Better Odds- Blackjack Or Active Management?

When we review prospective client portfolios, it is almost guaranteed some portion of their money is invested in some sort of active management strategy.  As you may know, active management is the strategy of attempting to beat a benchmark.  This could be done through market timing (buying and selling at opportune times) or stock picking (buying winning stocks and selling ones that will underperform).  The alternative strategy is often called passive management, though we like to call it "evidenced based" management.  Essentially, you own the entire market and don't try to time when to buy or sell securities or pick one stock over another.  The "evidence" suggests that this method of investing has a much higher probability of success.

As I was thinking about the idea of probabilities, I thought it might be fun to compare active management to another game that is all about probabilities…blackjack.  First, let's look at the statistics on active management.  Actual results* show us that 17% of stock mutual funds have beaten their benchmark over the last 15 years.  Bond funds fared much worse, with only 7% beating their benchmark during the same period.  If the goal of active management is to beat a benchmark, they are not doing a very good job.

So what about blackjack?  The odds you will win one hand of blackjack (factoring out ties) is 46.36%.  But we are measuring 15 years of whether an active manager can beat the benchmark.  What is the chance you will win money at blackjack if you play 15 hands in a row?  The answer:  17.5%.

Long story short- you have almost identical odds to walk away with more money after 15 hands of blackjack than you do trying to pick an active manager that will beat the market over 15 years.  The odds are much worse trying to pick a bond fund that will beat the market.  We all have heard that as long as you play for a long enough time, the house always wins.  Maybe you should think about who the "House" is when you are investing and shift the odds more in your favor.


*The US Mutual Fund Landscape, 2016 Report

You Are Thinking About Risk All Wrong

Most investors think about risk completely wrong.  They focus on volatility but don't consider their holding period.  As an investment industry  we tend to look at a statistical metric called standard deviation.  That measures how much volatility you can expect with a specific data set.  The problem is that standard deviation is almost always quoted over a one-year period.  But what investor has a holding period of one year?  In reality, most people are investing for 10, 20 or 30 plus years.  What should matter to them is not what volatility their portfolio could experience over one year, but over their entire investing holding period.  Investors only realize losses after they sell.  If they don't have to sell, no losses have actually been realized.  As we have often said, there are really only two days that matter when you invest…the day you buy and the day you sell.  Everything in between is just noise.  As long as that noise doesn't scare you into selling, you can disregard the ups and downs of the market day-to-day, year-to-year.

How can I say this confidently?  I know what the data says.  First, let's look at risk and return statistics of the US Stock Market (CRSP 1-10 Index) from 1926 through September 2015:

  • Average annual return:  12.07%
  • Standard deviation:  21.20%

What that standard deviation statistic tells us is that over 1 year periods we can expect the following probabilities:  

  • 66% of the time we can expect returns to be between 33.27% and -9.13%.  
  • 95% of the time we can expect returns to be between 54.47% and -30.33%
  • 99% of the time we can expect returns to be between 75.67% and -50.53%

No wonder people think stocks can be risky.  Losses can be pretty common and losing a third of your wealth is just something you will probably need to accept at least once or twice in your investing career.  But remember, these are stats over 1 year.  How many of you are selling all your investments within the next year?  Probably not many.  More likely you need your money to last for decades.  So when we look at risk, shouldn't we be looking over your time horizon, not over some arbitrary period like one year?

I re-ran the statistics but instead of 1 year returns, I looked at 20 year returns (annualized):

  • Average annual return:  11.03%
  • Standard deviation:  3.18%

These statistics tell us that over 20 year periods, we can expect the following probabilities:

  • 66% of the time we can expect returns to be between 14.21% and 7.85%.  
  • 95% of the time we can expect returns to be between 17.39% and 4.67%
  • 99% of the time we can expect returns to be between 20.57% and 1.49%

Looking at this data should shift your entire way of thinking about risk.  Stocks really aren't that risky if you can hold them for 20+ years.  In fact, when you look at them over longer time periods, they are even safer than bonds.  For example, Long-Term Government bonds have a standard deviation of 3.51% over rolling 20 years (compared to 3.18% for stocks) and their average 20 year return has been 5.56%, about half that of stocks.

This is why most people should be holding a decent portion of their portfolio in stocks.  As long as they can stomach the year-to-year volatility, their actual risk is quite low when you extend out their holding period. 

*Data take from DFA Returns 2.0 Program

The Risk Of Star Managers

For those of you not following the investment industry closely, one of the highest profile mutual fund managers recently left the firm he co-founded (you could say he was forced out) to start at a new company. Bill Gross, dubbed the "Bond King" ran the PIMCO Total Return Fund, the largest bond fund in the world after disagreements with the Board of Directors at his parent company, a supposed autocratic leadership style, and trailing performance at his fund for the past several years. This is a classic example why we try to avoid "Star Managers". Let me explain our reasoning:

  1. Funds run by star managers are dependent on those managers- if you invest in a fund that has a high profile manager running it, you are really putting all your hopes in that manager being able to continue.  What if he retires?  What if he becomes disabled or dies?  What if he gets caught in some sort of scandalous behavior?  We don't like investment strategies that are dependent on one person or a small group of people.
  2. There is still no evidence star managers are skillful- studies and evidence confirm that past performance (the key metric of a star manager) has no predictive ability on future results.  The data suggests that it is much more likely that star manager performance is attributable to luck.
  3. Star managers typically cost more- because star managers have great track records they tend to charge higher expenses than funds that have no star performer.  For example, Bill Gross's flagship fund, the PIMCO Total Return fund has an expense ratio of 0.46% which is very competitive, but is still nearly 6 times more expensive than the Vanguard Total Bond Market Index Fund, a fund that has no star manager and just attempts to replicate an index.
  4. Star managers will underperform- every star manager will have some period of underperformance.  Bill Gross experienced this the last few years.  As an investor you have to determine whether or not that underperformance warrants a change or not.  There are plenty of managers that have bad performance and stay bad until their fund merges or shuts down.  Conversely, some star managers have small periods of underperformance before reversing course and outperforming again.  As an investor you need to figure out which direction your fund is going and position accordingly.  Unfortunately, there is no data that can help you determine what the right decision is.

Rather than focusing on funds run by "star managers" we prefer to focus on things under our control.  We call it evidenced-based investing:  investment strategies must be rooted in evidence that has been tested and found to be true.  If you take this approach it is very difficult to choose funds that have star managers.

“Simplicity Is The Ultimate Sophistication”

“Simplicity Is The Ultimate Sophistication”- Leonardo da Vinci

The shift towards alternatives like hedge funds and private equity, especially among institutional investors has accelerated in recent years.  After two bear markets in the last 15 years, you have to wonder if even the smartest investors are “buying high” right now; investing in products that are really designed to protect downside at a time when the market has been doing nothing but going higher.  Here is a great chart from the Wall Street Journal on the shifting landscape of investment portfolios:


The increase in alternatives has come at the expense of traditional investments like stocks and bonds, which have done especially well for the past 5 years.  Unfortunately, the retail investor tries to follow much of what these institutional investors do.  The difference is that they do not have access to the types of managers these billion dollar pensions and endowments do.  Believe me, no matter what your broker says, you are not investing alongside Harvard and Yale’s endowment when you buy that hedge fund-of-fund.  We often say at Greenspring that simple trumps complex.  I can think of no better example of complex than where seemingly sophisticated investors are allocating their portfolios.  Do yourself a favor by avoiding these alternatives and keeping things simple.  

And The Winner Is…

We are a quarter of the way through 2014, making it a good time to review what is working and what is not in the investment markets.  The Capital Spectator released this chart of asset class performance through 3/31:


The clear winners for 2014 are REITs and Commodities.  Unfortunately, those asset classes don’t typically account for a huge weighting in an average investor’s portfolio.  Last year people were upset because their portfolios were trailing the US stock market.  But when you are properly diversified you are always going to trail the best performing part of your portfolio (which last year was US stocks).  It’s funny because this year I haven’t had anyone mention that they are upset they are trailing the REIT index.  It all comes back to many of our inherent biases.  We all are exposed to the performance of the US stock market on CNBC every day, making us want to compare ourselves to it.  We are familiar with it.  It is important that investors gain exposure to asset classes like REITs because of the value of diversification.  This has been especially evident in the first quarter of 2014.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.