October 15, 2018
Excerpted from a letter sent to clients on October 15, 2018
As we’ve emphasized over the years, our global, value-based investment approach demands a multi-year timeframe. We often cite 7-10 years as the appropriate period to think about when planning or assessing returns. Such a strategy requires patience, and there are a couple of main risks that can challenge one’s ability to stay the course.
1 – Volatility Risk
This describes how much an account’s value changes over shorter periods. If volatility is too high for comfort, one might abandon the long-term approach due to a short-term market decline. We know that there will be inevitable and sizable swings in the markets. But by placing our clients into portfolios designed to experience a personally acceptable range of volatility risk, we’ve done our best to minimize the chance that our clients will experience an intolerable swing. This is something that we’ve been careful to address and are happy to re-address with you anytime.
2 – Risk of “Tracking Difference”
Another and much less discussed risk that has been noticeable lately is what we’re going to call “Tracking Difference” — the potential difference in returns between your portfolio and the US stock market.
The US media mainly focuses on the domestic stock market, so that’s what most US investors tend to be most aware of. The returns of the bond markets and international stock markets are often just an afterthought, if that. This is kind of strange, as the GDP of the rest of the world is twice the size of the US, and the international stock and global bond markets together are many times the size of the US stock market. But that’s the way it is.
The result is that if a US-based investor’s portfolio returns track too differently from the US markets, it can come as a surprise. That can lead to a lack of confidence and even the abandonment of a long-term approach.
Why put up with Tracking Difference?
We know that our strategy of focusing on the most reasonably priced areas of world markets can lead to divergences with the US markets. This can be uncomfortable, but we also think it’s worth it because we believe it’s the most prudent approach, and that it gives us the highest probability of better returns over time.
There’s a highly regarded institutional investment firm called Research Affiliates that forecasts future returns for many investments, using starting valuation as a major input. This methodology has historically been very predictive of future returns (more on that below). Here’s a chart showing their forecasts for several major asset classes over the next 10 years:
These forecasts suggest that the international stock markets are priced for much better returns than the US stock market from these levels. In fact, US stocks — the thing the media is always talking about — have the worst prospective returns of the bunch. This shows why we think it makes sense to branch out from these investments, even if it results in the discomfort of Tracking Difference.
We put a lot of weight in this forecasting approach because it makes sense and because it’s had historically strong predictive results. This is shown in the chart below, which matches multiple decades’ worth of forecasted returns to actual returns:
To explain: every 10-year forecast generated by this methodology was put into one of the categories listed along the bottom, which show a range of expected returns. For example, if the forecasted return for a given investment was 7% per year, that forecast would go into the “6% to 8%” expected return category. The numbers in the blue bars show what the median 10 year return actually ended up being for all the investments in that forecast range. So, for instance, out of all the investments that had a forecasted annual return of between 6% and 8%, the median actual return was 7.4% over the following 10 years.
It’s clear that this forecasting approach has been very predictive of typical outcomes. Looking at those blue bars, investments with higher forecasted returns tended strongly to go on to generate higher actual returns over the following decade, and vice-versa. There was an especially good relationship with the worst-case outcomes, shown by the gray circles, which were a lot worse for low-forecast investments than for high-forecast ones. (We have often written that overpriced investments are riskier over the long run than underpriced ones — the gray circles seem to strongly support that idea).
Interestingly, there was almost no relationship between the forecasts and the best-case outcome, shown by the orange diamonds. This goes to show that sometimes, buying expensive investments with poor forecasts has worked out very well. But it’s been far more typical for returns to be mediocre or worse.
We can’t know what exactly lies ahead for today’s investments, but its reasonable to assume that it it’s more likely to be the historically common outcome. The investment world is one of probabilities, and by using value-based forecasts like this, we are doing our best to put the odds in our favor.
When tracking difference hurts
The long-term projected returns for international markets may look relatively compelling, but they will go through periods of underperformance along the way. And it isn’t easy in real life to stick with a plan when things aren’t going one’s way.
We’ve been experiencing that recently. For most of the last few years, we saw most world markets move in the same direction, with international (particularly emerging) markets being the best performers. So, that all seemed just fine. But since May of this year, we’ve experienced an extreme divergence between the US and the rest of the world. To illustrate the point, here’s a chart of the markets since the beginning of 2017 through today. International stocks are in green, US stocks are in blue, and the other two lines are the bond markets (which are shown because they have contributed to the divergence with the US stock market for those with more moderate or conservative growth goals).
Up through early May of this year, international stocks looked like the place to be, but zooming in on the last 5 months, you can see why they say that past performance isn’t a predictor of future returns. Since then, the international markets have declined while the US has risen. Here’s how it looks just for this year:
This kind of divergence with the often talked about US market — the Tracking Difference — can be frustrating and uncomfortable for many investors.
Just as clients have different tolerances for volatility, we have found that they have different tolerances for Tracking Difference. Our goal is for our clients to be in a position to benefit from our global value approach if they would like to, but at the same time, to minimize the odds of diverging from the US markets by more than they can tolerate.
Knowing that the value-based projected future returns are lower for portfolios that will track more closely with US stock markets, and knowing that, on average, the value-based projections have been very predictive over time, the dilemma is in determining how much Tracking Difference to take on.
We want to help our clients take on the amount of Tracking Difference that is right for them, but this is not something that is a common practice to measure. We’ve found very little writing on this issue, and even after extensive research, we have not found a single quiz designed to measure investors’ tolerance for divergence from a typical US based portfolio or a particular market like the US. Every risk quiz we’ve seen relates to the other previously mentioned risk – that of volatility/loss. But we view Tracking Difference tolerance as an important issue, and it’s something we want to review during our next meeting or call.