Archive for May, 2015

Peak to valley, from June 1998 – March 2000 Warren Buffett’s Berkshire Hathaway lost over 50%. In the same period, the S&P 500 returned over 45% and the Nasdaq 100 returned over 315%. A new client said to me the other day “I’m in this for the long term, but if after a couple years I don’t see any gains then I’m going to tell you this isn’t working.” That feels logical, as two years can seem like an eternity for clients that tend to check their account balances almost every day. On a separate side note, I believe this behavior is rooted in an investors tendency to not completely trust their advisor which is legitimate in a field chock-full of conflicts of interest and bad advice which can largely be eliminated by a fiduciary standard. But historical and statistical evidence suggests that even the most efficient strategies and portfolios are almost guaranteed to have a period of losses or no growth that last at least a couple years during any investor’s lifetime. Nobody can predict when that will happen. Does the fact that Warren Buffett underperformed the S&P 500 by almost 100% and the Nasdaq 100 by more than 350% for almost a two year period matter, or does this matter?Berkshire

Source: http://awealthofcommonsense.com/buffetts-performance-by-decade/

Obviously the long term performance is what matters, yet investor’s actions regularly tell a different story and unfortunately this will never change. Are you mentally prepared to experience significant periods of underperformance? It’s inevitable. In fact, just about everything has underperformed the last few years relative to US stocks. Living through a track record is a LOT different than reviewing one on paper when you know how the story ends.

In our firm we believe pretty good is better than constantly pursuing perfection, and maximum risk-adjusted returns come from proper portfolio construction instead of concentrated bets. Every strategy, including Warren Buffett’s, has periods that appear where it’s broken. For us mere mortals with a plethora of emotional baggage and behavioral biases that come attached to our money, I contend the best, perhaps even the only way towards a successful investment experience, is through diversification.

“The most powerful tool an investor has working for him or her is diversification. True diversification allows you to build portfolios with higher returns for the same risk. Most investors…are far less diversified than they should be. They are way over-committed to stocks.” -Jack Meyer

“Thus timing, and in particular the selection of the beginning point and end point for studying a performance record – plays an incredibly important role in perceptions of success or failure” -Howard Marks

“No strategy is so good that it can’t have a bad year or more. You’ve got to guess at worst cases: No model will tell you that. My rule of thumb is double the worst that you have ever seen.” -Cliff Asness, AQR

I’m a big fan of the work of Cliff Asness and AQR (Applied Quantitative Research).  Cliff was recently on Bloomberg Radio with Barry Ritholtz. You can listen here to his Feb 21st interview.

About twelve minutes in Barry asked Cliff what it means to be a quantitative investor in which Cliff replied that “quantitative investment managers are about two things – averages and diversification.” Diversification is broadly accepted in finance, often called “the only free lunch” in investing.

Quant managers care about what works in trading and investing and what has statistically significant historical evidence to prove it. Value, momentum, and trend to name a few. Many in finance hold their beliefs about one particular style of investing (for example “active vs passive”) so closely that it’s like debating politics. To paraphrase Meb Faber, “many people have a hard time having two different points of view on investing in their head at the same time without it exploding.”

But quantitative analysis is not only about performance data. When done properly only modest and general conclusions should be drawn about the likelihood of the future to be like the past. Let’s look at an example:

Portfolio visualizer is a nice web site for backtesting passive asset allocations as far back as the early 1970’s. I took a few minutes to create a simple asset allocation of the following:

15% US equity

15% Foreign equity

15% TIP’s

25% Treasuries

15% Corporate bonds

5% REIT’s

5% Gold

5% Commodities

Cliff also talked about how quant managers like to do in sample and out of sample testing to confirm the validity of an investment strategy on both past data that you have seen as well as data you haven’t. This eliminates or at least reduces hindsight. Let’s go back in time a few years and assume for a moment it’s 12/31/2007. From 1973 to 2007 this simple asset allocation, rebalanced annually, produced some very impressive results (gross of fees and taxes as this is simply index data. Past performance doesn’t guarantee future results, and that’s one of the major points in this post):

Annualized return: 11.34%

Annualized volatility: 7.82%

Sharpe Ratio: .65

Worst Year: -3.65%

Here is the wrong way to review this information: “Wow, this portfolio makes over 11% per year, 32 out of the last 35 years, and can only lose -3.65%? I can easily stomach that kind of risk! I know my advisor told me not to focus too much on the past or something, but I wasn’t really listening because I was focused on the numbers and this looks as good as guaranteed to me!” 

Now let’s look at 2008-2014 and consider it “out of sample” results since at the time we didn’t know how it would work out:

Annualized return: 6.06% (47% lower)

Annualized volatility: 10.54% (35% higher)

Sharpe: .57 (12% lower)

Worst Year: -12.21% (234% higher)

Since 2008, every performance measurement has been worse than 1973-2007. But is there actually anything “wrong” with this portfolio? Not at all. 2008 was a historic global sell-off in asset classes and 7 years is a relatively small sample size. The problem that investors run into is focusing WAY too much on past performance without taking into consideration market conditions from a much higher level.  Humans tend to think the recent past will continue on forever, which is known as recency bias. Now analyzing this simple portfolio over the entire period of 1973-2014 gives an annualized return of 10.44%, and it will continue to change every year! Just like reviewing it only from 2009-2014 produces an annualized return of 9.46%. So is this portfolio going to make 6%, 9%, 10%, or 11% annually going forward? Probably all of them, it will just depend when you look at it. The only thing I’d be pretty confident in is that a portfolio like this will continue to provide real returns over the long term. Quantitative analysis can be an extremely powerful process for building evidence based investment strategies and portfolios. But there is a right way and a wrong way to do it.

“Thus timing, and in particular the selection of the beginning point and end point for studying a performance record – plays an incredibly important role in perceptions of success or failure” -Howard Marks

“No strategy is so good that it can’t have a bad year or more. You’ve got to guess at worst cases: No model will tell you that. My rule of thumb is double the worst that you have ever seen.” -Cliff Asness, AQR

“When investing over the long run, all you can have confidence in is that…holding assets should provide a return above cash…That’s it. Anything else (asset class returns, correlations, or even precise volatilities) is an attempt to predict the future.” -Ray Dalio, Bridgewater Associates

“You must be rigid in your rules and flexible in your expectations. Most traders (and investors) are flexible in their rules and rigid in their expectations.” -Mark Douglas

 

 

Our job as investment advisors is as much about human management as investment management. We spend as much of our time acting as behavioral counselors with clients as we do discussing strategy and markets.

In our recent article about quantitative investment management we touched on the limitations of analyzing investment portfolios only by their track record. In our recently published overview to our flagship LC Diversified investment portfolio, we made the following comments in the closing paragraph:

As always, please remember that past performance is not indicative of future results. While the strategy’s managers fully believe that LCD will continue to manufacture high risk adjusted returns over the long term, such results cannot be guaranteed. Any investor utilizing LC Diversified should be mentally and financially prepared to have periods of loss that could be substantial. Diversification does not provide protection against all potential loss or guarantee a profit. The managers of LC Diversified expect that the strategy’s maximum drawdown is in the future. The risk and return characteristics of LC Diversified suggest that a future drawdown of 10-20% lasting 2-3 years is statistically likely at some point in the next thirty years.

Overwhelming evidence shows how investors repeatedly chase performance. Specifically, recent performance over the last 2-3 years. Of course, we don’t suggest that you instead go out chasing recent poor performance (although if the strategy is robust we could easily make a case for that) but instead spend time attempting to understand the portfolio and individual strategies and the expected risk/return profile (which isn’t necessarily the same as the past risk/return profile).

Our quantitative analysis article gave an example of how you should always expect a maximum drawdown to be sometime in the future. We expect LC Diversified to be no different. It’s just impossible to predict when.

An investor recently shared concerns with us that “LC Diversified will eventually have it’s worst drawdown and first losing year”. We agree. The difference of why we agree is based on statistical expectation instead of a gut feeling that when examined further is rooted in fear. Unfortunately this investor was focusing completely on past performance and improperly concluding that when we have a future drawdown larger than any in the past this somehow will be an indication that the portfolio has become less effective. In short, this investor was confusing something good with what he hoped was something perfect. This is an example of performance chasing.

And here are some thoughts from others in finance on the subject:

“Thus timing, and in particular the selection of the beginning point and end point for studying a performance record – plays an incredibly important role in perceptions of success or failure” -Howard Marks

“No strategy is so good that it can’t have a bad year or more. You’ve got to guess at worst cases: No model will tell you that. My rule of thumb is double the worst that you have ever seen.” -Cliff Asness, AQR

“When investing over the long run, all you can have confidence in is that…holding assets should provide a return above cash…That’s it. Anything else (asset class returns, correlations, or even precise volatilities) is an attempt to predict the future.” -Ray Dalio, Bridgewater Associates

“You must be rigid in your rules and flexible in your expectations. Most traders (and investors) are flexible in their rules and rigid in their expectations.” -Mark Douglas