“The market is very, very risky, riskier than the standard models say.”
Benoit Mandelbrot, World Renowned Mathematician, 2004
“Whereas Treasury bills are guaranteed by the federal government, and are essentially risk free, investments in stocks are risky. Although the average rate of return has been 10 percent, there have been years when stocks have fallen by more than 30 percent.”
Richard Thaler, Professor of Behavioral Finance, University of Chicago
Author of Bestselling Book Nudge
“Vindicating Mandelbrot, my thesis shows (in nauseating detail) that distributions of stock returns are fat-tailed: there are far more outliers than would be expected from normal distributions – a fact reconfirmed in subsequent market episodes, including the most recent. Given the accusations of ignorance on this score recently thrown our way in the popular media, it is worth emphasizing that academics in finance have been aware of the fat tails phenomenon in asset returns for about 50 years.”
Eugene Fama, The 2013 Nobel Prize Winner Economics, 2010
Although the fourth quarter was not bad, full year returns were challenging, especially internationally and in emerging markets. Below are the indices I follow.
| Indices (USD) | 3 Months | 1 Year | 3 Years | 5 Years | 10 Years |
| S&P 500 | 7.04 | 1.38 | 15.13 | 12.57 | 7.31 |
| Russell 2000 | 3.59 | -4.41 | 11.65 | 9.19 | 6.80 |
| Russell 2000 Value | 2.88 | -7.47 | 9.06 | 7.67 | 5.57 |
| MSCI World ex USA (net div.) | 3.91 | -3.04 | 3.93 | 2.79 | 2.92 |
| MSCI World ex USA Small Cap (net div.) | 5.82 | 5.46 | 7.82 | 4.39 | 4.09 |
| MSCI Emerging Markets (net div.) | 0.66 | -14.92 | -6.76 | -4.81 | 3.61 |
| Barclays Treasury Bond 1-5 Years | -0.67 | 0.92 | 0.65 | 1.24 | 3.04 |
| BofA Merrill Lynch 1-Year US Treasury Note | -0.17 | 0.15 | 0.20 | 0.28 | 1.78 |
Value stocks underperformed in both the US, international and emerging markets. Small caps outperformed large caps internationally and in emerging markets, but underperformed large caps in the United States.
As the New Year has gotten off to a bad start in equity markets around the world, it is always important to remind investors what we are trying to achieve for the long-term, and to also remind them how much variability there is in stock returns in shorter time periods. I will use more slides than words to show this, so it will probably be easier to view this on your computer or iPad. As Mandelbrot reminds us above, markets are “very, very risky.” It is something we should never forget.
First, based upon academic research over the past sixty years, we try to target “dimensions” of expected return that have been shown to be positive over longer periods of time – greater than 10 years.
Below are the expected returns we target.
To pursue those expected returns, they have to be:
- Sensible from an economic theory standpoint
- Persistent across time periods
- Pervasive across different markets (US, International, Emerging)
- Statistically robust (A 95-99% confidence level based on standard statistical measures)
- Cost effective to capture in well-diversified portfolios
Below is likely the busiest chart of this newsletter. This shows the size, value and profitability premiums over time in the US, International and Emerging markets.
These premiums are volatile in shorter time periods, such as 1 and 5 year periods. They can be negative AND they can underperform the alternative asset classes (large, growth and less profitable) from time to time. Sometimes, these yearly observations of premiums can experience extreme and prolonged negative relative performance. However, positive premiums have occurred more frequently than negative premiums across all dimensions/factors. As a consequence, investors should take a longer-term view when targeting dimensions of higher expected returns and be prepared to stay disciplined throughout different market environments.
As an example, the following chart shows the US stock market premium over US treasury bills since 1928. As you can see, the average US stock market premium has been 8.15% through 2014. However, there are only 5 years since 1928 where the premium was within 2% of that number. The US market premium has varied widely while experiencing extreme positive or negative performance swings relative to T-bills. However, the annual average has been positive more often than negative, and on average the US market premium has also experienced a stronger upside than downside.
The same type of story also occurs for small, value and profitability.
As an investor lengthens his or her horizon, the number of negative performances of the premiums becomes less, as indicated by the following charts of the market, small, value and profitability premiums over 10 year periods.
The final slide shows the frequency of positive equity premiums over 1, 5, 10 and 15 year rolling periods in the US market. The message is pretty clear. To increase the probability of capturing the premiums, the investor has to stay invested in the plan for a considerable period of time. This is the real difficulty in investing, as emotions are very hard to keep in check for the period of time an investor has to remain patient and disciplined in a highly volatile marketplace.
As Gene Fama said in 2008:
“If the current high volatility makes you permanently averse to stock market volatility, and the inevitable variation in market volatility, you should get out. But you shouldn’t have been in the stock market in the first place since fluctuations in volatility are the norm. If you eventually want to come back into the market, then you shouldn’t leave. Bouncing in and out of the market is risky if your desired long-term asset allocation involves exposure to the market.”
That message is as true today as it was in 2008.
As a final point, depending upon client risk tolerances, we use short term high quality bonds to temper the volatility and risk of the portfolio. This asset class helps during times such as these. Although I use a few others, below are the funds used most often and their total returns for 2015.
| Total Return % (12/31/2015) Morningstar | 1-Year |
| VFIRX | 0.55 |
| DFGFX | 0.33 |
| VMLUX | 1.41 |
| VWSUX | 0.53 |
Although the equity markets have been bad for the first 2 weeks, here are the returns this year for the short term bond funds as of the close of business on Thursday, January 14, 2016.
| Total Return % (01/14/2016) Morningstar | YTD |
| VFIRX | 0.40 |
| DFGFX | 0.20 |
| VMLUX | 0.41 |
| VWSUX | 0.15 |
I know it is unpleasant, but please hang in there. Successful investing requires patience and discipline. As you can see, the bond funds are doing their job in these difficult equity markets, providing a bit of return, but more importantly, stability in this equity downturn.
Until next time,
Mike