- You cannot evaluate
an investment decision based on its outcome. Take a second to let that sink in. If you buy an individual
stock and double your money, you still made a bad decision. You had a good outcome, but you made a bad decision. Future stock returns are uncertain. When we are dealing with uncertainty, a good decision might
lead to a bad outcome and a bad decision might
lead to a good outcome. Looking past outcomes to
evaluate investment decisions is not easy for a human to grasp. We tend to have an
illusion of control bias where we overestimate our
influence on outcomes. This can be particularly dangerous when it comes to investing. I'm Ben Felix, portfolio
manager at PWL Capital. In this episode of Common Sense Investing, I'm going to tell you how to evaluate your investment decisions. (upbeat music) There is always going to be
an element of uncertainty that defines the ultimate
outcome of any investment. That is something that we cannot control. We can control the quality
of our investment decisions. If we can recognize the difference between a bad decision and a bad outcome, we may be better equipped to stick with a sensible long-term
investing strategy even when it is not
producing a good outcome. It is very important to realize that making a good investment decision does not mean that you're going to get the outcome that you hoped for. Think about your friend that doubled their money in weed stocks or your cousin making a ton of
money in Toronto real estate while your index funds relatively boringly
tracked the stock market. Evaluating a decision starts at the time that the decision is made, as opposed to when the outcome is known. Any decision is a risk. As investors, our decisions will result in us either making or losing money. To make a good decision, we need to know what risk we are taking, why we are taking it and
what the expected outcome is. Knowing those things will allow us to evaluate the decision in the future. When we talk about
investing in index funds, we're talking about taking
the risk of the market. People usually take on
the risk of the market to achieve a financial goal. Market risk has an associated risk premium that we expect to earn. Let's go through that one more time. Taking on the risk of the market in order to earn the market risk premium to achieve a financial goal would be a sensible decision,
regardless of the outcome. The market risk premium is well-documented around the world as far
back as we have data and it is sensible that it will persist based on the way that
capitalism functions. Going back to 1900, the global market has
delivered a risk premium that is a return in
excess of risk-free assets of 4.2%. This includes Russia's
market going to zero in 1917, and China's in 1949. Making a decision based on
an expected risk premium is perfectly reasonable. Knowing that the stock market delivers a positive risk premium over
the longterm might be helpful, but it does not make it
much easier to evaluate your investment decisions
in the short term. Even over 10-year periods, stocks have trailed bills
12% of the time in Canada, 15% of the time in the U.S. and 6% of the time in
international developed markets going back as far as
I have data available. There is a non-zero chance
of living through a decade of a flat or negative
risk premiums for stocks. That does not make investing
in stocks a bad decision, but it does leave a substantial amount of room for luck to influence the outcome. In his book, "How Much Can
I Spend in Retirement?" Wade Pfau pointed out
that retirees in 1973 and 1975 had 28 of their 30 working years overlap, but the 1975 retiree reached retirement with 36% less wealth
than the 1973 retiree. They both made the same
investment decisions and worked for the same number of years, but their outcomes diverged based solely on the uncertainty of
stock market outcomes. Similar thinking can be applied to small cap and value stocks. They have produced reliable
long-term risk premiums. For example, U.S. value
stocks beat U.S. growth stocks by 3.3% per year on average from 1928 through 2018. The same thing happened in Canada where value beat growth by 2.59% per year on average from 1977 through 2018 and in international developed markets where value beat growth by
5.01% from 1975 through 2018. These are reliable risk premiums. However, for the past decade, owning U.S. value stocks has
resulted in a bad outcome as value has trailed growth by 3.2% per year on average. Whether or not investing in
value stocks was a bad decision depends on why the decision was made. Value stocks are riskier
than growth stocks and there is a return premium
associated with that risk. Adding value stocks to a portfolio to capture an independent risk premium is not a bad decision, but that does not
guarantee a good outcome. Now, to be fair to value stocks, if we looked at the returns of U.S. value against growth in March 2000, we would find that
value had trailed growth for the past 5, 10, 15,
and 20-year periods. If we looked one year later in March 2001, we would see that value had beaten growth for the past 5, 10, 15,
and 20-year periods. Not only are we dealing
with uncertain outcomes but in order to increase the chances of achieving an expected outcome, it is crucial to stick with the strategy. This is what makes evaluating investment decisions so challenging. Investing in value stocks in
1980 was not a bad decision, but it resulted in 20
years of bad outcomes. And to finally get the
good and expected outcome you had to stick with it for
20 years of underperformance and hang on that one extra year. Probably an even better example
of an investment decision that is hard to evaluate is
owning individual stocks. The data on individual
stocks is not promising. Most of the returns of the market come from relatively few stocks and identifying those stocks ahead of time is impossible to do consistently. This makes picking individual stocks, on average, a losing bet, but there are still some people who will make money investing
in individual stocks. Not a good decision, but it can lead to a good outcome, though, a bad outcome's more likely. I think that this is
particularly important when we are talking about index funds and being committed to index investing. It will always be possible
to identify something, an active fund or an individual stock, that did better than an index fund. The problem for us
investment decision makers is that when something
does better than the index, that performance will be used as a tool to sell you on the strategy. A good outcome for an active fund does not make it a good fund. In their Persistence Scorecard, Standard and Poor's looks
at U.S. active mutual funds that have been top quartile
fund for the past five years, and then tracks them to see
how many stay top quartile for the next five years. In the March 2018 scorecard, only 2.33% or 13 of the original
557 top quartile funds remained in the top quartile. I think that I have established that evaluating investment
decisions is hard to do but basing decisions on
persistent risk premiums and sticking with the decision
for an investment lifetime is probably the best approach. We've also talked about the
role of luck in outcomes where bad luck can result in bad outcomes despite a good decision. One of the best ways to
reduce the role of luck in your investment outcomes
is through diversification. Earlier in the video, I mentioned that stocks in various markets can have 10-year periods
of underperformance. When that happens in one market, it will not always happen in
other markets at the same time. The last decade in the
U.S. is a perfect example. From late 1999 through 2009, a Canadian investor would have
lost money in U.S. stocks. Canadian stocks on the other
hand returned 6.47% per year on average, over the same period. We could not have known ahead of time what those outcomes would be, but diversification reduced
the impact of that uncertainty. Diversification is not limited
to geographic regions either. I have mentioned persistent risk premiums as being sensible basis
for investment decisions, even if they don't always pan out. The interesting thing about risk premiums is they are not perfectly
correlated with each other. When one doesn't pan out
over a given time period, there's a good chance
that another one will. This makes diversifying
across risk factors an interesting proposition
for any investor. Take our example of the last
decade in U.S. stocks again. Over that same period, U.S. small cap value stocks returned 6.45% per year on average, that is U.S. stocks as a whole
lost value over the decade but U.S. small cap value stocks made a substantial return
over the same period. We can take this one step further. Let's look at four U.S. risk premiums: market, size, value and profitability, and examine the 547
rolling 10-year periods from July in 1963 through 2018. If we look for 10-year periods where one of the risk
premiums was negative, that is the market risk premium, the premium of small
stocks over large stocks, the premium of value
stocks over growth stocks, or the premium of stocks
with robust profitability over stocks with weak profitability, there were 270 or 50%
of the 10-year periods where one of those risk
premiums produced a bad outcome, meaning a negative premium. If we instead look for 10-year periods where two of the premiums were negative, we only find 43 of them, or 8% of the time. For three of the four
premiums being negative, we find only one of the
547 10-year periods. This speaks to the
importance of diversification not only geographically, but
also across risk factors. It also speaks to the importance of almost blindly sticking
with investment strategies, as weird as that feels to say,
for an investment lifetime. If we have basis to make a decision today, it should take a massive
weight of evidence to deem it a bad decision
that needs to be amended. There's something called Bayesian thinking that I think it's worth
mentioning at this point. In Bayesian thinking, we start
with our prior assessment. No one simply has a
prior in Bayesian speak. The stronger the prior, the more overwhelming new evidence has to be to change our mind. In reality, anytime that
we get new information, we have a tendency to
weight it more heavily. This is called the availability heuristic. To apply Bayesian thinking, before drawing a conclusion
from new information, such as value stocks
underperforming for a decade, we have to consider it against
the weight of our prior. In the case of value stocks, our view might change a little bit after a decade of underperformance, but not much based on the
strength of our prior. Any investment decision should be made based on the intention
to take a specific risk for a specific reason with the view of achieving a goal. It is only on the quality
of the process used to make the decision, not on the outcome, that the decision can be judged. Even with the best decisions, there's a chance of a
bad outcome due to luck. The best way to reduce this chance is through diversification across both geographies and risk factors. How do you evaluate your
investment decisions? Tell me about it in the comments. Thanks for watching. My name is Ben Felix of PWL Capital and this is Common Sense Investing. If you enjoyed this video, please share it with
someone that you think could benefit from the information. Don't forget, if you've run out of Common Sense Investing videos to watch, you can tune into weekly episodes of the Rational Reminder podcast wherever you get your podcasts. (upbeat music)
