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Dumb Alpha: The Drawbacks Of Compound Interest

By Joachim Klement, CFA The second installment of this series presented evidence that a simple random walk forecast typically performs better than the amassed expertise of professional forecasters for short-term forecasts of about 12 months. In this post, I argue that estimation uncertainty is not reduced for long-term forecasts either, because mean reversion cannot overcome the effects of compound interest. Luckily, there is a range of techniques, from simple to sophisticated, that can help long-term investors with this challenge. The “Muffin Top” Problem As most middle-aged people can confirm, age inexorably leads to a slowing metabolism. If you don’t change your diet, your waistline expands quite generously. In my case, I refused to notice these changes until I grew an undeniable “muffin top” of belly fat above my belt line. Chagrined, I changed my diet and stepped up my exercise, but so far — muffin doin’. This little anecdote is a rather fitting (if unappealing) metaphor for long-term investing. What I tried to force my body to do was to revert back to its original state (the mean), but the forces of mean reversion were not strong enough to do so. This scenario can happen in the world of investing as well. Imagine someone who wants to invest for the next 10 years and who is thus not interested in short-term forecasts so much as the long-term average expected returns of assets. Common wisdom states that, while return forecasts can be widely off the mark in any given year, in the long run, returns should converge towards a rather stable long-term mean. Because of mean reversion, it should be easier to forecast long-term returns than short-term returns. Compound Interest Ruins the Day In an important article in the Journal of Finance , however, University of Chicago economists Lubos Pastor and Robert Stambaugh showed that, in the presence of estimation uncertainty, mean reversion is not strong enough to reduce the volatility and uncertainty of long-term stock market returns. The main reason is that an estimation error in the first year will propagate and compound over the subsequent nine years, an estimation error in the second year will compound over the subsequent eight years, etc. Take, for example, an investment you know will average an annual return of 10% per year over the next 10 years. If in the first year the return is -10%, the average return over the subsequent nine years needs to be about 12.48% per year to make up for this shortfall. In other words, a 20% estimation error in the first year requires a relative increase in annual returns over the next nine years of 24.8%. If, on the other hand, the asset in the first year has a return of 0%, the average return over the subsequent nine years needs to be about 11.17% to make up for the shortfall. So a 10% estimation error in the first year requires a relative increase in annual returns of 11.7%. Half the estimation error requires less than half the relative return increase to make up for the shortfall. The investment results of the first few years have an oversized influence on the long-term investment returns — something that retirement professionals know as “sequence risk.” If you start saving for retirement and experience a major bear market in the first few years, you are much less likely to achieve your long-term financial goals than if you experience a rather benign environment at first and a bear market later. While the research by Pastor and Stambaugh is theoretical in nature, there is empirical evidence that long-term return forecasts are, in fact, just as uncertain and “inaccurate” as short-term forecasts. Ivo Welch and Amit Goyal have looked at the predictive power of many different variables that are commonly used to forecast equity market returns. They find that the forecast error does not materially change for forecast horizons between one month and 10 years. In other words, despite the existence of mean reversion, the uncertainty about future equity returns does not decrease in the long run. Facing the Challenge If long-term return forecasts are just as difficult to make as short-term forecasts, what can long-term investors do to create robust long-term portfolios? After all, we know that traditional Markowitz mean-variance optimization is about 10 times more sensitive to return forecast errors than to forecast errors in variances . There are in my view several possibilities, increasing from least to most in degree of sophistication: The equal weight asset allocation discussed in the first part of this series does not rely on forecasts, and thus is a simple and effective way to create robust long-term portfolios. Minimum variance portfolios and risk parity portfolios do not require any return forecasts and, if done properly, can outperform traditional portfolios by a wide margin. More sophisticated methods like resampled efficient frontier methodologies or Bayesian estimators can include estimation errors into the portfolio construction process and thus create portfolios that are more immune to unexpected events. Whatever technique one favors, there are ways to deal with forecast errors. Most critically, it is time investors take estimation uncertainty more seriously for the benefit of their clients and the long-term success of their portfolios. If you liked this post, don’t forget to subscribe to the Enterprising Investor . All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Perception Vs. Reality And Emotion Vs. Reason

If I were to tell you that: The price of oil would decline beneath $30 dollar a barrel before Iran had economic sanctions lifted from $90 per barrel a year ago, increasing global disposable income by over $3 trillion dollars Monetary authorities would all maintain easy monetary policies with the supply of capital far outstripping demand for capital The Fed funds rate was 0.375% and was on hold for now Bank earnings, liquidity and capital ratios continue to improve The dollar remained strong and capital flows accelerated from abroad helping to push 10 year bond yields below 2.0% That there would be 3 million new jobs created in the U.S in 2015 alone with growth in wages of 2.6% year on year GNP would continue to expand between 2-2.5% led by the consumer without inflationary pressures and profits, x-energy and materials, would continue to increase China expanded by over 6.8% in 2015 despite major headwinds policy changes and would expand by over 6.0% in 2016 M & A would reach new heights and remains strong Private equity valuations and the number of new issues cooled There is a change occurring in national elections everywhere away from the establishment (look at Taiwan) Japan and the Eurozone would maintain excessive monetary ease India would continue to grow around 7% Bearish sentiment was at a multi-month high and the market was selling at 15 times earnings then; and finally, Change was happening everywhere for the better. Then, would you predict a rising stock market, excluding energy and material stocks, or a falling one? There is a major disconnect between perception and reality in the marketplace today as emotions are overcoming reason. Whose view of the global economy would you consider most relevant and on the mark: Jimmy Dimon, Chairman of JP Morgan Chase, or a market pundit/news commentator? I suggest that you read for yourself the transcripts of earnings conference calls, as the media has been taking many comments out of context. We participate in at least three conference calls a day during earnings season to gain a true perspective of what is happening in the real world. This is a period of excessive volatility. It creates tremendous opportunities to capitalize on inefficiencies in the marketplace. Each long investment in our portfolio has superior management and is going through positive change which will lead to more revenue and volume growth; enhanced global competitiveness; higher returns on revenues and capital; increased free cash flow to be used for reinvestment in growth and enhancing shareholder value; and finally, each one has a current yield over 3%. But, change does not happen overnight so you need patience and liquidity to let it unfold. For example, I owned GE for 18 months, purchased at $19 per share, before the marketplace woke up and began to re-evaluate the stock. It took Nelson Peltz’s filing to turn the light bulb on for investors. His cost is $27. We are still in the early stages of GE’s transformation. As I say, this is a market of stocks, not a stock market. Unfortunately, electronic/technical/systematic trading takes no prisoners and can override fundamentals over the short-term. Stop thinking as a trader and start thinking as an investor! Don’t buy for next quarter’s earnings but focus instead on the next few years’ volume and revenue growth, competitive position, the mix of business, operating margins and returns, cash flow, especially free cash flow, and valuations. We want multiple ways to win on each investment while protecting our downside too. We are global investors with a global perspective. Let’s take a look at the key data points by region that occurred last week: The United States takes center stage as the largest economy in the world. It appears that fourth quarter GNP growth slowed significantly from the third quarter and follows a similar pattern that has existed for several years with one strong quarter followed by a weaker one with overall growth remaining in the 2-2.5% range without inflation and led by the consumer. Jimmy Dimon, Chairman of JPM mentioned on the 4th quarter earnings call last week that he sees continued strong growth by U.S. consumers; GNP growth between 2 and 3%; continued good business demand for loans; continued strong M & A as his book is full; continued improvement in credit quality; maximum write-downs for energy loans at $750 million with oil prices around $30 per barrel and max write down exposure to the materials sector of $200 million out of a total loan portfolio of $837 billion and total assets on $2.4 trillion; continued growth in deposits and decent growth overseas. JPM has little exposure to China, which he mentioned is slowing but still showing above average economic growth. It’s quite amazing that JPM recorded record earnings despite a relatively flat yield curve. The heads of Citi (NYSE: C ), PNC , WFC and USB echoed his comments. I was on each call. Growth in the United States continues to be led by the consumer (over 68% of GNP) as the production sectors, including energy and materials, remain comparatively weak. Data points to reinforce this view include: University of Michigan consumer confidence index rose to a 7 month high of 83.3; the gauge of expectations six months out increased to 85.7; retail sales fell 0.1% in December and rose only 2.1% over the prior year (lower gasoline sales penalized this number); manufacturers sales and shipments fell 2.8% compared to a year ago while inventories rose 1.6% therefore the inventory/sales number rose to 1.32; producer prices fell 0.2% in December but rose 0.1% excluding food and energy; consumer comfort index rose to a 3-month high of 44.2; import prices fell 1.2% in December and 8.2% over the last year and finally the Beige Book was reported last Wednesday which supported an improving labor market, “slight to moderate growth” in consumer spending, weakness in manufacturing penalized by a strong dollar, additional problems in the energy patch and finally, little sign of wage pressures and minimal price pressures. I believe that the U.S economy will expand in the low end of 2-2.5% this year, inflation will run under 1.5% and the Fed will raise rates two times or less in 2016. Policy will remain accommodative. Watch the national elections as the status quo is out and change is in the air for D.C., too. Chinese Premier Li Keqiang confirmed that China’s economy grew close to 7.0% in 2015 which is still quite amazing considering all the changes going on to stem past excesses and shift emphasis to consumption/services (40% of the economy) from production/exports (60% of the economy). China finished with over $3 trillion in foreign reserves and is still generating $50-$55 billion in trade surpluses per year. China’s consumer and economy has also benefitted greatly from lower energy prices. Change is hard but I applaud their government who has a five-year plan to build a stronger and sounder foundation for the future. The Asian infrastructure bank was launched this week. I expect China to grow at 6-6.5% in 2016. China is on the path towards joining the established global economic leaders with policies to back it up. Did you happen to notice what Haier was willing to pay for GE’s appliance business to become a true global competitor? Ten times trailing EBITDA vs. 7 times, which Electrolux had previously offered. Export growth in the Eurozone and Japan are suffering from changes in global trade patterns and weakness in demand. Both the ECB and BOJ are maintaining incredibly easy monetary policies but there is a limit to what that can accomplish. There is a pressing need for more regulatory and financial reform to stimulate growth in both areas. Did you notice that Germany ran a record budget surplus of $13.14 billion? The government has earmarked $6.5 billion to cover migration related costs. Regulatory, budgetary and financial change is in the air to support and stimulate growth. Here comes Iran on the global energy markets. Iran complied with the terms of its international agreement to curb nuclear development. Therefore sanctions were lifted on Saturday and $50 billion in frozen cash was released. Iran can begin trading with the rest of the world including selling oil. I believe that much of the recent decline in oil below $30 per barrel factored in Iran selling an incremental 1-1.5 million barrels per day on the marketplace by mid-year 2016. Global production currently exceeds global demand by 1.5 million barrels per day and storage is already full to the brims. It has not helped to have unusually warm weather in parts of the world curbing demand growth. Industrial commodity prices have continued to weaken, too, in concert with oil, despite reductions in production, capacity and inventory levels. If the world continues to grow even at 2.5-3%, industrial commodity prices will begin to rise as inventory levels are drawn down. I expect dividend cuts even at the strongest companies but that is a positive at this point, not a negative. Expect many bankruptcies in the energy/industrial commodity and materials markets. The financially strong companies as well as private equity funds will buy these hard assets at 3 to 5 times EBIDTA offering great value and returns on their investment even at these depressed prices as the debt gets extinguished. The reality is that the outlook for global growth is not all that bleak although it may not reach historical rates of gain. On one hand, the global consumer is the huge beneficiary of lower energy prices and low inflation but on the other hand, those countries/companies that are resource- or production-based will suffer. While price determines value, I like to invest where the wind is at your back which is the U.S. where consumption is nearly 70% of GNP compared to a much lower level in Europe, China, Japan, and most emerging markets. It is very difficult to see a recession in any of the major industrialized countries but growth will stay sub-par until there are regulatory and financial changes to stimulate growth as the most of the gains from monetary ease are behind us and depreciating one’s currency is never the answer. Don’t let the pundits fool you. A strong dollar is good for many reasons. Right now the stock markets are being controlled/manipulated by the electronic/systematic technical traders rather than investors. Fear is everywhere and capitulation may have already occurred. It does not help to hear Larry Fink, head of BlackRock, say that the market can decline near term but will increase even more later in the year. That is talk of a trader rather than an investor and argues for passive management over active management. The bottom line is that I see value everywhere and no recession. If you believe the economy will slow for an extended period of time and won’t pick up much as we move through 2016, then buy the global pharmaceuticals and consumer staple stocks. But if you see growth, albeit slow, for an extended period of time, then look at industrials, too, and eventually, some financially strong commodity companies. Banks as a group are just cheap under any scenario. It is amazing that JPM had record earnings with such a flat yield curve and that is very telling. It goes for the other major banks, too. Volatility, confusion and fear create opportunity. We love it! There is more to say but that is enough for today. Look at the facts and take out all of the emotion before making any decisions. Invest, don’t trade. So remember to review the facts; step back and reflect; consider proper asset allocation; maintain excess liquidity and control risk; do in-depth independent research on each investment and…Invest Accordingly!