Do you know anyone who has ever cashed a winning ticket for a six-way parlay on Pro-Line? Back in 1993, my final year of undergrad, Pro-Line sports betting had just launched and my pal Buck had a six-way bet on some NHL games late in the season. The first five had come in, including some big underdog wins and ties, and his $5 bet was going to pay out roughly $800 if the last game went his way. It was the expansion Ottawa Senators on the road against a strong New York Islanders squad, and Buck had the Islanders to win. Ottawa had not won a road game all year, and were something like 0-38 at the time. This was a lock.
Sports fans know how this ends. Ottawa would win their only road game of the year to finish 1-41-0, which is still the worst away record in NHL history. Back then, $800 was a ton of cash for a struggling student and Buck was devastated. For comparison, imagine a day at the racetrack and an 11-race parlay with ten horses in each race. You’d need to pick each winner to cash your bet for a huge prize! This would be analogous to an investment strategy which tries to pick the best investment in the field year after year. Not the best strategy. So how’s a young Buck to beat the investment odds?
Investing vs. speculating
Betting on sporting matches or hot stocks is not investing – it’s speculating. Professional wealth management involves using a mix of asset classes to create a diversified portfolio designed to deliver the client’s desired/required rate of return, with an acceptable level of volatility. The three main asset class categories are equities (stocks), fixed income (bonds) and cash (T-bills/money market). Within these broad categories are various distinct asset classes (i.e., Emerging Markets, U.S. Large Cap, High Yield Bonds, REITs, etc). Most professionally-managed portfolios contain five to 12 of these asset classes, in varying weights.
Markets are rational in the long term
The long-term annualized returns for each asset class are fairly consistent over time, and thus predictable for building expected returns into portfolios. Returns are easily measured, and volatility (aka ‘risk’) is measured by the standard deviation of those returns. Figure 1 shows a positive relationship between return and risk/volatility. However, this relationship is not linear: each additional unit of volatility brings a smaller amount of incremental return.
Figure 1: The Security Market Line
Well-built portfolios blend certain amounts of each asset class together to achieve a desired level of return, while incurring the least amount of volatility possible – giving you a bigger bang for your buck, so to speak. This works because the returns of various asset classes have different correlations to each other (i.e., they are not always moving in the same direction at the same time). This is at the heart of portfolio management, and is known as ‘portfolio diversification’.
Markets are random in the short-term
While long-term asset class returns are consistent with their respective volatilities, over shorter periods they are anything but consistent or predictable. Figure 2 shows the year-by-year returns for nine major asset classes (and one blended portfolio) over an 11-year period from 2009-19. Each year shows the annual return for every asset class, ranked from best to worst.
Figure 2: Annual Returns % (2009-2019)
Source: FactSet, as of 12/31/19.
Six of these nine asset classes took turns being the market leader, five shared the bottom rung and three did both. Anyone managing an investment strategy based on anticipating which asset class was about to deliver returns well above historical averages would have had absolutely no chance of success. It would be pure guesswork. As the saying goes, hope is not a strategy.
Patient investors are always rewarded
On the other hand, the annualized returns for each asset class over this 11-year period generally followed the pattern you would expect based on their volatility. Rational investors demand higher returns to compensate them for accepting higher volatility. The top three asset classes were U.S. Large Cap stocks (14.6%), U.S. REITs (13.3%) and U.S. Small Cap stocks (13.1%). The U.S. Aggregate Bond index was second last at 4%, while Commodities were dead last with an awful -2.8%.
There was a significant gap between U.S. stocks (12-14%) over non-U.S. stocks (7.5-9%), as it was a particularly strong decade for the U.S. Tech sector. However, inside similar groupings of asset classes, there was a rational order. Emerging Markets (9%) outperformed International stocks (7.7%); and U.S. High Yield bonds (11.8%) significantly outperformed the U.S. Aggregate bond index (4%). The general risk/return relationship remained intact.
Worth noting, the Global 60/40 Balanced portfolio (60% stocks/40% bonds) delivered decent returns (8.75% annualized), never better than 4th or worse than 8th in any given year. Most personal financial plans are quite successful with long-term returns over 8%. As well, it only had three losing years over that stretch, with only one of those below -2%. This would provide valuable stability versus a plan that rotated all the capital from one asset class to another each year, chasing the highest potential returns.
If you were unlucky and ended up in the worst asset class, you lost money seven of 11 years. The best year was +6.6% and in the worst you watched your capital decline by a third (-32.5%) in the ‘safe’ MLP/Utility sector.
Impatient investors eventually get punished
Fear of Missing Out (FOMO) is powerful. Human beings have a natural desire to strive for high returns, and it’s common to see money flowing into asset classes that have recently had very strong returns. Five of the last 11 years saw at least one asset class return 30% or more. Even in the worst years, the top asset class was always in positive territory.
Investors generally hate losing money even more than they like making it. There is a strong incentive for investors to rotate their capital around the investment universe, chasing high returns and avoiding losses. However, this is the classic mug’s game. Over the past 11 years, a strategy that invested all capital in the previous year’s top performing asset class would have returned an underwhelming 5.2% per year. Only U.S. Bonds and Commodities were worse.
As the evidence clearly shows, it is impossible to predict which asset class will be next year’s biggest winner. Recall my friend Buck and his six-way hockey bet. He came close to glory but got nothing in the end. This is not investing – it’s speculating.
Long-term returns are all that really matter
Retrospectively speaking, we can see that the best bet for investors would have been to stick with a professionally managed, balanced and diversified asset allocation strategy. No one can pick the winning horse in every race, and in this case, chasing ‘last year’s winner’ over the past 11 years would have turned $1.0MM into just $1.49MM. Whereas sticking with the Global Balanced 60/40* portfolio would have turned that same $1.0MM into $2.5MM – a difference of more than a million dollars (the entire beginning stake).
After 11 long years in the market, years you will never get back….which would you rather have?
*Global 60/40 is comprised of 60% MSCI ACWI and 40% Bloomberg Barclays Global Aggregate Bond Index.