The Difficulties Of Discipline

In a June 1999 interview with Businessweek, Warren Buffett is quoted as saying, “Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”

Michael Mauboussin, director of research at BlueMountain Capital Management (and prior to that, head of global financial strategies at Credit Suisse and chief investment strategist at Legg Mason Capital Management), seems to agree with Buffett. In his book, “More Than You Know,” Mauboussin wrote: “Investment philosophy is really about temperament, not raw intelligence. In fact, a proper temperament will beat high IQ all day long.”

Temperament is critical to successful investing because markets persistently test investor discipline with periods, often long ones, of volatile and/or poor performance. In my more than 20 years of counseling individual and institutional investors, I’ve learned that, when it comes to judging performance, most investors think three years is a long time (e.g., that’s the typical period over which institutional investors judge performance when considering whether to retain or fire a fund manager), five years is a very long time, and 10 years is an eternity.

On the other hand, financial economists know that when evaluating the performance of all risky assets, 10 years is likely nothing more than noise and, thus, should be ignored. Warren Buffett certainly appears to agree, as he stated in Berkshire Hathaway’s 1988 annual report that the company’s favorite holding time is forever. In the Berkshire Hathaway’s 1996 annual report, he added: “We continue to make more money when snoring than when active.”

It’s many investors’ inability to ignore market “noise” that leads to poor performance. The following example should make this point clear.

Underperformance Tests Discipline

It has long been known that small-cap and value stocks have provided higher returns than large-cap and growth stocks and the market overall. Shortly after Eugene Fama and Kenneth French published their 1992 paper, “The Cross-Section of Expected Stock Returns,” which showed the public that small-cap and value stocks had provided a large premium, Dimensional Fund Advisors launched the first small-cap value fund that did not engage in any individual stock selection or market timing (i.e., active management). (Full disclosure: My firm recommends Dimensional funds in constructing client portfolios.)

The inception date of Dimensional’s U.S. Small Cap Value Portfolio (DFSVX) is April 1993. (The first small-cap value index fund, Vanguard’s Small Cap Value Index Fund (VISVX), had its inception on May 20, 1998.) Note that my firm has used DFSVX in client portfolios almost from the very beginning. Almost immediately, investor discipline was severely tested. As you review the data, keep in mind my maxim about how long most investors believe is long enough to judge performance.

Over the more than seven-year period from inception in April 1993 through May 2000, Dimensional data shows that DFSVX fund underperformed the S&P 500 Index by 6 percentage points a year (19.8% versus 13.8%). Thanks to the power of compounding, that gap resulted in an underperformance in total return of 265% versus 153%.

That’s not the only long period of underperformance. Over the most recent 5 ½-year period, January 2014 through June 2018, DFSVX underperformed the S&P 500 Index by 3.8 percentage points a year, producing a total return difference of 61% versus 38%. Periods such as these test the patience of most investors.

Long-Term Payoff

Now, let’s look at the fund’s performance over the full period. Despite enduring those two long periods of underperformance, totaling more than 12½ years (virtually half the fund’s life), Dimensional data shows that, from inception through June 2018, DFSVX provided a total return of 1,642% versus the 893% total return for the S&P 500 Index. Annualized returns were 12.0% for DFSVX and 9.5% for the S&P 500 Index.

Investors who had faith in the size and value premiums, as well as the required discipline to stay the course, were rewarded well for their belief that capital markets work efficiently, and it’s likely that riskier assets will provide higher returns (the longer the time horizon, the more likely that will be case).

Despite the long-term outperformance, the recent underperformance of U.S. small-cap value stocks has led some investors to question the existence of the size and value premiums. History, however, has provided other examples of long periods of underperformance. It’s just that many investors don’t take the advice offered by Spanish philosopher George Santayana: “Those who cannot remember the past are condemned to repeat it.”

Instead, many investors tend to keep repeating the same mistakes while expecting a different outcome. They also continue to ignore Buffett’s wisdom about his favorite time frame being forever.

There’s another thing I’ve learned over the years about individual investor behavior. While many investors see other people’s decisions being the result of temperament, they see their own as the result of objective, rational thought. That leads to cognitive errors, such as recency. Recency is the tendency to overweight recent events/trends and ignore long-term evidence.

This leads investors to buy after periods of strong performance (when valuations are higher and expected returns are now lower) and sell after periods of poor performance (when prices are lower and expected returns are now higher). Buying high and selling low is not exactly the prescription for success. It also is exactly the opposite of what disciplined investors would be doing: rebalancing to maintain their portfolio’s asset allocation. Instead, recency bias can lead investors to abandon even well-thought-out plans.

Summary

Over the two decades I’ve been working with investors, financial economists have documented many investment anomalies. But to me, the greatest anomaly of them all is that, while investors idolize Warren Buffett, they not only fail to follow his advice, they often do exactly the opposite, sometimes to their great detriment. As that legendary cartoon character Pogo said, “We’ve met the enemy, and he is us.” That observation led me to author “Think, Act, and Invest Like Warren Buffett.”

Whenever an asset class (or investment strategy, such as momentum, selling volatility insurance, or reinsurance) performs poorly for any extended period (which for many is as short as a year or less), I’m often called in to dissuade investors from committing what I call portfolio suicide (i.e., abandoning a well-thought-out plan). This generally is caused by two mistakes: the aforementioned recency bias and the mistake called “resulting.” Resulting, which I wrote about earlier this year, is the tendency to equate the quality of a decision with the quality of its outcome.

Hedge fund manager and “Fooled by Randomness” author Nassim Nicholas Taleb put it this way: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”

Hopefully, this article and the example it offers will help you avoid the mistakes of recency and resulting. It may also help you ignore the noise of the market, accepting even very long periods of underperformance as the “price” you pay for investing in risky assets in the expectation (but not guarantee) that you will be rewarded with a risk premium.

Larry Swedroe is the director of research for The BAM Alliance.

This commentary originally appeared July 30 on ETF.com.

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