June 26, 2015
Written by Nathan Erickson, CFA®, CAIA, Cheif Investment Officer
“A wise man… proportions his belief to the evidence.” David Hume, An Enquiry Concerning Human Understanding (1748)
It always seems fitting after the first quarter of any year to make some analogy to the NCAA college basketball tournament, and this year is no different. Whether you’re a sports fan or not, “March Madness” brings excitement through upsets, Cinderella stories, powerhouses, and fierce competition. Even if you are not a basketball fan, this culminating “One Shining Moment” video with Luther Vandross singing in the background is sure to bring a tear to your eye.
This year’s tournament was over before it started, according to the experts and even Vegas sports lines, who favored Kentucky with an unprecedented 50% chance to win the entire tournament. Kentucky entered the tournament undefeated, which no team had done since the Indiana Hoosiers in 1976. It was said that the only team that could beat Kentucky was Kentucky’s second string.
Like Kentucky’s winning team, the S&P 500 has been the powerhouse of investment markets since the end of the financial crisis. After six straight years of positive returns averaging 17% a year, arguments for investing in any other asset class become more difficult. Europe continues to struggle, the dollar is stronger than it has been in a long time, China‘s growth is slowing down, and the U.S. just keeps moving along. Why invest anywhere else?
Of course, there are contrarians who would say that neither Kentucky’s winning streak nor the S&P 500’s positive returns can go on forever. Naysayers would argue that Kentucky had some lucky wins early in the season and were bound to lose eventually. Likewise, several renowned investment experts who analyze the S&P 500 have the same opinion. They point out the fact that the U.S. market has never experienced positive returns seven years in a row (price only), and cannot continue to hit all-time highs.. They believe the market is due for a contraction, as supported by the current Shiller P/E ratio, which implies the market is highly overvalued.
Financial experts and the media point out these statistics, winning streaks, charts, and signs, encouraging investors to believe that they will benefit from using this information in their investment decision making. We disagree.
Applied Quantitative Research (AQR), an investment manager that Miller Russell Associates uses in portfolios, recently published an article titled “Challenges of Incorporating Tactical Views”. In it they test the idea that decisions based on valuation measures can improve a portfolio’s outcome. If one simply owns less of the market when it’s overvalued and more of the market when it’s undervalued (as measured by the Shiller P/E ratio), one would be better off. While some might argue this is true (Isn’t it simply buy low sell high?), what AQR suggests is that getting the timing right around those decisions is extremely difficult. In the article, AQR states that “valuations can drift higher or lower for years or decades, making it difficult to categorize the current market confidently as ‘cheap’ or ‘expensive’ without hindsight calibration. Only part of the dataset (the past) is available.”
The 1990s is a perfect example of poor timing. Based on the Shiller P/E ratio, the S&P 500 was considered overvalued in 1991. If investors had adjusted their portfolios based on this valuation, they would have missed eight more years of positive returns, including 1995-1999 where S&P 500 returns were 20% or higher each year. The reality is that when investors are greedy, they may remain greedy for years to come. As John Maynard Keynes famously said, “markets can remain irrational longer than you can remain solvent”.
Perhaps the biggest takeaway from AQR’s article is that those who make tactical decisions in a portfolio do so with the assumption that it will pay off, but ignore the cost of those decisions. It is true that increasing or decreasing concentration in one asset class does have a cost, which is the overall diversification of the portfolio. AQR’s research shows that for a portfolio with relatively uncorrelated asset classes, tactical decisions on average can result in a potential 15-30% cost in Sharpe Ratio or risk-adjusted returns! Statistically, to add value to that portfolio through tactical decisions (relative to a portfolio that doesn’t make these decisions), one would need to be correct more than 60% of the time.
Going back to our college basketball example, let’s take the contrarian view and assume Kentucky has run its course. In which round of the tournament will it lose? The first round? The second? The Sweet Sixteen? The Final? To be profitable in Vegas you must bet big on that decision, and you can’t bet on all the teams and make money. Contrary to betting on March Madness in Vegas, when investing we can bet on all the “teams” (asset classes) and still make money.
While diversification limits our upside relative to the best performing asset, it also limits the downside of the worst performing asset. After comparing a diversified portfolio to the S&P 500 for the last six years, that statement doesn’t appear to be worth much, but it is. In fact, a better-diversified, less-risky portfolio may actually generate higher long-term absolute returns than any one asset for the simple reason that it is less likely to trigger costly decisions in the toughest moments. Investors may lament missing out on the highest points, but if their portfolio tracks markets on the downside, they are far more likely to change their allocation or go to cash. A portfolio can withstand moderate returns in a screaming bull market, but can be forever impaired by going to cash in a bear market.
At Miller Russell Associates we constantly focus on building that better-diversified, less-risky portfolio. We recently completed our annual Capital Markets Analysis, where we gather forward-looking expected returns and risk for as many asset classes as possible from as many sources as we can. Our view is that the collective wisdom of the investment industry is greater than our own. The asset classes and estimates are evaluated against our existing portfolios to answer one question: Can our current portfolios be improved? We define improvement as increasing return for the same level of risk, or maintaining the same expected return with less risk. We only make changes if they will meaningfully improve portfolios.
Investments compensate investors for taking risk, and the risk/return relationship is fairly constant. To build and grow long-term wealth, there are really two options: invest all your money in the highest returning asset class each year and be right more than 60% of the time, or invest some of your money in many unrelated asset classes and be right with some and wrong with some, all of the time. The first option has never been successful on a long-term basis, neither when betting in Vegas nor on Wall Street. Decades of evidence have shown that the second option is the most successful way to retain and grow wealth.
In reference to our opening quote, we prefer to proportion our belief to the evidence.