In investing and in life, we know we can’t always control the outcomes that occur from the decisions we make. Bad things can happen to the wisest among us. Likewise, even a fool can get lucky.
But just because this makes sense does not make it any easier for most investors to effectively evaluate their investment decisions. To do so, the evaluation should be based on the decision’s inherent quality rather than its outcome.
Deciding Today About Tomorrow’s Outcomes
Decisions versus outcomes is a tricky topic. This is because investors tend to overestimate how much control they have over good and bad outcomes. Bottom line, future stock returns are uncertain. When we are dealing with uncertainty, we can tilt the odds of success toward or away from us by making better or worse decisions. But a good decision can still yield a bad outcome, and vice-versa.
So what should you do as an investor? First, don’t be fooled into reading too much into investment outcomes, which are relative wild cards. Instead, control what is most readily controllable, which is the consistent quality of your investment decisions. If you can recognize the critical difference between decisions and outcomes, you may be better equipped to stick with your sensible long-term investment strategy. This, in turn, should help you move past the times when good decisions aren’t producing desirable outcomes.
Let’s put this another way: Making good investment decisions does not guarantee outperformance. Almost everybody knows somebody who doubled their money in cannabis stocks, or made a killing in Toronto real estate. These were bad investment decisions, but the fortuitous outcomes may make them seem more appealing than staying put in a relatively boring, low-cost market-tracking index fund.
Good Decisions and the Investment Risks Involved
Any investment decision involves taking risks; we must make our choices today, rather than waiting until the good or bad outcomes are known. So, to make good investment decisions, we need to know what risk we are taking, why we are taking it, and what the expected outcome is. Knowing these things also allows us to more effectively evaluate the decision over time.
If you invest in a basic stock index fund, you are taking on market risks, hoping to earn market returns. That’s how investing works. Market risk has an expected associated risk premium. It’s a premium that has been well-documented around the world for as far back as we have data. Going back to 1900, the global market has delivered a risk premium (returns in excess of risk-free assets) of 4.2%. This outcome includes Russia’s market going to zero in 1917, and China’s market doing the same in 1949.
Since it is sensible to expect this robust market premium to persist, making a decision based on the expected risk premium is also perfectly reasonable. In other words, if you decide to take on market risk to achieve a financial goal, you’re making a sensible decision – regardless of the outcome.
Short-Term Angst vs. Long-Term Decision-Making
Knowing that the stock market is expected to deliver a long-term risk premium might be helpful. But it does not make it much easier to evaluate the outcome of your investment decisions in the short-term. And by “short-term”, I mean at least a decade. For as far as I have data available, 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.
This means there is a non-zero chance of living through a decade of flat or negative stock risk premiums. Again, this does not mean you’ve made a bad decision if you decide to invest in stock funds, but it does leave substantial room for luck to influence your outcomes.
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 if you compare two otherwise identical investors (who made the same investment decisions and worked the same number of years), the 1975 retiree reached retirement with 36% less wealth than the 1973 retiree. Their outcomes diverged based solely on market uncertainty.
We can apply similar thinking to small-cap and value stocks. Focusing on value stocks, they too have produced reliable long-term risk premiums. For example, U.S. value stocks beat U.S. growth stocks by 3.30% per year on average from 1928–2018. The same is true in Canada, where value beat growth by 2.59% per year on average from 1977–2018; and in international developed markets where value beat growth by 5.01% from 1975–2018.
These are reliable risk premiums. However, for the full past decade, U.S. value stocks have delivered a bad outcome, as value has trailed growth by 3.20% per year on average. Despite this outcome, whether or not investing in value stocks is 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. If you added value stocks to your portfolio to capture this independent risk premium, it suggests you made a good decision, even if it has generated a bad outcome to date.
But is it still a good decision? Consider this: If you looked at the returns of U.S. value vs. growth in March 2000, you would find that value had trailed growth for the past 5-, 10-, 15-, and 20-year periods. If you looked again one year later in March 2001, you would see that value had gone on to beat growth for the past 5-,10-, 15-, and 20-year periods. The message is clear: In the face of uncertain outcomes that can change on a near-term dime, you are best off sticking with a good decision if you want the best chance to ultimately achieve it.
This is why it’s so challenging to evaluate investment decisions in real time. Investing in value stocks in 1980 was not a bad decision, but it resulted in 20 years of bad outcomes. To finally get the good, and expected, outcome, you had to stick with it through those 20 years of underperformance, hanging on for just one extra year. Of course, you wouldn’t have known that at the time.
Individual Stocks vs. Index Funds
Perhaps you think you could make better decisions if you owned individual stocks instead of stock market funds. Instead, I would suggest it makes the decision-making even harder. The data on identifying individual winning stocks is not promising. Most of the overall market’s returns come from relatively few stocks, and they cannot be identified in advance.
This makes picking individual stocks a losing bet on average, even though there will still be some people who will get lucky and make lots of money picking from them. Now that you’re getting the hang of how to assess decisions vs. outcomes, I hope you can see that this is one of those bad decisions with a good outcome – but that a bad outcome was more likely.
I think this is particularly important when we are talking about being committed to index fund investing. It will always be possible to identify some active fund or individual stock that outperformed an index fund. But if someone tries to use that past outperformance as a marketing tool to entice you to buy in, you should now be able to recognize the ploy for what it is. It’s more likely a bad decision than a good investment.
A good outcome for an actively managed fund does not make it a good fund. In fact, odds stack up against its continued success. In its March 2018 Persistence Scorecard, the S&P Dow Jones Indices looked at U.S. active mutual funds that had been top-quartile funds during the previous 5 years, and then tracked them to see how many stayed in the top quartile during the subsequent 5 years. In the March 2018 scorecard, only 2.33% of the original 557 top-quartile funds remained in the top quartile.
Diversification Is Your Secret Weapon
I have now established how hard it is to evaluate your investment decisions in real time. Instead, basing your decisions on persistent risk premiums and sticking with them for your investment lifetime is preferred.
We have also talked about how bad luck can result in a bad outcome even when it’s based on a good decision. Fortunately, you have a powerful ally to help you reduce the role luck plays in your investment outcomes: global diversification.
Earlier, I mentioned that stocks in various markets can have 10-year periods of underperformance. But when that happens in one market, it will not always happen in others. The “lost decade” in the U.S. stock market is a perfect example. From late 1999 through 2009, investors 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 these outcomes in advance, but diversification reduced the impact of the uncertainty.
Diversification is not limited to geographic regions. I have mentioned that persistent risk premiums are a sensible basis for investment decisions, even if they don’t always pan out. The interesting thing about risk premiums is that they are not perfectly correlated. When one doesn’t pan out over a given time period, there is a good chance another one will. This makes diversifying across risk factors an interesting proposition.
Let’s revisit the U.S. stock market’s lost decade, from late 1999 through 2009. 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 a step further by looking at four U.S. stock risk premiums – market, size, value, and profitability – and examining the 547 rolling 10-year periods from July 1963 through year-end 2018.
If we look for 10-year periods when just one of these four risk premiums produced a bad outcome (a negative premium) we find 270 times, or nearly half of the 10-year periods, when this was the case. If we instead look for 10-year periods when two of the premiums were negative at the same time, we only find 43 instances, or 8% of the time. Three premiums were simultaneously negative only once during all 547 10-year rolling periods.
Shifting Your Decision-Making Mindset
All of this speaks loud and clear to the importance of diversification – geographically and across risk factors. It also speaks to the importance of sticking with your well-devised investment strategy with nearly blind discipline for your investment lifetime … as weird as it may sometimes feel. If you made your good investment decisions today based on a massive weight of evidence measured across decades upon decades of time, it should take at least an equal mass of time and evidence to warrant an amendment.
There’s even a fancy name for this sensible logic. It’s called Bayesian thinking. The stronger the prior decision, the more overwhelming any new evidence should be before you change your mind. Instead, investors are susceptible to an availability heuristic, which tempts us to give excessive weight to new information.
To make good investment decisions, base them on your intention to take on a specific risk, for a specific reason, with the view of achieving your own long-term financial goals. Then shore up your good decisions by diversifying your investments across geographies and risk factors. You can then judge your decisions over time based on the quality of your sound process, rather than the whims of unfolding outcomes. This becomes especially important during those times when your best decisions are yielding bad-luck outcomes.
How do you evaluate your investment decisions? Are you thinking of switching to Bayesian thinking? I hope you do, and after that, you can also tune into weekly episodes of the Rational Reminder Podcast wherever you get your podcasts.