Tuesday, February 24, 2015

The Best Investment of the Last 50 Years

One of my favorite writers, Morgan Housel, recently pointed out the most profitable stock since 1968 in his article titled “The Extraordinary Story of America’s Most Successful Industry." Any guesses what it might be?

The company with the best performing stock must have revolutionized the world in some way. The product must have been innovative, like computers or a cure for a dreaded disease.  Perhaps it was a small shop that became an international rage. Maybe it was a company that has been on the cutting edge for the last five decades.

As sound as those assumptions are, they are all incorrect. The best performing stock since 1968 is Altria, the cigarette company. While $1 invested in the S&P 500 in 1968 would now be worth $87, $1 invested in Altria at the same time would now be worth $6,638. That is an annual return of 20.6% for a 47 year period. Not bad!

I mention Altria not to discuss the impact of buying an addictive substance or the role of ethics in investing, but as a perfect example of the benefits of diversification. 

When thinking about the process of investing, it is human nature to think of the factors mentioned in our guesses – the sexy ingredients to success like technology or the garage shop going global. These are typical descriptions of growth-style companies. Growth companies usually utilize their profits to improve their systems, reach, or products. Further developing their infrastructure and merchandise allows them to grow faster and generate more revenue, and ultimately, more profits. This benefits investors in that the price of the company’s stock increases as its ability to generate additional profits increases.

Value-style companies are different. Value companies sell products and services that no longer require significant ongoing innovation. Consequently, rather than using profits to continue to expand, value companies payout the majority of their profits in the form of dividends to shareholders. While growth companies are new and exciting, value companies are frequently old and quite boring. As you might imagine, cigarettes are essentially the same today as they were 50 years ago.  However, since the tobacco industry hasn’t required a large expense to continually upgrade their product, an unusually high proportion of revenues have been paid out to owners of the stock. 

Clearly, an exciting new product that everyone must have and quickly generates tremendous profits makes a good growth company.  A good value company, on the other hand, is a company that earns mediocre profits for an extended period of time. Remember, to be effective compound interest requires long holding periods. Thus, Altria is a perfect example of a value-style company.

So is investing in value stocks a more profitable strategy than investing in growth companies? As always when investing, the answer is “it depends.” As Fidelity points out, value stocks did in fact outperform growth stock for the 30 year period ending in 2010, with large cap value earning an average annual return of 11.66% while large cap growth earned 9.91% annually over the same time period. Further, large cap value stocks endured less volatility over this period, with a standard deviation of 15.78 as opposed to the standard deviation of 21.89 for large cap growth stocks.

However, since 1990, large cap growth has made more than 34% during a calendar year six times, while large cap value has accomplished that feat only once, and we don’t want to miss out on all those exciting growth companies that are on the cusp of changing the world, right? Fortunately, the point of diversification is to hold uncorrelated assets in our portfolio so that when one asset category goes through rough times, other asset categories might maintain or even increase in value. Investing in assets that respond differently to various market events ultimately reduces volatility in our portfolio as a whole, and thus, reduces risk. For this reason, growth stocks are a wonderful compliment to value stocks.

The Dow Jones US Large Company Growth Index has performed surprisingly different from the Dow Jones US Large Company Value Index in various market environments since 1990:

Large Growth
Large Value

Large Growth
Large Value

While investing in companies on the verge of changing the world is exciting and worthwhile, don’t forget about the dull value companies with a tried-and-true business model and established market for their products or services. Due to lower expenses and higher dividend payout ratios, these value companies can be just as lucrative as those sexy growth investments. Fortunately, the benefits of diversification make holding both of these positions together more value than owning either by itself. 

Tuesday, February 17, 2015

How Recent Events Hinder Your Return

Investors should be conscious of the recency bias when developing their portfolio. The recency bias is the habit to assume recent trends in market activity will continue well into the future. For example, an investor might have the tendency to overweight large cap stocks in 2015 just because large cap stocks were the big winner in 2014, significantly outperforming small cap and international equities.  This is dangerous because purchasing the asset category that has recently done well is frequently the equivalent of buying something when it is overvalued rather than positioning yourself to benefit from the market’s future movements.

In another example, Tony Robbins recently published a new book titled MONEY Master the Game: 7 Simple Steps to Financial Freedom which falls prey to an increasingly popular version of the recency bias. Mr. Robbins worked with famous hedge fund manager Ray Dalio to create the so-called “All Weather” investment strategy. The asset allocation for the strategy is:

·        30% Stocks
·        40% Long-term Bonds
·        15% Intermediate-Term Bonds
·        7.5% Gold
·        7.5% Commodities

As Mr. Robins points out, the All Weather portfolio has performed quite well during the last 30 years. From 1984 through 2013, this portfolio averaged an annual return of 9.7%, achieved a positive return in 86% of calendar years, and never suffered a loss worse than -3.9% during a calendar year. Not bad!

However, these backdated results create a significant error due to the recency bias. Unfortunately, these investment results reflect only the past 30 years, which happens to represent the strongest bond bull market in history. Assuming bonds will have an equally strong 30-year period going forward is questionable at best and destructive at worst. In fact, as investment analyst Ben Carlson showed, the same All Weather portfolio only returned 5.8% annually during the much longer time period of 1928 to 1983.

Of course, my point is not that Tony Robbins’ book isn’t worthwhile, or that the All Weather portfolio is a poor investment.  In fact, all of Mr. Robbins’ seven steps are sound financial practices, such as learning to invest in your future, keeping investment fees low, setting realistic rate of return goals, diversifying, and creating a retirement plan. Additionally, the All Weather portfolio may actually be an appropriate investment for investors who don’t need much return to achieve their retirement goals and are most interested in minimizing risk.

My point, however, is that we should not let the recency bias skew our expectations for our investment portfolios going forward. It could be catastrophic if an investor assumed they would achieve a 9.7% annual return during retirement utilizing the All Weather portfolio only to have the historic rally in bonds fade out, making that rate of return unachievable. Similarly, it would be equally damaging to assume a loss of more than -3.9% isn’t possible, since examining results before 1983 tells us that this portfolio has lost as much as -17.5% in a calendar year.

The recency bias can cause us to make unproductive modifications to our portfolios based on recent market movements. Further, over-weighting recent investment results and trends can lead to unrealistic expectations for our portfolios’ risk and return levels. These behaviors can be destructive to an investment strategy. Always be aware of our tendency to overweight recent market trends and resist the temptation to let them negatively impact your long-term investment strategy.