Episode #208: How Long Can You Handle Underperforming?
Guest: Episode #208 has no guest, It’s a Mebisode.
Date Recorded: 2/20/20
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Summary: Episode 208 is a Mebisode. Meb reads a recent piece that highlights the data and reality of market drawdowns, underperformance, and some statistics that illustrate that investors may not be prepared to face the reality of how long underperformance can last.
Tune in for this and more in episode 208, including how Meb frames his market expectations.
Links from the Episode:
- 0:40 – Intro
- 1:02 – How Long Can You Handle Underperforming? (or, How To Beat 94% Of All Mutual Funds) (Faber)
- 1:17 – Natixis Global Survey of Individual Investors
- 2:59 – The Meb Faber Show Podcast – Episode #101: Paul Merriman, “The People That Have Come Out Ahead Are the People Who Have Put Their Trust in the System Over the Long-Term”
- 9:53 – Invest with the House: Hacking The Top Hedge Funds (Faber)
- 12:30 – Triumph of the Optimists: 101 Years of Global Investment Returns (Dimson, Marsh, Staunton)
- 12:35 – Credit Suisse Global Returns Yearbook
- 12:40 – The Meb Faber Show Podcast – Episode #100: Elroy Dimson, “High Valuations Don’t Necessarily Mean That We’re Going to See Asset Prices Collapse”
- 14:42 – Now Is The Time To Be Contrarian (Chiappinelli)
- 16:04 – The Meb Faber Show Podcast – Episode #206: Meb’s take on Investment Plans, Building and Maintaining Wealth, How Meb Invests, and Investing in the time of Corona
Transcript of Episode 208:
Welcome Message: Welcome to the Meb Faber Show, where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber’s the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s fonts on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: Hello there podcast listeners. Today we have a very short Mebisode, which means I’m talking about a short research piece. Sometimes they don’t have to be long, they don’t have to be an hour-long of me droning on. It can be short and sometimes short is better. Today, what are we gonna talk about? We’re gonna talk about expectations. The name of today’s piece is a recent article we did called How Long Can You Handle Underperforming? (or, How To Beat 94% Of All Mutual Funds. The genesis of this is polls that we see over, and over, and over again. And they’re almost always the same, but there was a recent one by Natixis that did a survey of global individual investor expectations. So they asked them, “What do you expect your portfolio to return?” And the answer all around the world was 11.7%. And that, by the way, listeners, was real after inflation return, so if you add on 2% that gets you to 13.7%, I don’t think that’s really a fair question for most people because a lot of individual investors struggle with the concept of nominal versus real. But even if it was 11.7%, is that reasonable based on history? So today we have some good news. We have some bad news. Well, not so much bad news, it’s really sobering news. And, of course, the silver lining is when you understand the sobering news and allow it to temper your expectations, you’re more likely to benefit from the good news. So enough of this vague introduction. Let’s jump in with the good news.
Most people will invest in stocks. Almost everyone I talk to is a stock investor, equity investor, and almost everyone believes that given enough time and compounding what Einstein calls the eighth wonder of the world, at least it’s attributed to him, saving and investing results in massive wealth. Unfortunately, this is true. This is one of my favourite stats. I tell people, “If you just said at 10% returns per year, in 25 years, you 10X money. Not 100%, 10 times your money, and in 50 years, you 100X it.” Think about that for a second. Ten thousand dollars turns into $1 million with enough time. We talked about this a lot in Paul Merriman podcast. If you haven’t listened to it, go back. It’s a great episode.
Now let’s quickly ruin this wonderful news with the sobering news. Most people are woefully unprepared for the roller coaster ride that gets you to the pot of the gold at the end of this rainbow. And to illustrate, a while back, I asked my Twitter followers, who, given what I tweet about all day long, have to be engaged in investors and probably pretty intelligent and good-looking, better than average in all regards and most likely are professionals, because if you’re not a professional investor, you probably couldn’t stomach the nerdery and quantery that I tweet about most of the time. But I posed the following question. I said, “What stretch of underperformance of stocks versus bonds would you be willing to tolerate before selling your stock allocation?” And there was four choices: 0 to 10 years, 10 to 20, 20 to 30, and over 30 years. The vast majority of people said only 0 to 10 years, 47%, so almost half said under a decade. And then it scaled on various amounts, 21% said 10 to 20 years, 8% said 20 to 30 and only 24% said over 30. So to double-check this response, because sometimes questions, the way you phrase them, lead to different outcomes, I phrased it a slightly different way, but it had a similar outcome. I said, “Would you be willing to invest in an asset that historically outperforms bonds by a few percentage points per year but has multiple times in history, generated 0 outperformance for stretches that lasted over 30 years?” And most people said they wouldn’t. Most people said no. Sixty-percent said they would not invest in that asset. And so, most people could only go a short amount of time before they throw in the towel. And we’ve seen this over and over again. If you’re listening and you sold all your stocks in 2009, never to invest again, this may be speaking directly to you. So the correct answer, just based on history, this has happened before to what is the longest stretch of stocks underperforming bonds? Think about it in your head, listeners, what do you think it is? The answer is 68 years. Let that sink in. You could theoretically go an entire lifetime and not see any equity risk premium over bonds.
Now, to be fair, this stretch occurred over 100 years ago. So you may say, “[inaudible 00:05:31]. I dismiss that. That was too long ago. Markets are different today.” Well, in modern times, there have been multiple periods in which stocks have underperformed for decades, and this is just in the U.S. by the way. The other countries have suffered far, far worse, including some countries’ markets completely shutting down like in China or Russia. Now, given the results of my Twitter poll, this means many respondents would be bailing on stocks right then and there. So people want the reward, but as one of my friends say, they don’t wanna risk it to get the biscuit. Lots of people also wanna go a step further. How many listeners do we have, they’re not even satisfied with stocks, they wanna beat the market. Most of these people, and this includes institutions, by the way, do not think you’re immune from this. Almost all the academic literature says you’re as bad or worse than individuals. Most people allocating to active managers, even less prepared for the realities of how long underperformance can last.
I asked a similar question on Twitter, received thousands of votes. I said, “What stretch of underperformance by a portfolio manager would you be willing to tolerate before selling the allocation? Zero to three, three to six, six to nine, and over nine years?” The vast majority, 53% said under 3 years. Another 33% said 3 to 6 and then 7% each said 6 to 9, and over 9 years. These responses are so telling and illustrates everything that is wrong with investing. Many portfolio managers can go years or even longer underperforming their benchmark and still be viable allocations over time. I like to give a simple example that everyone can relate to. If you go back in time to 1965, an investor that put $10 grand, $10 grand into Berkshire Hathaway, what do you think that turned into? Ten grand turned into $200 million. That’s about as magic compounding as you get. And by the way, if you just put it in the S&P, you’ll still end up with almost $2 million. Okay? So that’s the magic of compounding. Put it in, forget about it, go away, let it sit, let compounding do its magic. But most of the people could never have handled the roller coaster ride to get to the finish line. Stocks, and then forget about Berkshire and Buffett. It’s easy to fantasize about $200 million finish line, but think about suffering through one of Berkshire’s many, many 50% declines. Charlie has a quote along the lines of, and I may get it wrong, but it says, “If you can’t handle 50% declines in quota securities, you should never be invested in stocks.”
So right now, revisit some past chapter of your life, say savings for a down payment on a house, opening your kid’s college tuition bill, or maybe needing a new roof after finally getting that leak checked, you go check your finances for the first time in a while, only realize you’re down 50% because Berkshire has been tanking. Would you have held, having no idea whether the losses would continue to come or not? If it would get worse, yet knowing that that down payment or tuition or roof had to be paid? Active managers can have a large drawdowns, but it’s even harder to sit through periods of underperformance relative to the broad stock market index like the S&P 500 underperforming your neighbor is the hardest behavioral bias to overcome and Charlie has a quote where he says, “I’ve heard Warren say half a dozen times, it’s not greed that drives the world, but envy.” Buffett and friends stock picks and similarly Berkshire stock have gone long periods underperforming the broad U.S. stock market. How long could you take that? How long could you handle it? Most, according to our survey, say less than three years and given his track record of Warren and Charlie and friends, maybe they get a pass and so, okay, maybe let’s go crazy and assume you can handle it for five years. How would you react if I told you that Berkshire and subsequently the stock picks, which are near identical performance, which we outlined in our book, “Invest with the House”… By the way, you can get a free copy if you go to either mebfaber.com or cambriainvestments.com and download a free copy of the book that outlines how Buffett and Charlie stock picks perform. How would you react if I told you that their stock picks have underperformed for the past 17 years? What if I said that they’ve underperformed 11 of those 17 years? How many of you guys would stuck around? Forget 11 of 17, most people would’ve thrown in towel after 2 out of 3, 3 out of 5, 5 out of 10. No chance anyone would last 17 years. Yet just to illustrate how crazy this is, had you invested at Berkshire at the turn of the century or the stock picks, so if you took top 10 stock picks, publicly disclosed when they were public, rebalance them once a quarter, takes about five minutes a year, their stock picks would have outperformed the S&P by three percentage points per year. In fact, the performance would have beaten 94% of all mutual funds during this period. And the best part, they don’t charge you any management fee. Average management fee of mutual fund is 1.25%. You could have bought Berkshire’s picks, updated it like a sloth, they don’t trade that much, and you would have stomped the S&P.
However, that’s what it takes to outperform over time, is you have to go through these periods where you underperform. The technical phrase I like to use being an engineer is long ass periods of suck. Can you handle it? Most say they can. So maybe the solution is you just should invest in the S&P 500. Well, as you recall, most said they can’t handle that either. You can’t handle stocks underperforming bonds for a decade or two or God forbid, 68 years. This is why despite being quite a simple endeavor the formula is not that hard. Save, invest, and leave it alone. Many people consistently fail at investing. Most will never leave their funds alone long enough to achieve this magical 10X returns. Forget 100X. So what should your expectations be? Are they reasonable based on history? Here’s mine based on the path of investments over the past 120 years. You could come up with different expectations. We talk a lot about valuations, and tilts, and everything else, but if you were just to look at how investments have performed in global markets over the past 120 years and again, we love to cite “Triumph of the Optimists”, my favourite book, the free version, which is the Global Investment Returns Yearbook put out by Credit Suisse. You can go back and listen to our podcast with Professor Dimson.
My return expectations for investments over time, and this is after inflation are for global stocks, 5% a year, global bonds, 2% a year, and global bills or short term cash-like investments, 1% a year. Again, you can add on inflation to get to whatever numbers you expect, but that’s real after returns. My old 5:2:1 rule: stocks, bonds, bills, 5:2:1. Now, the real drawdowns are losses for any of the above, 50%. Think about that for a second. Going back to our old article we have on the Get Rich Portfolio, most people expect bonds to be the safest investment because nominally, they don’t have big drawdowns, but on a real after inflation basis, they do. So in any of these asset classes, you should expect to lose 50% at some point. Now, the worst case is much worse. U.S. stocks have declined over 80%. So I say worst-case investment scenario for any of these investments is 90%. Now, if you have a nicely constructed allocation, in which case you diversify globally and across assets, we say your expectations should be 4% per year. And that’s historically, if you look at our global asset allocation book where we test all sorts of asset allocations, all sorts of different ones, in general, they tend to cluster around 4%, 5% per year real after inflation. My expectation is some point that portfolio will lose 1/3, around 30%. You can’t find me an allocation that doesn’t lose a 1/4 at some point after inflation. And I consider the worst-case is you’ll lose half. How many portfolio managers and financial advisors tell you that reality? Most don’t because they know if they told you how histories behave, they probably won’t have you as a client. They wanna tell you is the magical 12% that people expect with low volatility and no drawdowns.
Now, GMO had a recent piece which we’ll link to in the show notes on the blog talking about how long allocations can go with no real return. The summary is the length of time any investment could have zero return or underperform a benchmark and still be viable is 20 years. Think about that. I used to say 10, now I say 20. If you have an asset, I don’t care what it is. Gold, real estate, bonds, stocks. If you have an active manager, I don’t care if it’s Warren Buffett or any of the thousands of mutual funds, ETFs, whatever your strategy may be, how long could it go underperforming and still be viable? Think about value investing today, has stunk it up for the last decade. Anything other than U.S. stocks. Stunk it up. How long can it go and still be viable? My answer is 20 years. My real answer is 68 years, but no one will listen to me and they’ll all think I’m a crazy person. But that was the worst-case scenario in history. Stocks underperform bonds 68 years. Many assets have underperformed for that long. Gold is a great example.
So for those of you listening that love to click on ads on the internet, they’re promised 20% returns per year, those that promise outperformance every year, good luck. You’ll need it because that’s not the reality of history. In future podcasts, Mebisodes, we’re gonna do a few more. We talked about the Stay Rich Portfolio. We finally completed our Get Rich Portfolio as well as my allocation, how I go about thinking about putting all this together into a portfolio that works for me. Doesn’t work for everyone, but I think a lot of people like listening into how a portfolio manager thinks about it, but I think it’s really important ahead of time to lay the foundation of expectations to then develop into how you actually put it all together. Thanks for listening, friends, and good investing.