From 1926 through August of this year the S&P 500 has generated an annualized return of 10%. During that same period one-month Treasury bills, believed by many to represent the risk-free rate of return, have generated 3.43% annually, This outperformance of stocks, of 6.57% annually is otherwise known as the equity risk premium. It is the added return you achieve for accepting the risk of the equity markets. To put this number in better context, it is usually more helpful to think about it in dollar terms. If you had invested $1 in each of these asset classes in 1926, here is your ending wealth as of September 1st 2015:
- Stocks- $5,159
- Bonds- $21
Inflation alone has caused a dollar in 1926 to be worth $13 today, so T-bills are a great investment to keep pace with inflation, but stocks have been where the real growth comes from. Before you go and put all of your investment assets in stocks, there is one thing that you have to remember about the equity risk premium: You have to earn it.
There are no free lunches in this world and investing is no different. In order to achieve outsized returns like we have seen in the past you have to be willing to accept catastrophic losses in the short and intermediate term. The Great Depression, Black Monday in 1987, the technology bust of 2000 and the financial crisis in 2008 are just some of the horrific periods you would have had to live through to achieve the equity risk premium. We pay for this premium with self-doubt, sleepless nights, and the feeling that you are the only fool riding this thing out.
Why do we bring this up now? We are in another one of those periods that makes you question whether you should be in equities (or at least at the level you are at now). What if China blows up, what happens when the Fed ends this unprecedented zero interest rate policy, what if oil prices continue to collapse, what if ISIS continues to grow in strength, what will happen if The Donald wins the presidency? No one knows the answer to these questions. Even more, no one knows how the market will react if any of these actually come to fruition. That is why you have to earn this equity risk premium. It takes courage, perspective and wisdom to stick with a strategy or investment when it is underperforming. Hopefully, as the data has shown, the prize is well worth the effort.
In an earlier post we discussed how basic math confirms that an average active manager ALWAYS underperforms it's passive counterpart. They key word in that statement is average. Quite a few managers will outperform their passive brethren each year even though the average manager will underperform. I promised to revisit this in a future blog post to discuss whether or not we could determine if the outperforming managers were skillful or just plain lucky.
I find it interesting that consultants and advisors in our industry tend to talk about the skill of a manager after a period of outperformance. After several years of outperformance, consultants begin to conclude that this manager is not merely lucky, but skillful. In the institutional world it is pretty common for consultants to want a 3 year track record before they would consider recommending an investment to a client. But how long does a manager need to exhibit outperformance before we are sure they are actually skillful, rather than just lucky? It is a very important question since random chance tells us that a fairly high number of managers will outperform.
In a paper written by Brad Stein, called "The Paradox of Skill" he identifies how long of a period you would need to see outperformance of a manager before you could conclude they were skillful (and not just lucky):
Alpha is a measurement of outperformance over a benchmark. The t-stat tells us the statistical significance. So, if you have a manager that has outperformance (alpha) of 1% per year and the volatility of that outperformance is minor (4% standard deviation), it would take 64 years before you could be sure that manager was skillful! The more likely scenario is the manager that has outperformance over long periods of time, but that outperformance is very lumpy (some periods they significantly underperform and others they outperform). A good example of that would be a manager with 3% alpha (which is a huge annual outperformance) and 8% standard deviation. You would need to see this type of outperformance for 28 years before you could be confident that you had a skillful manager.
As you can see, consultants and advisors in our industry really don't understand statistics. Recommending an investment strategy after it has had 5 or 10 years of success is paramount to saying a coin flipper is going to flip heads a fifth time because the first four were heads. Random chance (luck) tells us that managers can and will outperform. What this research also tells us is that it takes an extremely long time to be sure that outperformance is actually due to skill versus just getting lucky.
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.