, while the other makes the last three years look like a screaming bull market. And yet the two sample periods have 33 of their 36 months in common.
How can this be? The first sample begins just before the Lehman Brothers collapse in September 2008, while the second one starts after the market had already dropped about 30%. The two ads demonstrate how easily dates can be selected to make virtually any investing strategy look either magic or tragic, depending on your motives.
2001: A Spud’s Odyssey
How many times have you heard that the last decade “proves” that a simple buy-hold-rebalance strategy no longer works? That claim is a prime example of how you can use start dates to manipulate performance data to either celebrate or condemn the same investment approach.
To show you what I mean, I compiled some historical performance data for the Global Couch Potato, a portfolio of 40% bonds and 60% equities (divided equally among Canadian, US and international). These are index returns only, without accounting for fees, but it’s the relative figures that are important here. How would the Couch Potato strategy have served an investor who cashed out at the end of 2010? It depends entirely on your start date:
- Since 1996, the Global Couch Potato delivered an annualized return of 6.65%. Index investing rewarded investors with excellent returns during a 15-year period that saw both strong bull markets and two of the worst market meltdowns in history.
- Since 2001, the Global Couch Potato delivered an annualized return of 3.74%. An active money manager could argue that the strategy doesn’t work, because it delivered a decade of dismal returns that barely outperformed T-bills. Time for a phone call to MegaAlpha Investments.
- Since 2003, the Global Couch Potato delivered an annualized return of 6.15%. Index investing rewarded investors with excellent returns during an eight-year period that included both a strong bull market and one of the worst market meltdowns in history.
So take your pick. If you want to sing the praises of the Couch Potato strategy, look back 15 years or only eight. Or you can start your assessment just before the dot-com bust and use this one 10-year period to “prove” that passive investing doesn’t work. However, if you decide to take that approach, act now because you have only 13 months left. Once 2012 is in the books, all 10-year fund performance data will start with 2003 and the report card may look quite different.
The mastery of marketing and statistics! Unless you are a highly trained/educated business graduate how does the average joe investor( and the majority of us are such otherwise financial advisors would be extinct) have a chance at being hooked up with the “best” advisor out there. Millions invest trillions with advisors that profess to be working for your best interest(s). As you have brilliantly pointed out, placing a computer generated report to an investor favouring the company’s bias and/or top performing funds to the exclusion of lessor funds by Megaalpha Awesome Equity leaves the average investor bewildered/confused/or possibly brow beaten into submition. The average joe investor does not have access to the ‘top 1000 advisors in your county’ as voted on by their peers. How does an average investor have a chance?
My own wanderings have led me to the place where I find it useless to look at 10 yr. asset returns for the very reason Dan illustrates. Each decade or 10 yr time frame is going to be different and looking at 10yr or even 5 yr returns can be nonproductive because that information is not prognostic of the next decade nor will it necessarily resemble the previous decade so what’s the point? Better to do your homework and arrive at an investment strategy and asset plan that you will stick with for the long term which is, I think, until your dead since you can’t predict even that! Looking at 10 yr returns will only distract you from your investment strategy to which you should commit to like a marriage! (BTW, marriage commitment is a very wise investment strategy and even if you have some tough years stay committed :). )
This idea of cherry picking periods to make broad points is also used by climate change skeptics/deniers who claim that the Earth has been cooling since the late 1990s. They leave aside the point that 1998 was a freakishly hot year and that they deliberately chose it to distort the record. If you pick a decade or 7 year period at random, there is a high probability that it shows a rising temperature trend. It’s like taking 3 year equity returns from 2000 – 2003 and claiming that equities are wealth-destroying. Nevermind that 10 year returns were positive.
A better analysis might be to compare rolling ten year performance each year.
@Andrew: You make an interesting comparison. I am certainly not a climate change skeptic, but there does seem to be a tendency to dwell on a specific period of history and project that into the future, much the way market commentators do.
You’re absolutely right about rolling 10-year (or 20-year) periods being much more useful. I don’t know any investor who put all of their money into the markets in 2001, never added a penny, and then took it all out in 2010. People inevitably accumulate wealth slowly and then draw it down slowly: we don’t have one start date and one end date.
The last two posts are interesting. My take on investing is that timing does matter because timing determines value on a longer term basis. The early 1980s were a great time to buy long dated bonds because interest rates were at extreme highs – you had a very high total return these past 25 or more years. From a longer term perspective now is a not such a great time to own new bonds because as rates rise you will have capital losses, however you ladder it.
Similar for equities. There are cycles of profit peaks and troughs. There is considerable evidence we are in a peak for profits and profits determine equity values:
http://www.bloomberg.com/news/2011-11-28/grantham-calls-margins-freakishly-high-that-doll-says-are-here-to-stay.html
I like the work of Grantham on this front because he identifies times when certain asset classes will outperform over a 7 year basis. His track record is very good.
On a rolling 20 year basis now is not a great time to invest because we are coming off a peak and there may be some way to go:
http://www.ritholtz.com/blog/2011/12/dow-jones-industial-average/
It is also necessary to look at Tobins Q and Shillers CAPE to see cycles of over and undervaluation and to optimize timing for putting new money to work in equities over the long haul. If you invest when these measures are overvalue you have a higher probability of lower returns in the future – they are currently overvalued. Also the cycle of valuation depends on the earnings multiples which according to this research have a way to go to bottom.
I subscribe to the investment process that is forwarded by Dan and this great site.
So what is a couch potato to do if any of the above is true? I know some of it may seem counterintuitive.
I would continue to hold a diversified portfolio (Ray Dalio of Bridgewater, arguably the best hedge fund out there says 12- 15 “classes” of investment with the lowest possible correlations to each other is optimal for long run returns with lowest volatility – this can be achieved using ETFs if capital sufficient) and tactically rebalance it strategically using a valuation approach for the investment class with an overlay of risk management by a mechanical rules driven process. (see below)
This approach needs to consider the macro situation for the investment class because it is just a given that if you invest when the market is peaking on a 20 year rolling basis you are almost guaranteed to lose money. Any new money needs be be invested using value averaging, not dollar cost which is not fine tuned enough to capture lower value moments in the life cycles of an investment class.
Here is a primer on value averaging if anyone is interested:
http://en.wikipedia.org/wiki/Value_averaging
Look up Bernstein (Investors Manifesto) and Edlesons work if interested in this strategy.
If you have the skills there are some hedging strategies that do add value as well.
Finally, I would like to see a discussion on the use of a simple technical rule for risk management with a diversified ETF portfolio because it does work: Selling and going to cash when an asset class exceeds its 40 week moving average to the downside does improve risk adjusted returns. This is a simple strategy that works with couch potato portfolios easily. Look at the work of Mebane Faber (“A Quantitative Approach to Tactical Asset Allocation”) to see how it works.
@Andrew: Great post. I was going to post the same link to the rolling 20 year Dow returns.
@CC: While most investors don’t have formal start and end dates, in practice they actually do. Once investors accumulate enough savings so that money added each year is much smaller than the overall portfolio, the new money actually makes very little difference in overall returns, regardless of how or when it’s added over the years. (This result may be counterintuitive, but it’s a sister phenomenon to what most people refer to informally as the power of compound interest.) So, generally, people eventually do acquire a “start date”.
Likewise, most investors have an end date at which point they have to decide whether to stop working or are forced to retire due to health issues or job losses. Of course they don’t withdraw all their money at this point, but facing down this kind of deadline and looking at a decade of mediocre returns can trigger all kinds of irrational investing decisions.
@Andrew: Thanks for a great comment, with lots of links for readers to follow up. I don’t think there’s any question that timing and valuation matters immensely. Unfortunately, reliably identifying favourable periods in advance (even with a quantitative approach) is very difficult, and implementing those changes requires enormous discipline. In many ways, a simple rebalancing schedule accomplishes at least some of the same thing, in a much easier way. It’s not perfect, but it certainly helps.
I’m a big fan of Edleson’s book on value averaging, and I’m sure that it would be an excellent system to follow. But again, I think it is beyond the ability of most retail investors, both in terms of the math and the behavioural discipline. Do you employ this technique yourself?
@Chris: Fair enough. Certainly investors have a more finite investing horizon than, say, a pension fund.
I was just speaking with an investment advisor today who mentioned that this is probably a very good period for young investors who are accumulating assets they plan to spend in 20 to 30 years, while it is challenging one for those who are now drawing down their portfolio. I would expect, however, that over an investing lifetime (which may be 50 or 60 years), things even out quite a bit. The investor who is 70 years old today enjoyed a prolonged bull market between 1982 and 2000, when they were in the prime earning years, for example.
Thanks for the feedback Dan.
I did not know about value averaging until several years ago but on reflection I was doing it in a manner. Now I do use it but not as strictly as prescribed. I am trying to develop a simple way to use value averaging for any new savings using ETFs and also applying a value averaging approach to rebalancing.
I want to seek out the optimal measures we can take to fine tune a portfolio. This site is an excellent resource for that.