Investing Lesson 9: They are Called Risk Premiums for a Reason
Larry Swedroe, Director of Research, The BAM Alliance, 1/29/19.
Lesson 9: They are called “risk premiums for a reason”.
Many investors have been bemoaning the fact that the value premium—the excess return of value stocks relative to growth stocks—seems to have disappeared, turning negative for the past 10 years in the U.S. (although value has outperformed growth in international markets).
The trouble with this line of thinking, however, is that stock returns are extremely noisy from a statistical perspective. Thus, even a time frame as long as 10 years isn’t long enough to make a definitive statement about any strategy that invests in an asset class or investment factor.
For example, consider the 10-year period from 2000 through 2009, when the S&P 500 Index returned -0.9% a year and underperformed riskless one-month Treasury bills by 3.7 percentage points a year.
Even over the longer 13-year period 2000 through 2012, they underperformed, with the S&P 500 returning 1.7% and one-month Treasury bills returning 2.1%. The S&P 500 also underperformed one-month bills over the 15-year period ending in 1943, and over the 14-year period ending in 1982. Hopefully, such long periods wouldn’t prove long enough to convince you that stocks shouldn’t be expected to outperform Treasury bills. Or consider the even longer 40-year period from 1969 through 2008, when the U.S. total stock market returned 8.8% and underperformed the 8.9% return of long-term U.S. Treasuries.
Consider also the performance of international and emerging market stocks, which have underperformed over the most recent 10-year period. For the period 2009 through 2018, and using data from Portfolio Visualizer, the Vanguard Total Stock Market ETF (VTI) returned 13.3% per year, outperforming both the Vanguard FTSE Developed Markets ETF (VEA) and the Vanguard FTSE Emerging Markets ETF (VWO), which returned 6.1% per year and 7.5% per year, respectively.
Many investors will look at such performance and conclude that investing internationally is a bad idea. After all, 10 years is a long time to them. However, we get an entirely different view if we move back in time and look at the performance of the prior seven years, from 2002 through 2008.
During this period, and again using data from Portfolio Visualizer, the Vanguard 500 Index (VFIAX) lost 1.6%, underperforming the Vanguard Developed Markets Index (VTMGX), which returned 4.0%, by 5.6 percentage points a year, and the Vanguard Emerging Markets Index (VEIEX), which returned 10.9%, by 12.5 percentage points a year. An investor making decisions at the start of 2009 based on the prior seven years of performance would have made a very poor choice.
Unfortunately, far too many investors put too great an emphasis on recent short-term performance when considering investment decisions. The media tends to exacerbate the problem as opposed to helping investors stick to a disciplined strategy.
Chasing past performance can cause investors to buy asset classes after periods of strong recent performance, when valuations are relatively higher and expected returns are lower. Alternatively, it can lead investors to sell asset classes after periods of weak recent performance, when valuations are relatively lower and expected returns are higher.
In fact, investors who chase recent performance are systematically buying high and selling low. A better approach is to follow a disciplined rebalancing strategy that systematically sells what has performed relatively well recently and buys what has performed relatively poorly recently.
When evaluating your asset allocation, recent performance should not be a factor in the decision. Smart investors know that all investment strategies that entail risk-taking will have bad years, or even many bad years in a row. That’s the nature of risk. After all, if this weren’t the case, there wouldn’t be any risk. With that knowledge, smart investors know that recency is their enemy, and patience and discipline (accompanied by rebalancing) are their friends.
- Investing Lesson 1: Active management is a loser’s game
- Investing Lesson 2: Diversification is always working; sometimes you like the results and sometimes you don’t
- Investing Lesson 3: The mistake of recency
- Investing Lesson 4: Your Discipline Will Be Tested
- Investing Lesson 5: The Stock Market and the Economy are Different
- Investing Lesson 6: Crystal Balls are Cloudy
- Investing Lesson 7: “Sell in May and go away” is the financial equivalent of astrology
The BAM Alliance is an active community of more than 140 independent firms dedicated to delivering true wealth management. As Vermont's only member of the BAM Alliance, Copper Leaf Financial is very pleased to have access to all of the organization's resources and industry thought leaders including Larry Swedroe. Larry is the well-respected author of 16 books on personal finance, and has at times shared his insights directly with Copper Leaf clients.