Let’s take a look at failure in the investing world, because we all fail. Warren Buffett, the Oracle of Omaha, makes investing mistakes. The question is: Why? So let’s take a look at some intriguing data.
The newest SPIVA Scorecard from S&P with respect to actively managed U.S. funds shows that over the 15-year period ending December 2016, 92.15% of large-cap, 95.4% of mid-cap and 93.21% of small-cap managers trailed their respective benchmarks.
Markets in every sector, every asset class and every geographical location provide similar results. Institutional managers fare no better. It is a matter of simple arithmetic and a demonstrable fact. Investing successfully is really hard.
The problem relates to skewness, the asymmetry of the distribution of returns. In any given year, the best-performing stocks skew the overall averages upward such that most stocks lag the market averages.
Some recent and powerful academic research has put a finer point on things. Using 90 years of performance (through 2015), 58% of all stocks underperformed one-month U.S. Treasury bills, while a majority lost money over their lifetimes. The best performing 86 stocks accounted for over half the $32 trillion (with a “t”) in value generated by stocks in excess of bills over that time span. Just 4% of stocks accounted for all the outperformance of stocks over bills. Active investors are not quite looking for a needle in a haystack, but their challenge is a daunting one.
A similar asymmetry applies to when stocks perform. Michael Batnick of Ritholtz Wealth Management has shown that nothing happens in the market a lot of the time, at least in the aggregate. The real growth of a dollar invested in the S&P 500 was $1.08 from 1929-’43, $10.83 from 1944-’64, $0.94 from 1965-’81, $11.90 from 1982-’99 and $1.35 from 2000 to today.
However, the volatility we suffer is surprisingly consistent. Research done by Ben Carlson, also with Ritholtz, shows the worst peak-to-trough drawdowns on the S&P 500 by calendar year through 2016. The average drawdown was -13.5%, while the median was an intra-year loss of -10.5% over this 67-year period. There were double-digit drawdowns in more than half of all years, and one out of every six years saw a 20% or worse drawdown.
Yet, as Ben points out, despite these big and consistent drawdowns and despite the S&P going up barely 50% of all trading days, the S&P has gained over 11% per year since 1950 and has been in positive territory for nearly 80% of those years. The S&P gained 10% or more roughly 60% of the time and was up 15% or more almost half the time.
In response to this drawdown risk, we would like to think that we can time the market — moving in and out of the market and in and out of various market sectors to achieve market upside while avoiding the downside. But there is shockingly little evidence that anyone is any good at it.
For example, over the past five years (per Morningstar), tactical managers in the aggregate have underperformed the S&P 500 by more than 1,000 basis points per year. Breaking the numbers down even further, for the five years ending December 2016, the S&P beat the best tactical manager by 363 basis points per year, the median tactical manager by 949 basis points per year and the worst tactical manager by 1,750 basis points per year.
There is no way to sugarcoat those numbers. They are abysmal.
One conclusion to be drawn from these various data sets is that everyone should index. Overwhelmingly, when money goes into stock funds today, it has been going into passive index vehicles. Over the past decade, $2.2 trillion has entered passive funds while the same amount has left active funds. These facts suggest that perhaps active management needs to go in what Buffett calls the “too hard” pile.
Yet Buffett himself provides powerful disconfirmation for that idea. Just a few weeks ago, Buffett issued his influential annual investor letter and announced that his firm, Berkshire Hathaway, had returned 20.8% annually to investors from 1965-2016 (more than 50 years!). That’s more than double the annual return of the S&P 500 over that same period.
Whether you choose a great concentrated manager like Buffett, use factors with a history of persistent outperformance or another active approach, active management is far from dead. That said, difficult as it may be to find, great investing still runs the risk of suffering through very long periods of underperformance.
As analysis from Newfound Research shows, while Buffett is obviously a great investor, Berkshire still underperformed over half the time and suffered some huge drawdowns. In the last 30 years, Berkshire has dropped 37% (1987), 37% again (1989-90), 49% (1998-2000) and 51% (2007-09). Roughly every six to seven years on average, Buffett takes a big loss.
With hindsight, that may not seem like a big deal. But in real time, as it was happening, plenty of owners of Berkshire stock bailed and lived to regret it. You might recall that a famous Barron’s cover in December 1999 asked, “What’s Wrong, Warren?” and the accompanying article suggested that “Warren Buffett may be losing his magic touch.”
Here is an important corollary to my primary thesis: Even great investing is really hard to abide. Indexing offers no protection whatsoever in this regard.
Suppose you had perfect foresight and could pick the best performers from among the largest 500 U.S. companies in advance. My friend Wes Gray of Alpha Architects computed the historical five-year “look ahead” returns for all common stocks for the 500 largest NYSE/NASDAQ/AMEX firms beginning July 1, 1926. He then created decile portfolios (portfolios consisting of the top 10% of performers from among the field of 500 companies) based on the forward five-year compound annual growth rate (CAGR) of those companies.
The first portfolio formation was on July 1, 1926 and was “held” until June 30, 1931. The second portfolio was created on July 1, 1931 and was “held” until June 30, 1936. This pattern was repeated every fifth year.
What Wes found is astonishing. The performance is staggeringly good: 29% CAGR in the aggregate. But consider the drawdown numbers, which ranged from about -84.6% (the S&P 500′s ’29-’32 decline) to -13.7% (its ‘80-‘81 drop-off).
Even the best possible portfolios suffer huge (and thus terrifying) drawdowns. Here is the bottom line, thanks to Wes: Perfect foresight provides great returns, but still demands gut-wrenching drawdowns. Even if we could hire God as our money manager and He always picked the top stocks in advance, most of us would still fire Him for the drawdowns — many times over!
With shocking regularity, we engage in performance chasing. We discard what has recently underperformed to chase what has just been hot, with the net result being we sell low to buy high — exactly the opposite of what we should do. As poor as investment returns are in the aggregate (again, see the SPIVA Scorecard noted above), investor returns are even worse, demonstrating our performance-chasing ways conclusively.
The “behavior gap” between investment returns and investor returns is huge. Depending on who is doing the measuring, the gap ranges roughly from 1% to 5% or even more per year, providing powerful evidence of the problem. Compounded over time, even the lower end of that range (which I think is more accurate) makes an enormous difference.
By this point it should be obvious that investing successfully is really hard and that even great investing is really hard to abide. That is because volatility is the cost of the much higher returns stocks provide as compared to other investment choices.
Suppose back in 1928 you had invested in stocks (the S&P 500), bonds (10-year U.S. Treasury notes) and cash (3-month U.S. Treasury bills) and held on through the end of 2016. Over that period, stocks averaged an 11.42% annual return, bonds averaged 5.18%, and cash averaged 3.46%.
That enormous disparity looks even bigger when considered in dollar terms. If you had invested $100 in each of those vehicles back in 1928, at the end of 2016 you would have $1,988 in the cash account, $7,110.65 in the bond account and an astonishing $326,645.87 in the stock account. Over that time, stocks earned 165 times more than cash and 46 times more than bonds. If you avoid stocks because of the volatility, you will make it exponentially harder to reach your financial goals.
Investing successfully is really hard. Even great investing is really hard to abide. But if you avoid stocks or do not find a way to abide stock market volatility, it will be really, really hard for you to meet your financial goals.