It’s old news that managing expectations is usually the main challenge in finding success with an investment strategy.
To paraphrase Pogo in the quest to earn a respectable return through time, we’ve met the enemy of prudent behavior and he is us. Less obvious is the tendency for this behavioral risk to go to extremes early on in the period immediately following the establishment of a new investment. By comparison, a decade or more into the holding period — assuming you make it that far — is relatively safe from a behavioral perspective.
The probability of getting whipsawed is high, in other words, soon after you deploy capital anew to a mutual fund, ETF or portfolio strategy. Therein lies the biggest risk that an investor will abandon a strategy in wake of steep short-term losses — or assume that unsustainably high performance early on is the norm. Either way, early impressions can be and probably will be misleading, which can lay the groundwork for trouble later on in the crucial task of managing expectations.
To hang some hard numbers on this issue let’s consider how performance varies across an expanding time horizon for three mutual funds representing the US stocks market, US investment-grade bonds, and a widely respected multi-asset class fund of funds:
Vanguard 500 Index Investor (VFINX)
Vanguard Total Bond Market (VBMFX)
Vanguard STAR (VGSTX)
In the first example, January 31, 1990 is the start date. The return is annualized in the first subsequent month, then for the first two months, then for three months, and so on. By the end of the time window we’ll have an annualized return that reflects the entire 28-year-plus holding period.
The main takeaway is that performance is extremely volatile in the first few months or even years. As time passes, returns settle down and become contained within a relatively narrow band that’s usually more or less in line with the asset’s long-run projections. The lesson is that the rationale for an asset or strategy isn’t likely to deliver real-world confirmation of the return projections until well after the initial investment. As a result, the preliminary holding period will probably be noise in terms of the returns (or losses), which means that the signal arrives with a lag, perhaps a lengthy one.
For example, a January 31, 1990 investment in the Vanguard 500 Index Investor (VFINX), a proxy for the S&P 500 Index(NYSEARCA:SPY), earned a 9.5% annualized total return through last month’s close (October 31, 2018). Notably, that return has been relatively stable in recent years compared with the roller-coaster ride in the early phase.
Consider that in the first 36 months of investing in VFINX following the January 31, 1990 start date the annualized returns ranged from a steep 29% loss to a gain of nearly 13%. By comparison, the range of returns at the tail end of the investment period (the ten years through last month) posted a substantially narrower range of returns: 6.1% to 9.9%.
Moving the start date up to January 2007, just ahead of the Great Recession and the financial crisis of 2008-2009, doesn’t change the pattern: lots of volatility early on, followed by relatively stable performance.
Even if we shift the start date to January 2010, after the turmoil in the financial markets had passed, the high volatility early on remained intact.
The pattern of high volatility(NYSEARCA:VXX) in the early months of a new investment isn’t surprising. Simple math tells us why. When your holding period is short, any one or two months can unleash a big impact on the trailing return, for good or ill. Eventually, the influence of any one month – or six – has minimal influence on the annualized performance for the full trailing period. The main point is that at some point the performance you were expecting (assuming it was a reasonable forecast) is likely to prevail, give or take.
Therein lies a key issue to consider for behavioral risk: even the world’s greatest portfolio strategy will likely suffer from whipsaw early on. In turn, an investor who bought into the strategy is at high risk in this preliminary period by jumping ship (due to sharp losses) or assuming that the unusually high returns will be the norm. In either case, behavioral risk is in the red zone.
How long does this red zone last after the initial investment? It varies, depending on the asset or strategy and the prevailing economic and financial climate, but as a rough estimate it’s reasonable to assume that an initial period as long as five years is a high-risk whipsaw window.
Fortunately, managing this type of behavioral risk is easy — if you’re prepared for it. It starts with modeling the range of paths for a strategy to develop perspective on what may be coming.
For instance, imagine that an investor was considering an investment in the Vanguard STAR fund. The first order of business: running a Monte Carlo analysis for, say, 10,000 possible paths for how the fund’s performance may unfold in the years ahead. With the results in hand, you have a reasonably reliable snapshot of what’s lurking — noise tends to dominate in the early going, followed by the signal later on.
Reviewing this data and planning ahead for the inevitable whipsaw is essential for financial advisors running money for new clients (or consultants working with institutional investors for new mandates). A sophisticated investor will recognize the challenge that’s likely to impact the strategy in the early years and react appropriately. But the average client is in dangerous terrain without coaching and hand-holding.
Behavioral risk comes in many flavors, of course. But in the grand scheme of events that can derail the best-laid investment plans, whipsaw risk is second to none in the litany of hazards. No wonder that it’s a hazard that probably explains the lion’s share for why the average investor’s success rate with investing is mediocre or worse.