I think a large part of the investment industry have lost sight of what really is the goal of investing.
If you ask most people what they are trying to achieve with their investments the answer is likely to be something along the lines of .. "grow my money". The average person is not striving to beat some index or to deliver attractive risk-adjusted returns. Most people want a nice nest egg for when they retire, which means they need to protect and grow their capital at an attractive rate above the rate of inflation. Remember the power of compounding.
If you were to reverse the question and ask, what is it you want to avoid … I suspect the majority of people would answer .. "not lose my money".
Here are some of the problems I see..
The industry is fixated on relative returns. Everyone is trying [and most are failing] to beat an index. The basic premise of this strategy is as follows .. over time the stock market rises at an attractive rate. Therefore if you make a little more in the up periods and lose a little less in the down periods [ie your relative returns are better] then over time you'll have a lot more money than just sticking it in an index fund. Even a few percentage points have a significant impact on a compounded number over the long term.
The first issue is that the market doesn't always go up. In fact a stock index can go for long periods of time with negative returns. A few examples worth considering are Japan's Nikkei index and the S&P500. The Nikkei peaked in 1989 at nearly 39,000 versus the current level of 16,700. The S&P500 has spent quite a few periods of 10 years or more without positive returns.
"Investors can lose sight of the fact that the market has gone through long periods when returns were minimal. During the 14 year period from the middle of 1968 to the middle of 1982 the S&P500 appreciated by less than 1% per year” Lee Ainslee
"Say you were forty-eight years old in 1964 and put $100,000 into the Dow on the last day of 1964 with instructions that dividends be reinvested, confident that you would have a nice nest egg when you retired at age sixty-five. When the last day of 1981 rolled around, your money would be worth statistically less than your initial investment because of a moribund market and the depredations of inflation" Leon Levy
“There have been periods of longer than a decade for which investing in the stock market in expectation of a 7 percent real return turned out to be a devastating mistake. It took the market twenty-five years to regain its levels of 1929” Andy Redleaf
Considering most investors think five years is a long time, an index fund or a relative return strategy, may not provide the returns your were hoping for.
The second issue is that most individual investors don't get anywhere near the returns of the index regardless of the time in which they enter the market. Numerous studies show that individual investors under-perform the index significantly either because they are scared out of markets during a downturn and/or are trading in an attempt to enhance returns.
"In 2014, Dalbar released its 20th report QAIB (Quantitative Analysis of Investor Behaviour) and the results for the two decades are very instructive. From 1994 to 2013, the average return of investors in 14 equity funds was 5.02% compared to 9.22% for the S&P 500. Over 20 years, the total return to investors was 166% versus 484% for the S&P 500. This is an astronomical difference. And this shortfall is what might be called a "behavioral penalty." Francois Rochon
Most investors panic, sell at the lows and buy higher up when things are looking more favourable. The psychology of the average investor almost guarantees under-performance. An index on the other hand is unemotional and doesn't get scared out of the market at the bottom. It rides out the lows.
Thirdly, relative returns are not what individual investors want. I'm sure the majority of investors would rather make 15% even if a market that was up 20% than lose 15% when the market was down 20%.
Finally, minimising the downside is likely to help investors stay invested rather than be scared out of the market by a large negative return.
One of the industry solutions suggested to meeting an individuals investing goal is the asset allocation process The general consensus is that if you are young, with a long time horizon for investments, you should have a high exposure to equities. This is because equities have historically provided higher returns over a long period of time. As you get older you should have less exposure to equities and more exposure to less volatile assets such as bonds.
In principle the equity assumption makes sense provided you are adding to your retirement account on the way through, which most people of course are. Remember whether you lose 10% in year 1 or year 10 or 20, if the capital amount doesn't change you'll end up with the same amount in the end.
But asset allocation has its own issues. One issue is that most asset allocation models are rigid - such as 40% bonds and 60% equities. In this case no-one is making a call on the relative attractiveness of the asset class. The manager who gets the 60% equities exposure is generally required to be fully invested by virtue of his or her mandate. She's supposed to be the expert on equities yet she can't go to cash if she can't find attractive investments. Her best bet is to buy defensive stocks. Unfortunately in a bear market there usually aren't many places to hide.
The bond manager who has 40% of the money has a few options. She can move to shorter duration bonds to protect the fund from rising interest rates. But if rates are very low, like they are now, it maybe difficult or impossible to earn attractive returns relative to inflation. Time has not always been kind to bond investors.
“An individual in a 50% bracket who put money into T-bills or government bonds after World War 2 and kept re-investing in these instruments to 1996, lost the major part of his or her capital” David Dreman
Looking in the rear view mirror the 40/60 portfolio has been a great performer over the last 30 odd years. Bond yields have trended lower and equities, although volatile, have trended higher. But driving with reference to the rear-view mirror is dangerous. Bond yields are now at record lows. The risk is now asymmetric in as much as bond yields can't fall much further but could rise a lot. With yields so low they no longer provide an attractive income stream. It's return free risk. So don't expect the returns out of a 40/60 portfolio over the next 10 years to mirror the last 30 years. It is unlikely to happen.
What do the Investment Masters do..
A major difference between the Investment Masters and most mutual funds is that the Investment Masters are FIRST trying to preserve capital before striving to make money. This means they are focussed on absolute returns and not relative returns. They are seeking to avoid the permanent loss of capital.
The Investment Masters are not aligned with an index and have the ability to go to cash if opportunities are scarce. They can build portfolios that are more durable than indexes. While these portfolios may be unconventional they may be significantly more conservative.
Conventional investing does not imply conservative investing. A portfolio's historic performance can give a guide to how conservative it is but its future risk of permanent loss of capital is what determines how conservative it is.
The Investment Masters recognise that the cost of outperforming in down markets may result in under-performance in a bull market. In the quest for higher long term returns the Investment Masters consider this a worthy price to pay.
"We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%" Warren Buffett
Remember investment profits and losses are not symmetrical. Consider the following two investment funds:
Fund A .. loses 50% in year 1, makes 50% in year 2 and then makes 10% in year 3
Fund B.. loses 50% in year 1, gets back to break-even in year 2 and makes 0% in year 3
Which would you prefer?
Fund B should be your preference. You get your money back. Fund A is still down 17.5% at the end of year 3. Profits and losses are not symmetrical. To get back to break-even Fund A would have needed to make 81.8% in year 2 (not 50%) and then 10% in Year 3.
Is you fund focussed on preserving capital? Is your fund focussed on outperforming down markets and accepting of some level of under-performance in strong markets?