“Most lack the courage and stamina to stand apart from the herd and tolerate short-term underperformance to reap long-term rewards.” – Seth Klarman
Ask anyone off the street to name a great investor and chances are you’ll hear Warren Buffett—often held up as the paragon of investing success. But what if I told you he spent more time underperforming the market than he did beating it?
According to Eric Crittenden at Longboard Asset Management this is exactly the case. Based on their research, over the last thirty years, Buffett’s Berkshire Hathaway has underperformed the market a little more than half the time.
And it’s not just Buffett’s performance either that frequently lags. Crittenden found this same phenomenon among other successful investors. Here’s Eric as a guest on Meb Faber’s podcast (emphasis mine):
So one of the things I wanted to look at was let’s look at the best performing managers over a long period of time, Berkshire Hathaway, George Soros, Bridgewater, and whatnot. The theory is that they must have done something that other people aren’t comfortable doing. And one of the things that people are very uncomfortable doing is underperforming their benchmark either frequently or for an extended period of time. And what we found was very interesting. When I looked at some of the best track records out there, they underperformed the S&P 500 or 60/40 portfolio most of the time. And Berkshire Hathaway is a glaring example. If you look at Berkshire Hathaway on a daily, weekly, monthly, quarterly, or six-month basis over its entire history, an investor in Berkshire Hathaway would have underperformed the S&P 500 more than half the time. But despite that, an investor in Berkshire Hathaway would have made tremendously more money than an investor in the S&P 500.
We wrote recently about the key to factor investing: a willingness to be different than the market and then being able to stick with your strategy during periods of underperformance. And this is exactly what Longboard found the most successful investors are willing and able to do.
Again, take Buffett as an example. In the late 90’s during the tech bubble he was massively underperforming and being ridiculed as a result. Take a look…
But, instead of abandoning his strategy he stuck with it which paid off handsomely going forward as Berkshire returned 53% compared to a loss of 25% for the S&P 500 over the next three years.
Recent Underperformance Doesn’t Mean Future Underperformance
Any mention of underperformance right now reminds me of the International equity markets versus the US markets. Since 2011, the US equity markets have marched upward while International stocks have gone nowhere.
Right now, US stocks are being viewed as a bullet-proof asset class and have even been referred to as “the safety trade”, given their ascent during a rocky time for the rest of the world’s economies and geopolitical situations. But you need not look far back to discover eras during which the S&P 500 was very far from a safety trade, even relative to European or EM equities.
Because of the strong recent performance for U.S. stocks, the trend gets projected by many as sure to continue indefinitely. It’s easy to forget that markets are cyclical. Today’s winners are tomorrow’s losers.
We don’t have a home country bias in the portfolios we build for clients and obviously this has hurt performance recently relative to a U.S.-only benchmark. But over the long-term, we expect global diversification to work. Japan, for example, became the largest country by market cap by the end of the 80’s with many seeing no end in sight to its fantastic run. However, since then an investment in Japanese stocks hasn’t worked out too well. Here’s the author and BAM Alliance Director of Research Larry Swedroe on the subject (emphasis is mine):
If you doubt the wisdom of global diversification, consider the case of Japan—understand that the same thing could happen here. From 1970 through 1989, Japanese stocks far outperformed U.S. stocks. The MSCI Japan Large Cap Index returned 22.4 percent, 10.9 percentage points a year higher than the return of the S&P 500 Index.
Unfortunately, over the next 25 years, the S&P 500 returned 9.6 percent per year while the MSCI Japanese Large Cap Index fell 0.8 percent a year, an underperformance of 10.4 percentage points per year. In 1989, there was a lot of focus on how the Japanese economy was taking over the world, even gobbling up prime U.S. real estate (like Rockefeller Center and Pebble Beach Golf Course).
But I’m not aware of anyone who predicted what actually happened. And I’m sure it caught Japanese investors by surprise. The bottom line is that failing to diversify globally means inviting a lot of unneeded risk.
Investing internationally to diversify and reduce the concentration risk that comes with making a bet on a solitary market is one thing, but what about outperformance? What about increasing returns? Again, here’s Swedroe on the expected outperformance of international stocks going forward:
How would increasing the allocation to international stocks impact expected returns today? The CAPE 10 for non-U.S. developed nations is currently about 15. That produces an earnings yield of 6.7%. Making the adjustment for the five-year lag produces an expected real return of 7.4%, or 3.2 percentage points more than for U.S. stocks.
Thus, every 10% increase in your allocation to these stocks relative to U.S. stocks would raise the expected return of the portfolio by 0.32%. In a portfolio with 60% equities, a 50% allocation to international developed-market stocks instead of a 0% allocation would increase the portfolio’s expected return by almost 1% (30% x 0.32%). That’s a dramatic improvement.
As we learned by observing the track records of great investors; as we remember with the Tech bubble in late 90’s; and as we see today with International stocks, a period of pain in the form of underperformance is typically required to get any chance at what everyone wants: beating the market. But as Eric Crittenden said in his conversation with Meb, “in practice, very few people are actually willing to do the things necessary in order to achieve that.”
Outperformance isn’t easy to realize because underperformance isn’t easy to sit through. However, the best investors in the world know that being different and therein underperforming frequently is required to earn the chance of outperformance.
Frequent underperformance is painful, but remind yourself the best investors view it as a feature, not a bug of investing. You should too.
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