Managing great expectations

I think, write and talk great deal about the value of investors staying focused on the long-term, and rightfully so.  It’s easy to get caught up in the noise of the short-term and lose sight of what we’re trying to do: build and maintain real wealth over time. But it is equally important for us to recognize that “long term” doesn’t mean “all the time.”

To begin, I’m going to borrow from a recent piece from Ben Carlson at A Wealth of Common Sense titled “The Small Cap Value Cycle.” In it, Ben dives into the outperformance of small cap value strategies over time.

The academic research on the small cap value premium is fairly well-known in investment circles at this point. The theory is that the riskier smaller companies which trade at lower valuations will tend to outperform the broader market over the long-term.

The evidence of the small cap value premium is clear looking back at historical returns, but it’s not always easy to earn those returns. This is the whole point of a risk premium. Riskier stocks should reward investors with higher performance over time, but it comes at the cost of long periods of lagging returns.

Here’s the annual return data in five year increments going back to 1979:

What we see is that over the long term small cap value strategies do outperform a broad cap-weighted index but it doesn’t always work that way. In fact, you can find yourself in a relatively long period of time (say, 15+ years) where the small/value risk premium is negative

This isn’t just about the research and facts behind the small/value risk premium.  This is about nearly all of our “over the long term” rules not meaning “always.” As examples:

Over the Long Term…”

…but not “always.”

Stocks outperform bonds..

Unless a 30-year bond bull market and a nasty stock bear market end at the same time (e.g. 2008-09)

Small cap value outperforms…

Except for frequent periods when the risk premium is negative (e.g. 1996-2000)

Global diversification adds value…

Except when it drags on performance (e.g. 2009-2013)

Expensive markets mean revert…

Except in periods of extended euphoria (e.g. 1999)

Housing is a reasonable investment…

Unless you bought before a global financial crisis (e.g. 2007)

Stocks deliver the best returns after inflation…

Unless we’re in a high-inflation recessionary period (e.g. 1973-74)

This isn’t to say we should go and throw away things we know to be true over the long term.  But the world is a complex place and how each generation of investors experiences these long term truths may be very different. This is simply a reminder that in some periods, we may have a different experience than these long-term facts. There may not be a lot we can do about it – most of us should not be predicting when and if these long term facts will be true next year or for the next five years.

Most importantly we should be aware that “over the long term” doesn’t mean “always” in advance so that we aren’t surprised when we experience the opposite result of our long-term beliefs. Knowing that we will go through these periods will help us to not give up the ship when our long-term strategy “isn’t working.” If we want to earn the higher returns that come with owning stocks, we are going to have to hold a long-term perspective, even when it seems foolish.

Categories: Finance