5 Steps Transform Long Term Investment Returns

Step 1: Dalbar 2017 Report: Understand why “investors suck at investing”.

Step 2: Appreciate the benefit of consistently positive low volatility returns.

Step 3: Understand repeatability of returns and use a better investment metric: RVAR (Repeatable Volatility Adjusted Returns)

Step 4: Risk assessment. General market long term risk could be as high as it’s ever been.

Step 5: Putting it all together for long term success and peace of mind.

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Step 1: Dalbar 2017 Report: Understand Why “Investors Suck At Investing”.

https://www.advisorperspectives.com/commentaries/2017/09/25/dalbar-2017-investors-suck-at-investing-tips-for-advisors

Dalbar has been studying investor results and behavior for many decades and their annual review of investment results is always insightful. The constant themes are that, in general, investors consistently underperform benchmark indexes, and by a wide margin. There are many potential causes for this as is well described in the link above.

“The biggest of these problems for individuals is the “herding effect” and “loss aversion.”

These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of “holdouts” finally “buys in” as the financial markets evolve into a “euphoric state.”

As the markets decline, there is a slow realization that “this decline” is something more than a “buy the dip” opportunity. As losses mount, the anxiety of loss begins to mount until individuals seek to “avert further loss” by selling.

As shown in the chart below, this behavioral trend runs counter-intuitive to the “buy low/sell high”investment rule.

In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision-making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

More importantly, while there are many articles chiding investors into “buy and hold,” and “passive indexing” strategies, the reality is that few will ever survive the downturns in order to see the benefits.”

For Investors to do better than this they need to take on board all these problems and find a better long term durable solution. One of the key messages from the lessons learnt above is that most investors don’t know how to respond well to major swings in the market either way. Emotions take over at often the worst possible time.

Investors make similar mistakes when they choose an investment manager. Just looking at a few years of investment returns to review an investment manager or “the market” leads to a similarly poor assessment. While it is easy to understand why investors are so focused on return, as it is usually accessible and represents the goal of the investor, it is a very dangerous sole metric as discussed above.

I believe that other metrics are far more important. For example, just a little analysis reveals the misunderstood and significant benefit of consistently positive low volatility returns.

Step 2: Appreciate the benefit of consistently positive low volatility returns.

The next step is to begin to appreciate the significant benefit of low volatility returns, both for downside protection AND also for upside long term compounded returns.

Without the emotional swings that result from high volatility returns investors are:

1.     Better placed to avoid poor decision making.

2.     Have much less chance of finding themselves experiencing significant capital impairment.

3.     Start to appreciate the significant benefit of consistent compounding of their long-term wealth. Stable returns compound at a faster rate of return as shown below.

The best way to explain why this is with an example.

Why volatility of returns is so important

Here are 3 different sets of returns produced by 3 different asset managers.

These results show the significant benefit to investor’s long-term wealth of finding a manger with consistent positive returns even if these returns are all in single digits. Manager A at first glance seems very uninspiring and does not give the impression that this would be the way forward for an investor to accumulate long term wealth.

This impression could be entirely wrong!

Manager B and especially Manager C may have much more exciting returns, or so it may seem, and at first glance just viewing the last 3 years of returns might suggest they may be better managers of your wealth even though they both lost money in year 4.

A 5-year analysis, however, suggests that in this case, that conclusion would be very wrong! Manager A outperformed both Manager B and Manager C, while also preserving the wealth of the investor much better. In fact, Manager A managed to both lower the investor’s risk AND produce a higher return over 5 years.

This 5-year compounded return shows the following conclusions can be made:

1.     One big loss in any year can be devastating for an investor’s long-term return. Even with the 38% return in year 5, Manager C still only had a 5-year return of around 1% over the whole period.

2.     Consistency of return through any investment conditions compounds at a faster rate of return.

Step 3: Understand repeatability of returns and use a better investment metric: RVAR (Repeatable Volatility Adjusted Returns)

While a track record is always revealing, it is also important to consider the extent to which past returns are likely to be repeated in the future. Indeed, if there is a metric to use to assess an investment manager, the most useful metric is RVAR. This metric combines the benefits of a return metric that takes on board the volatility of returns with consistency and adds in repeatability.

The Repeatability assessment flows naturally from a good understanding of how the investment manager made his returns in the past. These questions lead to additional useful assessments:

How much of the past returns were attributable to the manager and how much to investment conditions?

How would the manager do if the market changed its behavior?

Does the manager run investment models, and how rigidly does he follow them?

How diverse are the manager’s approaches or models?

How effective are they at adapting and risk managing in different circumstances?

For example, the chart below shows a track record of more than 40 years for a simple model. This kind of insight can change the degree of confidence an investor could have with the repeatability of a strategy or model given the simplicity of the model, and the longevity of the testing period.

Three asset classes: Stocks, bonds, gold.

A simple example shows the benefit of Active Asset Management

http://chrisbelchamber.com/investment-management-why-you-need-a-complete-rethink-part-4-active-asset-management-further-steps-to-rvar-improvement/

Step 4: Risk assessment. General market long term risk could be as high as it’s ever been.

The next assessment is how important is risk management in the current environment. This refers to general market risk, not the suitability risk level specific to the individual investor. Both are important but everyone is subject to general market risk.

Asset values are the highest in history relative to Disposable personal income

Mean reversion risk is the highest in history.

http://chrisbelchamber.com/fed-fixes-failing-risk-misunderstood-message-to-passive-investors/

US fiscal policy is unsustainable, according to the IMF

Unusually, the IMF has recently published and discussed the exceptional and unsustainable nature of US fiscal policy.

http://chrisbelchamber.com/imf-warns-on-us-policy-markets-depend-on-us-not-fixing-it/

The US economy has never before demonstrated this degree of long term underperformance

 

 These observations show that despite very poor long term underlying economic results, the stock market is on many measures as highly valued as it has ever been. This is a combination that most investors should realize is a high-risk situation for long term investing.

This is a very important time to reassess whether your mindset and investment criteria are correctly chosen.

Step 5: Putting it all together for long term success and peace of mind.

Putting it all together for a full assessment of an investment manager takes far more steps than most people realize. Much of so called “common wisdom” is, in fact, dangerously misleading, so it is important that investors understand this and create their own approach with more effective guidelines.

Most investor’s returns have been very poor over the long-term, as shown in the Dalbar reports. So, it is clear that investors need a better check list for improving their long-term returns.

It is all too easy to fall into the trap of just looking for big past returns over a few years to show ability to make money for the investor. As discussed above this is actually a highly dangerous approach.

It is much more important to make sure that there are no big losses even once in any year, AND the least possible risk of any big loss in the future. High past returns can sometimes just reflect high risk rather than investment ability.

Then consistency is the next most important factor as stable returns actually compound faster, and typically represent lower risk too.

It is also key to review how effective the Manager’s risk management system or approach is likely to be in any environment into the future. The track record, and the longer the better, can help show performance through different conditions. With a fuller understanding of the manager’s approach, it should also be possible to assess robustness and likely future success.

Only once these conditions have been satisfied and understood should an investor look at any single metric. The best way to describe this overall approach, or metric, is RVAR (Repeatable Volatility Adjusted Returns). Most professional investors should at least be able to show you volatility adjusted returns, if not that could be a red flag.

Markets have shown huge cycles over recent decades, being able to navigate smoothly through these periods is essential for achieving high long-term returns. A skilled investor should be able to manage through many different market circumstances. Up and down markets, cycles in different asset classes, high and low periods of volatility.  

Lastly, investors should be able to view their accounts and performance in detail and in real time and be updated with strategic views as markets develop. This enables an investor to monitor what their manager is doing and thinking. Ongoing transparency enables an investor to continuously check that their manager is staying on track with all the assessments above.

Investors who approach their investments in this way, will likely have the stability and consistency to be able to make better financial decisions and a transformed financial platform for their lives.

 

 

 

 

 

 

 

 

 

 

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