There are many successful investment strategies that have performed well over time. Yet, capturing these returns is not easy for investors. Patience can help.
Years of investment experience have taught us that all investment strategies, even ones that have outperformed over time, go through periods of underperformance. This can lead many investors to sell out of a good strategy, often at the worst time, which can destroy long-term results.
A recent study by Chris Tidmore and Andrew Hon from Vanguard Research, “Patience with active performance Cyclicality: It’s harder than you think”, concluded that investors need to endure long periods of underperformance in the hopes of achieving excess return over the long-term. The study examined the patience needed from investors by quantifying the wide range of occurrences, lengths, and degrees of return swings that occur with active management or factor-based strategies.
Key findings of the study
- Long-term outperforming strategies are prone to large drawdowns and frequently lag their benchmark indexes, sometimes by wide margins.
- Almost all outperforming traditional active equity managers and equity factors have frequent periods of underperformance relative to the equity market, some of which are long in duration and large in magnitude.
- Close to 100% of outperforming funds have experienced a drawdown relative to their style and median peer benchmarks over one-, three-, and five-year evaluation periods.
- Eight out of 10 outperforming funds had at least one five-year period when they were in the bottom quartile relative to their peers.
- More than half of outperforming active equity funds have underperformed their style and median peer benchmark by at least 20%—and three-quarters of funds that recovered from their largest drawdown took more than three years to do so.
- About 70 percent of outperforming funds underperformed their style benchmarks between 40 percent and 60 percent of all one-year evaluation periods.
- An outperforming manager can expect to experience a continuous drawdown lasting 2 years or more every 10 years and a drawdown of at least 20% over time.
Another paper by Jeffrey Ptak from Morningstar, “Winning funds often look like losers” reached similar conclusions in 2016. It studied the 20-year returns of all unique diversified US mutual funds as of October 31, 2016. It found that funds in the top 10% for the 20-year period lagged their indexes in more than one of every three rolling three-year periods. In other words, the top funds spent roughly a third of the time underperforming.
Implications for investors
- Success in investing requires patience. You need patience when what you are invested in is performing poorly—and you need it when what you don’t own is performing well.
- View periods of underperformance as inevitable, rather than something which triggers regret and the impulse to sell.
- Performance track records can be misleading. It is not enough to select investment strategies based on 1-, 3-, or 5-year track records alone.
- Randomness and chance affect returns. Sometimes good strategies do poorly, and sometimes poor strategies do well.
- The benefits of using outperforming managers and factor tilts can be significantly eroded, if an investor fails to maintain a long-term patient perspective. Even outperforming managers experience inconsistent returns, and this wears on patience.
- Consistency is not the goal. Markets do not provide consistent rewards even for skilled managers. The more genuinely active a strategy is, the greater the likelihood it will experience spells of pronounced and often extended underperformance. This makes it hard for many investors to reap the long-term benefits.
This is not a slight on active strategies. There are plenty of active managers and factor-based strategies that have generated attractive returns over time. Even successful active approaches will suffer periods of challenge.
For it to work, it has to be hard. If achieving outperformance with a certain strategy was “easy”, enough investors would flood the strategy with money, pushing prices higher, until it stopped working. Rather, for a strategy to outperform in the long run, it has to be hard enough to stick with I the short term that it causes investors to “bail-out” and effectively pass along the opportunity to outperform to those with the fortitude to “hold.”
Don’t chase returns. It seems sensible to buy outperforming strategies and sell the laggards. And it feels better, emotionally. This is simple performance chasing, which doesn’t often end well for investors. On the other hand, it requires a great deal of discipline to stick with a strategy that is underperforming, even when we believe that short-term results are not consistent with reasonable expectations and analysis.
Signet can help
One of the major benefits of working with a Signet advisor is behavioral coaching. We help clients make informed decisions with their wealth. We seek to manage your expectations and increase your confidence in your financial plan, thereby improving your patience with your investment choices.
To learn more about how Signet can help you create and stick with a well-designed investment plan, please contact your Signet advisor, or Steve Tuttle directly at 800-390-2755 or firstname.lastname@example.org.