How Long Can You Handle Underperforming? | #208

Episode Summary

Executive Summary: The episode argues that investors badly overestimate how much return and how little pain they can tolerate. Using survey results and historical examples, the host shows that outperformance often requires enduring long stretches of disappointment, sometimes for decades. His core message: set realistic expectations for returns, drawdowns, and manager underperformance, or you’ll likely abandon sound strategies before compounding can work.

Main Topics: Investor expectation mismatch (Priority: 5/5): The host opens by contrasting what investors expect to earn with what history suggests is realistic, emphasizing that many people misunderstand real versus nominal returns. The behavioral challenge of long underperformance (Priority: 5/5): Survey results and historical examples show that most investors cannot tolerate extended periods of underperformance, whether in stocks versus bonds or active managers versus benchmarks. Compounding and patience as the source of wealth (Priority: 4/5): The episode highlights the extraordinary long-term power of compounding, but only if investors stay invested through volatility and bad stretches. Berkshire Hathaway and active manager reality (Priority: 5/5): Buffett and Munger are used to illustrate that even elite investors and their stock picks can underperform for long periods before winning over time. Historical return and drawdown expectations (Priority: 5/5): The host offers practical real-return expectations for global stocks, bonds, and bills, plus realistic drawdown assumptions for diversified portfolios and individual assets. Why most investors fail (Priority: 4/5): The episode concludes that many investors and advisors cannot handle the realities of drawdowns and underperformance, leading them to abandon strategies too early.

Key Arguments: Investors commonly expect unrealistically high real returns; a global survey cited 11.7% real returns, which the host says is far above history. The main barrier to successful investing is not complexity but behavior: most people cannot endure the ride required to earn long-term returns. Stocks can underperform bonds for extremely long periods; historical stretches reached 68 years, so short-term patience is often insufficient. Most investors claim they would tolerate only a few years of active manager underperformance, yet real-world active strategies often need much longer horizons. Even legendary investments like Berkshire Hathaway require tolerating severe drawdowns and long periods of lagging the market. A simple, diversified, long-term approach can work, but only if expectations are set near historical norms rather than marketing-based promises. The host’s practical return assumptions are far lower than typical investor hopes: about 5% real for global stocks, 2% for bonds, and 1% for bills. Diversified portfolios should still be expected to suffer meaningful losses, including roughly 30% drawdowns and possibly 50% in bad cases. If an asset or manager cannot be held through multi-year underperformance, it is likely not suitable for many investors. The episode frames expectation-setting as a prerequisite to any portfolio design, whether for passive, active, or factor-based strategies.

Data Points: Expected global investor return (survey): 11.7% real after inflation - Natixis survey of global individual investor expectations cited by the host Implied nominal expectation: 13.7% - Host adds 2% inflation to the 11.7% real expectation Stock compounding example: 10% annual return doubles roughly every 7 years; 10x in 25 years; 100x in 50 years - Used to show the power of compounding over time Twitter poll: tolerable stock underperformance vs bonds: 47% said 0-10 years; 21% said 10-20 years; 8% said 20-30 years; 24% said over 30 years - Host asked how long investors would tolerate stocks lagging bonds Twitter poll: would invest in an asset with long zero outperformance stretches: 60% said no - Follow-up question about an asset that historically outperforms bonds but has had 30+ year zero-outperformance periods Longest historical stock underperformance vs bonds: 68 years - Host says this is the longest historical stretch in which stocks underperformed bonds Twitter poll: tolerable active manager underperformance: 53% said under 3 years; 33% said 3-6 years; 7% said 6-9 years; 7% said over 9 years - Poll on how long investors would tolerate manager underperformance before selling Berkshire starting example: $10,000 invested in 1965 became about $200 million - Illustrates Berkshire Hathaway’s long-term compounding S&P 500 starting example: $10,000 became almost $2 million - Used to show that broad-market investing also compounds massively over decades Berkshire/stock picks underperformance period: 17 years - Host says Buffett and Munger-style stock picks underperformed the S&P 500 for the past 17 years Years underperforming within that period: 11 of 17 years - Same Berkshire-related stock picks underperformed in most of those years Performance of Berkshire stock picks vs S&P 500: Outperformed by 3 percentage points per year - Backtested/public stock picks rebalanced quarterly from the turn of the century Mutual fund comparison: Beaten 94% of all mutual funds - The Berkshire-style stock-pick portfolio is said to outperform the vast majority of mutual funds Average mutual fund management fee: 1.25% - Used to contrast fee-free replication with typical active fund costs Host’s real-return rule of thumb: Global stocks 5%, global bonds 2%, global bills 1% - Presented as expected real after-inflation returns based on 120 years of history Diversified portfolio expectation: 4% per year real - Host’s expectation for a well-constructed diversified allocation Typical portfolio drawdown expectation: About 30% - Host says a diversified portfolio should be expected to lose about a third at some point Worst-case drawdown expectation: 50% or even 90% in worst-case scenarios - Host says some assets can lose 80%+ and worst-case expectations should be severe Global allocation viability horizon: 20 years - Host cites GMO-style framing for how long an asset/manager may underperform and remain viable

Pivotal Quotes: "What stretch of underperformance of stocks versus bonds would you be willing to tolerate before selling your stock allocation?" — Matt Baber: Twitter poll question used to measure investor patience "The technical phrase I like to use being an engineer is long ass periods of suck." — Matt Baber: Describing the reality of enduring underperformance to achieve long-term gains "If you can't handle 50% declines in quoted securities, you should never be invested in stocks." — Charlie Munger: Quoted to emphasize the severity of drawdowns investors must accept

Implications: Investors should reset return expectations, accept deep drawdowns, and plan for years or decades of underperformance. Without that discipline, even good strategies, active managers, or legendary franchises will be abandoned before compounding can reward patience.