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How to Evaluate Your Investment Decisions - YouTube
Channel: Ben Felix
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- You cannot evaluate
an investment decision
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based on its outcome.
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Take a second to let that sink in.
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If you buy an individual
stock and double your money,
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you still made a bad decision.
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You had a good outcome,
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but you made a bad decision.
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Future stock returns are uncertain.
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When we are dealing with uncertainty,
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a good decision might
lead to a bad outcome
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and a bad decision might
lead to a good outcome.
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Looking past outcomes to
evaluate investment decisions
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is not easy for a human to grasp.
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We tend to have an
illusion of control bias
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where we overestimate our
influence on outcomes.
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This can be particularly dangerous
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when it comes to investing.
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I'm Ben Felix, portfolio
manager at PWL Capital.
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In this episode of Common Sense Investing,
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I'm going to tell you
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how to evaluate your investment decisions.
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(upbeat music)
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There is always going to be
an element of uncertainty
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that defines the ultimate
outcome of any investment.
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That is something that we cannot control.
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We can control the quality
of our investment decisions.
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If we can recognize the difference
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between a bad decision and a bad outcome,
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we may be better equipped to stick
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with a sensible long-term
investing strategy
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even when it is not
producing a good outcome.
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It is very important to realize
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that making a good investment decision
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does not mean that you're going
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to get the outcome that you hoped for.
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Think about your friend
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that doubled their money in weed stocks
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or your cousin making a ton of
money in Toronto real estate
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while your index funds
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relatively boringly
tracked the stock market.
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Evaluating a decision starts
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at the time that the decision is made,
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as opposed to when the outcome is known.
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Any decision is a risk.
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As investors, our decisions will result
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in us either making or losing money.
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To make a good decision,
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we need to know what risk we are taking,
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why we are taking it and
what the expected outcome is.
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Knowing those things will allow us
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to evaluate the decision in the future.
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When we talk about
investing in index funds,
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we're talking about taking
the risk of the market.
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People usually take on
the risk of the market
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to achieve a financial goal.
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Market risk has an associated risk premium
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that we expect to earn.
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Let's go through that one more time.
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Taking on the risk of the market
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in order to earn the market risk premium
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to achieve a financial goal
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would be a sensible decision,
regardless of the outcome.
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The market risk premium is well-documented
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around the world as far
back as we have data
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and it is sensible that it will persist
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based on the way that
capitalism functions.
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Going back to 1900,
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the global market has
delivered a risk premium
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that is a return in
excess of risk-free assets
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of 4.2%.
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This includes Russia's
market going to zero in 1917,
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and China's in 1949.
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Making a decision based on
an expected risk premium
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is perfectly reasonable.
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Knowing that the stock market delivers
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a positive risk premium over
the longterm might be helpful,
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but it does not make it
much easier to evaluate
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your investment decisions
in the short term.
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Even over 10-year periods,
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stocks have trailed bills
12% of the time in Canada,
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15% of the time in the U.S.
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and 6% of the time in
international developed markets
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going back as far as
I have data available.
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There is a non-zero chance
of living through a decade
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of a flat or negative
risk premiums for stocks.
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That does not make investing
in stocks a bad decision,
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but it does leave a substantial amount
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of room for luck to influence the outcome.
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In his book, "How Much Can
I Spend in Retirement?"
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Wade Pfau pointed out
that retirees in 1973
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and 1975
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had 28 of their 30 working years overlap,
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but the 1975 retiree reached retirement
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with 36% less wealth
than the 1973 retiree.
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They both made the same
investment decisions
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and worked for the same number of years,
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but their outcomes diverged based solely
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on the uncertainty of
stock market outcomes.
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Similar thinking can be applied
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to small cap and value stocks.
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They have produced reliable
long-term risk premiums.
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For example, U.S. value
stocks beat U.S. growth stocks
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by 3.3% per year on average from 1928
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through 2018.
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The same thing happened in Canada
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where value beat growth by 2.59% per year
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on average from 1977 through 2018
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and in international developed markets
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where value beat growth by
5.01% from 1975 through 2018.
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These are reliable risk premiums.
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However,
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for the past decade,
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owning U.S. value stocks has
resulted in a bad outcome
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as value has trailed growth
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by 3.2% per year on average.
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Whether or not investing in
value stocks was a bad decision
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depends on why the decision was made.
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Value stocks are riskier
than growth stocks
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and there is a return premium
associated with that risk.
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Adding value stocks to a portfolio
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to capture an independent risk premium
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is not a bad decision,
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but that does not
guarantee a good outcome.
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Now, to be fair to value stocks,
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if we looked at the returns of U.S. value
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against growth in March 2000,
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we would find that
value had trailed growth
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for the past 5, 10, 15,
and 20-year periods.
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If we looked one year later in March 2001,
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we would see that value had beaten growth
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for the past 5, 10, 15,
and 20-year periods.
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Not only are we dealing
with uncertain outcomes
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but in order to increase the chances
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of achieving an expected outcome,
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it is crucial to stick with the strategy.
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This is what makes evaluating
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investment decisions so challenging.
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Investing in value stocks in
1980 was not a bad decision,
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but it resulted in 20
years of bad outcomes.
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And to finally get the
good and expected outcome
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you had to stick with it for
20 years of underperformance
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and hang on that one extra year.
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Probably an even better example
of an investment decision
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that is hard to evaluate is
owning individual stocks.
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The data on individual
stocks is not promising.
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Most of the returns of the market
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come from relatively few stocks
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and identifying those stocks ahead of time
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is impossible to do consistently.
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This makes picking individual stocks,
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on average, a losing bet,
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but there are still some people
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who will make money investing
in individual stocks.
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Not a good decision,
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but it can lead to a good outcome,
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though, a bad outcome's more likely.
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I think that this is
particularly important
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when we are talking about index funds
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and being committed to index investing.
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It will always be possible
to identify something,
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an active fund or an individual stock,
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that did better than an index fund.
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The problem for us
investment decision makers
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is that when something
does better than the index,
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that performance will be used as a tool
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to sell you on the strategy.
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A good outcome for an active fund
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does not make it a good fund.
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In their Persistence Scorecard,
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Standard and Poor's looks
at U.S. active mutual funds
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that have been top quartile
fund for the past five years,
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and then tracks them to see
how many stay top quartile
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for the next five years.
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In the March 2018 scorecard, only 2.33%
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or 13 of the original
557 top quartile funds
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remained in the top quartile.
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I think that I have established
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that evaluating investment
decisions is hard to do
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but basing decisions on
persistent risk premiums
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and sticking with the decision
for an investment lifetime
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is probably the best approach.
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We've also talked about the
role of luck in outcomes
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where bad luck can result in bad outcomes
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despite a good decision.
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One of the best ways to
reduce the role of luck
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in your investment outcomes
is through diversification.
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Earlier in the video,
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I mentioned that stocks in various markets
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can have 10-year periods
of underperformance.
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When that happens in one market,
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it will not always happen in
other markets at the same time.
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The last decade in the
U.S. is a perfect example.
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From late 1999 through 2009,
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a Canadian investor would have
lost money in U.S. stocks.
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Canadian stocks on the other
hand returned 6.47% per year
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on average, over the same period.
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We could not have known ahead of time
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what those outcomes would be,
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but diversification reduced
the impact of that uncertainty.
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Diversification is not limited
to geographic regions either.
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I have mentioned persistent risk premiums
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as being sensible basis
for investment decisions,
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even if they don't always pan out.
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The interesting thing about risk premiums
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is they are not perfectly
correlated with each other.
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When one doesn't pan out
over a given time period,
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there's a good chance
that another one will.
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This makes diversifying
across risk factors
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an interesting proposition
for any investor.
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Take our example of the last
decade in U.S. stocks again.
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Over that same period,
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U.S. small cap value stocks returned
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6.45% per year on average,
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that is U.S. stocks as a whole
lost value over the decade
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but U.S. small cap value stocks
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made a substantial return
over the same period.
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We can take this one step further.
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Let's look at four U.S. risk premiums:
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market, size, value and profitability,
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and examine the 547
rolling 10-year periods
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from July in 1963
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through 2018.
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If we look for 10-year periods
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where one of the risk
premiums was negative,
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that is the market risk premium,
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the premium of small
stocks over large stocks,
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the premium of value
stocks over growth stocks,
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or the premium of stocks
with robust profitability
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over stocks with weak profitability,
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there were 270 or 50%
of the 10-year periods
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where one of those risk
premiums produced a bad outcome,
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meaning a negative premium.
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If we instead look for 10-year periods
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where two of the premiums were negative,
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we only find 43 of them,
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or 8% of the time.
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For three of the four
premiums being negative,
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we find only one of the
547 10-year periods.
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This speaks to the
importance of diversification
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not only geographically, but
also across risk factors.
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It also speaks to the importance
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of almost blindly sticking
with investment strategies,
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as weird as that feels to say,
for an investment lifetime.
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If we have basis to make a decision today,
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it should take a massive
weight of evidence
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to deem it a bad decision
that needs to be amended.
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There's something called Bayesian thinking
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that I think it's worth
mentioning at this point.
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In Bayesian thinking, we start
with our prior assessment.
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No one simply has a
prior in Bayesian speak.
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The stronger the prior,
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the more overwhelming new evidence
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has to be to change our mind.
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In reality, anytime that
we get new information,
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we have a tendency to
weight it more heavily.
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This is called the availability heuristic.
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To apply Bayesian thinking,
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before drawing a conclusion
from new information,
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such as value stocks
underperforming for a decade,
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we have to consider it against
the weight of our prior.
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In the case of value stocks,
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our view might change a little bit
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after a decade of underperformance,
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but not much based on the
strength of our prior.
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Any investment decision should be made
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based on the intention
to take a specific risk
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for a specific reason
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with the view of achieving a goal.
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It is only on the quality
of the process used
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to make the decision, not on the outcome,
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that the decision can be judged.
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Even with the best decisions,
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there's a chance of a
bad outcome due to luck.
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The best way to reduce this chance
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is through diversification
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across both geographies and risk factors.
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How do you evaluate your
investment decisions?
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Tell me about it in the comments.
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Thanks for watching.
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My name is Ben Felix of PWL Capital
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and this is Common Sense Investing.
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If you enjoyed this video,
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please share it with
someone that you think
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could benefit from the information.
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Don't forget, if you've run out
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of Common Sense Investing videos to watch,
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you can tune into weekly episodes
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of the Rational Reminder podcast
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wherever you get your podcasts.
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