What to do When an Investment Strategy Performs Poorly

“Diversification for investors, like celibacy for teenagers, is a concept both easy to understand and hard to practice.” – James Gipson

Over the almost 25 years that I have been an investment advisor, I’ve learned that one of the greatest problems preventing investors from achieving their financial goals is that, when it comes to judging the performance of an investment strategy, they believe that three years is a long time, five years is a very long time and 10 years is an eternity. Even supposedly more sophisticated institutional investors, those who employ highly paid consultants, typically hire and fire managers based on the last three years’ performance. As Michael Mauboussin, director of research at BlueMountain Capital Management, noted, this tendency “causes investors to often make the critical mistake of assuming that good outcomes are the result of good process and bad outcomes imply a bad process.”

On the other hand, financial economists know that when it comes to investment returns, 10 years is nothing more than “noise,” a random outcome.

To demonstrate that point, the following table shows the persistence of performance of various equity factors (long-short portfolios) as well as the performance of naïve (equal-weighted) portfolios of factors. P1 is an equal weighting of the first four factors. P2 is an equal weighting of the first five. And P3 substitutes quality for profitability. The table has been updated to cover the period from 1927 through 2017 and shows the odds of a negative premium. The odds are based on gross returns before implementation costs. Live funds, even low cost, passively managed ones, have some costs. In addition, if future factor premiums are lower than historical, the odds of underperformance will increase. Of course, this is also true of market beta. As valuations are now higher than the historical average, expected returns are now lower. Note that R. David McLean and Jeffrey Pontiff, authors of the 2016 study Does Academic Research Destroy Stock Return Predictability?, re-examined 97 factors and found that, following publication, the average factor’s return decays by about 32%.

Data for market (beta), size, value, momentum and profitability is based on annual premiums from the Ken French Data Library. Quality is based on monthly data from AQR and compounded to approximate an annual premium. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio, nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. Using the historical mean and standard deviation, we calculate the likelihood the factor will be negative if the distribution is normal (e.g., percentage of times the premium will be 0 or less). *1964–2017 and **1958–2017 time frames are used for P2 and P3 respectively due to availability of data.

Observe three important things. In each case, the longer the horizon, the lower the odds of underperformance. No matter how long the horizon, each of the individual factors experienced some periods of underperformance, even at horizons of 20 years. The sole exception is momentum at 20 years. However, this certainly doesn’t guarantee future success for momentum at 20-year horizons. Even at 10-year horizons, riskless one-month Treasury bills outperformed highly risky stocks 9% of the time. And even at 20-year horizons, they did so 3% of the time.