How Long Can You Handle Underperforming? | #208

Episode Summary

Executive Summary: Meb Faber discusses the critical role of expectations in investing, highlighting that most investors expect unrealistic returns (11.7% real) and cannot tolerate long periods of underperformance. He uses historical data to show that stocks can underperform bonds for decades, and active managers can underperform for years, yet still be viable. He advocates for realistic expectations (5% real for stocks, 2% for bonds, 1% for bills) and emphasizes the need to endure significant drawdowns to achieve long-term compounding.

Main Topics: Unrealistic Investor Expectations (Priority: 5/5): A Natixis survey shows global investors expect 11.7% real returns, which is far above historical averages. This sets investors up for disappointment and poor decision-making. Long Periods of Underperformance (Priority: 5/5): Stocks have underperformed bonds for up to 68 years historically, and modern periods of underperformance can last decades. Most investors cannot tolerate even a decade of underperformance. Behavioral Biases in Investing (Priority: 4/5): Envy and the inability to tolerate underperformance relative to benchmarks or neighbors lead investors to abandon sound strategies. This is a major reason why most fail at investing. The Berkshire Hathaway Example (Priority: 4/5): Berkshire Hathaway's stock picks have underperformed the S&P 500 for 17 years (11 of those years), yet they beat 94% of mutual funds over the long term. This illustrates the need for patience. Realistic Return Expectations (Priority: 4/5): Meb proposes a 5-2-1 rule for real returns: 5% for global stocks, 2% for bonds, 1% for bills. He also warns of 50% drawdowns and worst-case losses of 90%. Active Manager Underperformance Tolerance (Priority: 3/5): A Twitter poll showed 53% of investors would fire a manager after less than 3 years of underperformance, but Meb argues that 20 years is a more realistic timeframe to judge viability.

Key Arguments: Investors expect 11.7% real returns, but historical real returns for stocks are about 5% per year. Stocks can underperform bonds for up to 68 years, and modern periods of underperformance can last decades. Most investors cannot tolerate even a decade of stock underperformance versus bonds, leading them to sell at the worst times. Berkshire Hathaway's stock picks underperformed for 17 years but still beat 94% of mutual funds over the long term. Active managers can underperform for 20 years and still be viable allocations. Realistic expectations: 5% real for stocks, 2% for bonds, 1% for bills, with 50% drawdowns and worst-case losses of 90%. Diversified portfolios historically return about 4% real after inflation, with expected drawdowns of 30-50%.

Data Points: Investor expected real return: 11.7% - Natixis survey of global individual investors Historical real return for global stocks: 5% per year - Meb's 5-2-1 rule based on 120 years of data Historical real return for global bonds: 2% per year - Meb's 5-2-1 rule Historical real return for global bills: 1% per year - Meb's 5-2-1 rule Longest stretch of stocks underperforming bonds: 68 years - Historical worst case, over 100 years ago Berkshire Hathaway underperformance period: 17 years - Stock picks underperformed S&P 500 for 17 years, 11 of those years Percentage of mutual funds beaten by Berkshire picks: 94% - Over the long term, despite underperformance Investors willing to tolerate <3 years of manager underperformance: 53% - Twitter poll results Expected portfolio drawdown: 30-50% - For diversified portfolios, after inflation Worst-case loss for stocks: 90% - Meb's worst-case scenario

Pivotal Quotes: "If you can't handle 50% declines in quoted securities, you should never be invested in stocks." — Charlie Munger (quoted by Meb Faber): Discussing the need to tolerate large drawdowns to achieve long-term returns "It's not greed that drives the world, but envy." — Charlie Munger (quoted by Meb Faber): Explaining why underperformance relative to others is the hardest behavioral bias to overcome "The length of time any investment could have zero return or underperform a benchmark and still be viable is 20 years." — Meb Faber: Advising on realistic expectations for judging investment strategies

Implications: Investors must reset expectations to historical norms, prepare for long periods of underperformance, and avoid reacting emotionally to drawdowns. Patience and discipline are key to achieving long-term compounding. Financial advisors should communicate these realities to prevent client panic.