- You cannot evaluate an investment decision
based on its outcome.
Take a second to let that sink in.
If you buy an individual stock and double your money,
you still made a bad decision.
You had a good outcome,
but you made a bad decision.
Future stock returns are uncertain.
When we are dealing with uncertainty,
a good decision might lead to a bad outcome
and a bad decision might lead to a good outcome.
Looking past outcomes to evaluate investment decisions
is not easy for a human to grasp.
We tend to have an illusion of control bias
where we overestimate our influence on outcomes.
This can be particularly dangerous
when it comes to investing.
I'm Ben Felix, portfolio manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you
how to evaluate your investment decisions.
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There is always going to be an element of uncertainty
that defines the ultimate outcome of any investment.
That is something that we cannot control.
We can control the quality of our investment decisions.
If we can recognize the difference
between a bad decision and a bad outcome,
we may be better equipped to stick
with a sensible long-term investing strategy
even when it is not producing a good outcome.
It is very important to realize
that making a good investment decision
does not mean that you're going
to get the outcome that you hoped for.
Think about your friend
that doubled their money in weed stocks
or your cousin making a ton of money in Toronto real estate
while your index funds
relatively boringly tracked the stock market.
Evaluating a decision starts
at the time that the decision is made,
as opposed to when the outcome is known.
Any decision is a risk.
As investors, our decisions will result
in us either making or losing money.
To make a good decision,
we need to know what risk we are taking,
why we are taking it and what the expected outcome is.
Knowing those things will allow us
to evaluate the decision in the future.
When we talk about investing in index funds,
we're talking about taking the risk of the market.
People usually take on the risk of the market
to achieve a financial goal.
Market risk has an associated risk premium
that we expect to earn.
Let's go through that one more time.
Taking on the risk of the market
in order to earn the market risk premium
to achieve a financial goal
would be a sensible decision, regardless of the outcome.
The market risk premium is well-documented
around the world as far back as we have data
and it is sensible that it will persist
based on the way that capitalism functions.
Going back to 1900,
the global market has delivered a risk premium
that is a return in excess of risk-free assets
of 4.2%.
This includes Russia's market going to zero in 1917,
and China's in 1949.
Making a decision based on an expected risk premium
is perfectly reasonable.
Knowing that the stock market delivers
a positive risk premium over the longterm might be helpful,
but it does not make it much easier to evaluate
your investment decisions in the short term.
Even over 10-year periods,
stocks have trailed bills 12% of the time in Canada,
15% of the time in the U.S.
and 6% of the time in international developed markets
going back as far as I have data available.
There is a non-zero chance of living through a decade
of a flat or negative risk premiums for stocks.
That does not make investing in stocks a bad decision,
but it does leave a substantial amount
of room for luck to influence the outcome.
In his book, "How Much Can I Spend in Retirement?"
Wade Pfau pointed out that retirees in 1973
and 1975
had 28 of their 30 working years overlap,
but the 1975 retiree reached retirement
with 36% less wealth than the 1973 retiree.
They both made the same investment decisions
and worked for the same number of years,
but their outcomes diverged based solely
on the uncertainty of stock market outcomes.
Similar thinking can be applied
to small cap and value stocks.
They have produced reliable long-term risk premiums.
For example, U.S. value stocks beat U.S. growth stocks
by 3.3% per year on average from 1928
through 2018.
The same thing happened in Canada
where value beat growth by 2.59% per year
on average from 1977 through 2018
and in international developed markets
where value beat growth by 5.01% from 1975 through 2018.
These are reliable risk premiums.
However,
for the past decade,
owning U.S. value stocks has resulted in a bad outcome
as value has trailed growth
by 3.2% per year on average.
Whether or not investing in value stocks was a bad decision
depends on why the decision was made.
Value stocks are riskier than growth stocks
and there is a return premium associated with that risk.
Adding value stocks to a portfolio
to capture an independent risk premium
is not a bad decision,
but that does not guarantee a good outcome.
Now, to be fair to value stocks,
if we looked at the returns of U.S. value
against growth in March 2000,
we would find that value had trailed growth
for the past 5, 10, 15, and 20-year periods.
If we looked one year later in March 2001,
we would see that value had beaten growth
for the past 5, 10, 15, and 20-year periods.
Not only are we dealing with uncertain outcomes
but in order to increase the chances
of achieving an expected outcome,
it is crucial to stick with the strategy.
This is what makes evaluating
investment decisions so challenging.
Investing in value stocks in 1980 was not a bad decision,
but it resulted in 20 years of bad outcomes.
And to finally get the good and expected outcome
you had to stick with it for 20 years of underperformance
and hang on that one extra year.
Probably an even better example of an investment decision
that is hard to evaluate is owning individual stocks.
The data on individual stocks is not promising.
Most of the returns of the market
come from relatively few stocks
and identifying those stocks ahead of time
is impossible to do consistently.
This makes picking individual stocks,
on average, a losing bet,
but there are still some people
who will make money investing in individual stocks.
Not a good decision,
but it can lead to a good outcome,
though, a bad outcome's more likely.
I think that this is particularly important
when we are talking about index funds
and being committed to index investing.
It will always be possible to identify something,
an active fund or an individual stock,
that did better than an index fund.
The problem for us investment decision makers
is that when something does better than the index,
that performance will be used as a tool
to sell you on the strategy.
A good outcome for an active fund
does not make it a good fund.
In their Persistence Scorecard,
Standard and Poor's looks at U.S. active mutual funds
that have been top quartile fund for the past five years,
and then tracks them to see how many stay top quartile
for the next five years.
In the March 2018 scorecard, only 2.33%
or 13 of the original 557 top quartile funds
remained in the top quartile.
I think that I have established
that evaluating investment decisions is hard to do
but basing decisions on persistent risk premiums
and sticking with the decision for an investment lifetime
is probably the best approach.
We've also talked about the role of luck in outcomes
where bad luck can result in bad outcomes
despite a good decision.
One of the best ways to reduce the role of luck
in your investment outcomes is through diversification.
Earlier in the video,
I mentioned that stocks in various markets
can have 10-year periods of underperformance.
When that happens in one market,
it will not always happen in other markets at the same time.
The last decade in the U.S. is a perfect example.
From late 1999 through 2009,
a Canadian investor would have lost money in U.S. stocks.
Canadian stocks on the other hand returned 6.47% per year
on average, over the same period.
We could not have known ahead of time
what those outcomes would be,
but diversification reduced the impact of that uncertainty.
Diversification is not limited to geographic regions either.
I have mentioned persistent risk premiums
as being sensible basis for investment decisions,
even if they don't always pan out.
The interesting thing about risk premiums
is they are not perfectly correlated with each other.
When one doesn't pan out over a given time period,
there's a good chance that another one will.
This makes diversifying across risk factors
an interesting proposition for any investor.
Take our example of the last decade in U.S. stocks again.
Over that same period,
U.S. small cap value stocks returned
6.45% per year on average,
that is U.S. stocks as a whole lost value over the decade
but U.S. small cap value stocks
made a substantial return over the same period.
We can take this one step further.
Let's look at four U.S. risk premiums:
market, size, value and profitability,
and examine the 547 rolling 10-year periods
from July in 1963
through 2018.
If we look for 10-year periods
where one of the risk premiums was negative,
that is the market risk premium,
the premium of small stocks over large stocks,
the premium of value stocks over growth stocks,
or the premium of stocks with robust profitability
over stocks with weak profitability,
there were 270 or 50% of the 10-year periods
where one of those risk premiums produced a bad outcome,
meaning a negative premium.
If we instead look for 10-year periods
where two of the premiums were negative,
we only find 43 of them,
or 8% of the time.
For three of the four premiums being negative,
we find only one of the 547 10-year periods.
This speaks to the importance of diversification
not only geographically, but also across risk factors.
It also speaks to the importance
of almost blindly sticking with investment strategies,
as weird as that feels to say, for an investment lifetime.
If we have basis to make a decision today,
it should take a massive weight of evidence
to deem it a bad decision that needs to be amended.
There's something called Bayesian thinking
that I think it's worth mentioning at this point.
In Bayesian thinking, we start with our prior assessment.
No one simply has a prior in Bayesian speak.
The stronger the prior,
the more overwhelming new evidence
has to be to change our mind.
In reality, anytime that we get new information,
we have a tendency to weight it more heavily.
This is called the availability heuristic.
To apply Bayesian thinking,
before drawing a conclusion from new information,
such as value stocks underperforming for a decade,
we have to consider it against the weight of our prior.
In the case of value stocks,
our view might change a little bit
after a decade of underperformance,
but not much based on the strength of our prior.
Any investment decision should be made
based on the intention to take a specific risk
for a specific reason
with the view of achieving a goal.
It is only on the quality of the process used
to make the decision, not on the outcome,
that the decision can be judged.
Even with the best decisions,
there's a chance of a bad outcome due to luck.
The best way to reduce this chance
is through diversification
across both geographies and risk factors.
How do you evaluate your investment decisions?
Tell me about it in the comments.
Thanks for watching.
My name is Ben Felix of PWL Capital
and this is Common Sense Investing.
If you enjoyed this video,
please share it with someone that you think
could benefit from the information.
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