Archives For August 2012

Evaluating investments correctly is one of the foundations of successful investing. This article demonstrates potential pitfalls with a case study. The results of avoiding them can be phenomenal, but you may have to overcome a psychological bias to obtain them.

Imagine the following: It is 2004, and two brothers, “Skeptic” and “Disciplined”, have $1M in investments. They hear about a stock portfolio with 15%+ annual returns, as simulated since 1970. They are both excited, since there is no individual stock selection or market timing, and the portfolio is highly diversified, leading them to believe that future returns may be good as well. They take different actions, as listed in the table below.

Year / Event

Skeptic

Disciplined

6/2004, they hear about a diversified stock portfolio with 15%+ annual returns, as simulated since 1970.

Tracks the returns for some time, before making any decision, because he is not sure he can get the same returns with his own money. Keeps a 60%/40% allocation to stocks (S&P 500) / bonds.

Moves his money to this stock portfolio, based on the long-term performance and the reasoning behind the performance.

10/2007, the portfolio grew by 143%.

Decides to move his money (grew to $1.3M by now) to the new investment, thanks to the demonstration of growth with Disciplined’s money.

Keeps his $2.43M ($1M + 143%) invested with no change.

3/2009, the portfolio declined by 60% (the worst recession since the 1930’s). Each of the brothers has saved $100k.

Seeing his investments well below the starting point ($520k), he questions the portfolio and keeps the $100k in cash.

Celebrates having money to add to the portfolio at a deep decline. He adds the $100k to his $972k portfolio => $1.072M.

12/2009, the portfolio gained 90%.

Regains his comfort with the portfolio (now $988k) and adds the $100k, for a total of $1.09M.

Enjoys the magic of nearly doubling his $100k addition, resulting in a total of $2.04M.

7/2012, the portfolio gained a mere 4%, its P/B declined by 45% since the peak, and both brothers are expecting a $1M inheritance.

Nearly 5 years since he started, and he is still at a loss ($1.13M, down from $1.3M). He plans to keep the money in cash, again waiting for proof that the portfolio makes sense.

Excited to add the expected inheritance to his portfolio according to his plan, and given the low valuations (P/B).

7/2012, balance

$1.13M

$2.12M

The portfolio above is a simulation of Long-Term Component going back to 2004. While the dollar amounts and exact details have been modified, the different actions of Skeptic and Disciplined reflect approaches that actual investors took, and the nature of the results is similar.

The main difference between the two investors is:

  1. Skeptic needed to see actual results with his brother’s money before trusting the investment. Disciplined understood the principles behind the investment, and was able to commit to it right away. Unfortunately, the need to see positive results before committing to an investment requires missing gains. Skeptic’s price tag for waiting from 6/2004 to 10/2007 was $1.13M, or 87% of his money.
  2. Skeptic questioned the investment whenever there was a decline that led his total returns to be low or negative. By delaying the investment of his saved $100k, from 3/2009 to 12/2009, he missed a 90% gain, costing him $90k.
  3. Skeptic was planning to delay investing his upcoming $1M inheritance, given that his account was still at a decline. By waiting for proof that the investment works, he guarantees missing the next substantial gain, because the timing will be after the gain, whenever it occurs.

While Skeptic’s experience may seem too bad to be true, it does reflect the difficulties that some real-life investors face. Skeptic believes what he can see in his own eyes. Unfortunately, this need has a large price tag, especially with volatile investments. It leads to missing significant gains, while experiencing all losses, resulting in substantially lower total returns. To make matters worse, the low returns (that he created with his own actions) make him question the investment even further, creating a vicious cycle.

If you invest in a disciplined approach that does not change with market conditions, and is based on long-held principles, you would do best to study the merits of the investment, and stick with your plan in good and in bad. This can allow you to benefit from buying low right from the beginning. Disciplined was able to more than double his money during 8 years that included the worst decline in generations.

Conclusion

While it is most believable to see the results of an investment in your own eyes before committing to it, it is not typically practical for several reasons:

  1. When you see impressive gains, you make sure to miss them. Since many investments are cyclical, you end up missing the gains and buying high.
  2. It is meaningful to see gains for a statistically significant period of 30+ years, but given the limited life expectancy, it is not practical to wait so long.

It is most practical to evaluate investments by inspecting principles that are likely to withstand the test of time, and reviewing statistically significant performance that you haven’t experienced with your own money (or your brother’s).

Disclosures Including Backtested Performance Data