For a variety of reasons, long-term individual and institutional returns indicate a failure to capture risk premium over time. We believe this is a major contributor to the individual retirement and pension fund funding crises.
High Probability Investing
Are you just another gambler or are you the house? What’s the difference and why does it matter? The casino owner and a good gambler understand that when the odds are in your favor, you want to play the game as long as possible. This will maximize the likelihood of your experience being close to the odds of the game. If the odds are against you, on the other hand, you maximize your likelihood of winning by playing the game as few times as possible. This is because you know that the longer you play the game the closer your experience will be to the odds of the game.
Owning a cap-weighted US equity portfolio has been a high probability investment for a long time. A popular chart showing annual returns dating back to 1926 illustrates that:
1) 74% of the years produce positive returns.
2) The annualized return has been about 10%, or about 7% over inflation.
What characteristics lead to this high probability outcome?
1) Investors own the most valuable publicly tradeable businesses in the US economy.
2) They own them in proportion to their market values.
3) Their sources of return come entirely from these businesses providing goods and services to their customers.
4) As customer preferences change, as technology changes, as these drivers of economic activity change across and within industries, the portfolio automatically adjusts.
5) Investors count on market prices to reflect all publicly available information.
6) Investors count on active managers being rewarded to do analysis to keep prices in line with that analysis – to keep the market efficient.
Owning a cap-weighted US equity portfolio is like playing a game where the odds are in your favor. You are the “house” and should want to play this game as long as possible, because you know that the longer you play the more likely that your experience will look like the long term experience.
Fooled By The Path
When investor experience does not look like the long-term, they believe the game has changed, and is no longer the high probability long-term game. In the history since 1926, there have been three distinct periods of 10 years when the annual returns have been zero. Following these periods investors believe that they are no longer being paid to be owners of these companies, that there is no return for taking the risk. There have also been two distinct periods of 10 years when the returns have been 20% per year. Following those times, investors believe that the market is a 20%/year sure thing. The truth is that the market’s underlying long term distribution has not changed, that neither extreme is the “new normal”, and that their experience is part of the path that does not look like the total path.