Good Consistently is Great Eventually
If you limit losses, small gains eventually compound into large sums.
An underlying theme of Investment Insights this year has been comparison. This is more happy coincidence than intentionally planned, but nonetheless valuable. Comparison of prior performance, comparison of a forecast, comparison of yourself – each column builds upon the last. While March’s lesson was more theoretical, April’s wisdom is more practical.
A unique attribute of building wealth is that, to have an exceptional long-term outcome, you need not be exceptional at all along the way. Rather, it is more important to simply avoid being terrible. This is rare. There are a few things in life where steady progress yields exponential growth, technological advancement comes to mind, but not many. In professional sports, for example, consistency without greatness gets you a long career, but not into the hall of fame.
This is a consequence of how compounding works. I’ve shared this with clients many times over the years, but never I feel with sufficient clarity. Perhaps the long-form and enduring nature of this format will prove better.
As gains accrue from prior gains, sustained small advances compound into something far greater, if – and this is a big if – you can avoid large and / or permanent losses. Consistency is far more important than periodic greatness. You do not have to own the best performing investment each year (though that doesn’t hurt every now and then). You may never compare well in the short run, but protecting and building wealth is about the long run.
The data prove it. The table below is an asset returns quilt. It appears chaotic, but allow me to explain. Each column is a calendar year. Each colored block within each column represents the performance of the stated asset class during that year, ranked from high to low. For example, in the top left corner, Large Cap Growth stocks had the highest return during 1998, 37%.
Don’t worry about reading each individual word and percentage though. The point is to focus on the movement of the colors up and down from left to right across time. Each color represents a different asset class. If you focus on the colors, rather than the words and numbers, you can follow the ups and downs of each asset class over time, the intended purpose of the table. For example, Large Cap Growth stocks were the best performing asset class during 1997 and the second-worst during 2002.
There is further method to this colorful madness. The various shades of orange represent growth stocks, the various blues value stocks and the two greens cash and bonds. Within both the orange and blue palettes, the darker shades represent large stocks, the standard tone small stocks and the two lightest hues developed and emerging market international stocks.
It is easiest to understand the purpose of the table if all but one asset class is grayed out. Below, only Large Cap Growth remains colored. You can now clearly see the strong performance during the Tech Bubble (1997-1999), followed by more than a decade of weak performance (2000-2010) before a resurgence toward the top of the table beginning in 2013.
International stocks, both developed and emerging, show a similar up and down pattern. For an eight-year stretch, beginning in 2002, international stocks were strong performers. Since then, however, it has been a different story with international stocks largely relegated to the bottom half of the table.
One last example, this time cash and fixed income securities. These two are hit or miss – typically near the bottom of the table, except for during bad equity markets when they rise to the top.
A key learning from this exercise is that no asset class outperforms all others all years. Eight of the ten shown were the best for at least one year and all ten have been within the top two at one point. Yet all ten have also performed below average for multi-year stretches. Trying to own the best-performing asset class every year is perhaps impossible. It is very often counterproductive as well. Asset classes that have performed relatively well and attracted investment tend to perform relatively poorly shortly thereafter and usually to the same extent. This behavior is called performance chasing, a rich topic with many implications best suited to its own column.
Perhaps more important, though, is what we learn by looking at the cumulative performance of each asset class across time. Large capitalization growth stocks, currently on a hot streak, have pulled away somewhat. Knowing we can’t always own the “hot” asset class, how would our illustrative “good, not great” investment strategy fare? What if you could match the performance of the fourth-best asset class each year? Where would your cumulative result fall?
Well, if you compounded the results of an annual fourth-place finish – never great but never bad either – you would end up in first place after 20 years. And not just by a nose either, by a margin of nearly 75%. If you fared a little worse and finished fifth each year you would have ended up third overall, still very respectable despite never being much above average.
With such great potential, why is this approach seemingly so rare? First, though the bar is lower, there is still no guarantee of success. Perhaps better to aim high then. Second, there are psychological challenges. No one likes to “lose” every year and compare poorly to others (we covered this last month). Third, humans do not intuitively understand compounding and tend to underestimate its long-term effects. Fourth, it is a challenging business strategy. “We’ll be fourth best every year” isn’t exactly the best sales pitch.
This is why discipline is important to protecting and building wealth. Can you resist the pressure to change an effective long-term approach when it does poorly in the short term, as it inevitably will? Can you stay resolute when everyone around you is racing ahead? The only comfort is knowing those at the top often don’t stay long and the ensuing fall can be severe.
Success requires combining a risk-first approach – protect, then build – with balance and flexibility. A 50% loss requires a 100% gain just to get back to where you were before. Best then, from a long-term perspective, to position yourself to do relatively okay in just about any environment rather than take the risk of performing catastrophically in one specific environment. If you limit losses, small gains eventually compound into large sums. When it comes to protecting and building wealth, good consistently is great eventually.
Thoughts? I would love to hear them. Email me at investmentinsights@zuckermaninvestmentgroup.com.
Written By Keith R. Schicker, CFA