If you are given a choice between two different long term investments :
Investment A – Track record of 13.6% compounded annual return over a 30 year period
Investment B – Track record of 8% compounded return over the same 30 year period.
Which one would you choose? In dollar terms, if you invested a $1000 for a 30 year period at the above rates, you would end up with about $46K with A and $10K with B. With just this amount of information, it’s seems like a complete no-brainer. However, let me ask you the same question after showing you the respective equity charts of the two investments. These are actual track records of real underlying investment instruments that are very much operational even today (source credits: www.iasg.com). For comparison sake, I have plotted the S&P 500 (in red) against each of these. What would your choice be?
Investment A
While Investment A has decimated the S&P 500 over a span of 30 years, for an interim period of 4.5 years between Feb 2003 and Aug 2007, the underlying instrument lost 57% of it’s value. It only resumed it’s upward trajectory after a 5-year gap.
Investment B
Investment B has coincidentally delivered exactly the same returns as S&P 500 since it’s inception, but the path of the returns has been very different from that of the S&P 500. Till July 2007, this investment has had a dream run, but in the last 7 years it hasn’t really gone anywhere.
Exiting at the wrong time
In case of A, there are investors who would have pulled out during that long painful drawdown (peak-to-trough decline) period. Some might have even done so at a loss, depending on their point of entry. This is quite obvious from the red AUM (Asset Under Management) chart over the life of the fund.
We can see from the subsequent performance, that this drawdown period was clearly the wrong time to exit (hindsight is of course 20/20). This is a very common scenario. I would probably have done the same at such a time as watching the investment lose value month after month can be quite excruciating. While many investments/funds generate great returns over a long period, the participant investors’ returns from the same underlying investments show a very different picture.
Assuming that the long term conviction was still intact, what would be the best way for an investor to tide over this 4.5 year period in A or the current 7 year period in B? Is there a way to participate in potential future upsides without risking permanent destruction of wealth?
If however something fundamentally has changed in the underlying investments or the broad market scenario, which render the repeat of the past track record unlikely, then the investor is better off cutting losses and seeking greener pastures elsewhere.
The solution
The solution to this lies outside of choosing the specific investments. While finding the investments that generate returns over time in important, it is equally (if not more) important to focus on the money management and position sizing. I am often amazed at how little thought goes into these factors. What some investors do not realize is that their lifetime of investment return (barring lucky exceptions) would depend more on how they money-manage a number of investments and allocate across multiple investments, than on the return from one specific investment. The 5% of the AUM that stayed put in the investment A, at the time of the long drawdown, probably belonged to investors who:
a. had invested or maintained a small/manageable % of their total net-worth in this one fund.
b. had a separate source of cash-flow that took care of their expenses such that they did not have to dip into this investment at the wrong time.
Investors with net positive cash-flows could have actually taken advantage of this drawdown period. These smart investors could be reinvesting the excess cash-flow in this instrument at a lower price, rather than exiting during the drawdown. It is easier said than done, but smart investors who have the discipline of practicing this, come out significantly ahead in the long run. This principle of reinvesting excess cash-flow or realized gains from elsewhere, into investments which have suddenly become inexpensive, is very core to our philosophy. This is the recipe for long term compounding of wealth, that we rely on.
We will be discussing generation and reinvestment of excess cash-flows in detail in future posts. We will also take a closer look at money-management best practices, that will help our readers to control the risk in each individual investment. We always encourage our readers to ask one important question before pulling the trigger on any investment/trade : “What if we are wrong?”. We will provide step by step approaches along with easy to understand examples, on each of these topics. We would encourage you to register with your email id here and/or like us on our Facebook page by the same name – moneywisesmart (https://www.facebook.com/MoneyWiseSmart).
I have not disclosed the names of the specific investments here as I would not like this to be viewed as an endorsement or promotion for any of these. The purpose of using these examples is purely educational.
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