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Principle 4: Discipline

Principle 4: Maintain perspective and long-term discipline

DisciplineInvesting can provoke strong emotions.

In the face of market turmoil, some investors may find themselves making impulsive decisions or, conversely, becoming paralyzed, unable to implement an investment strategy or to rebalance a portfolio as needed.

Discipline and perspective are the qualities that can help investors remain committed to their long-term investment programs through periods of market uncertainty.

 

Here we show the benefits of a disciplined approach to investing and the cost of allowing emotional impulse to undermine it. We provide evidence that:

 
  • Enforcing an asset allocation through periodic rebalancing can help manage a portfolio's risk.
  • Spontaneous departures from such an allocation can be costly.
  • Attempts to outguess the market rarely pay.
  • Chasing winners often leads to a dead end.
  • Simply contributing more money toward an investment goal can be a surprisingly powerful tool.

The case for discipline

Although the asset allocation decision is one of the cornerstones for achieving an objective, it only works if the allocation is adhered to over time and through varying market environments. Periodic rebalancing will be necessary to bring the portfolio back into line with the allocation designed for the objective. In a 2010 Vanguard research paper, Colleen Jaconetti, Francis Kinniry, and Yan Zilbering concluded that for most broadly diversified portfolios, the asset allocation should be checked annually or semiannually, and the portfolio should be rebalanced if it has deviated more than 5 percentage points from the target.

Of course, deviations resulting from market movements offer an opportunity to revalidate the targeted asset allocation. However, abandoning an investment policy simply because of these movements can harm progress toward an objective.

The illustration below shows how an investor's risk exposure can grow unintentionally when a portfolio is left to drift during a bull market. It compares the stock exposures of two portfolios—one that is never rebalanced and one that is rebalanced twice a year—over changing market environments since early 2003. Both of these hypothetical portfolios start at 60% stocks, 40% bonds, but four years later the "drifting" portfolio has moved to 75% stocks. That much equity exposure might seem appealing during a bull market, but by late 2007 the portfolio would have faced significantly greater downside risk as the financial crisis began.

The importance of maintaining discipline: Failure to rebalance can increase an investor's exposure to risk
Changes in stock exposure for a rebalanced portfolio and a "drifting portfolio," February 2003–December 2012

How risk exposure can grow unintentionally

Notes: The initial allocation for both portfolios is 42% U.S. stocks, 18% international stocks, and 40% U.S. bonds. The rebalanced portfolio is returned to this allocation at the end of each June and December. Returns for the U.S. stock allocation are based on the Dow Jones U.S. Total Stock Market Index through April 2005 and on the MSCI US Broad Market Index thereafter. Returns for the international stock allocation are based on the MSCI All Country World Index ex USA, and returns for the bond allocation are based on the Barclays U.S. Aggregate Bond Index. Source: Vanguard, using data provided by Thomson Reuters Datastream.

 

The next chart shows the impact of fleeing an asset allocation during a bear market for stocks. In this example, the investor moves out of equities at the end of December 2008. The portfolio escapes the stock market's further declines in January and February 2009 (stocks dropped an additional 17% in those two months), but it also misses out on the significant bull market that started in March. Although this represents an extreme example, it also reflects a reality for many investors: After abandoning exposure to an asset class, such as stocks, inertia makes it all too easy to postpone the decision to "get back in."

The importance of maintaining discipline: Reacting to market volatility can jeopardize
What if the "drifting" investor fled from stocks after the 2008 plunge?

The impact of fleeing an asset allocation during a bear market

Notes: The initial allocation for both portfolios is 42% U.S. stocks, 18% international stocks, and 40% U.S. bonds. The rebalanced portfolio is returned to this allocation at the end of each June and December. Returns for the U.S. stock allocation are based on the Dow Jones U.S. Total Stock Market Index through April 2005 and on the MSCI US Broad Market Index thereafter. Returns for the international stock allocation are based on the MSCI All Country World Index ex USA, and returns for the bond allocation are based on the Barclays U.S. Aggregate Bond Index. Source: Vanguard, using data provided by Thomson Reuters Datastream.

It's understandable that during the losses and uncertainties of a bear market in stocks, many investors will find it counterintuitive to rebalance by selling their best-performing assets (typically bonds) and committing more capital to underperforming assets (such as stocks). But history shows that the worst market declines have led to some of the best opportunities for buying stocks. Investors who did not rebalance their portfolios by increasing their stock holdings at these difficult times not only may have missed out on subsequent equity returns but also may have hampered their progress toward long-term investment goals—the target for which their asset allocation was originally devised.

Ignore the temptation to alter allocations

In volatile markets, with very visible winners and losers, market-timing is another dangerous temptation. The appeal of market-timing—altering a portfolio's asset allocation in response to short-term market developments—is strong. This is because of hindsight: An analysis of past returns indicates that taking advantage of market shifts could result in substantial rewards. However, the opportunities that are clear in retrospect are rarely visible in prospect.

Indeed, Vanguard research has shown that while it is possible for a market-timing strategy to add value from time to time, on average these strategies have not consistently produced returns exceeding market benchmarks (Stockton and Shtekhman, 2010). Vanguard is not alone in this finding. Empirical research conducted in both academia and the financial industry has repeatedly shown that the average professional investor persistently fails to time the market successfully. The chart below lists nine studies making this point, starting back in 1966 when J.L. Treynor and Kay Mazuy analyzed 57 mutual funds and found that only one showed significant market-timing ability.

Casualties of market-timing
These are groups found to have failed, on average, to successfully time the markets, along with the researchers responsible for the findings. (All the studies are listed in the References.)

The record of flexible-allocation funds

 

The chart below looks at the record of market-timing mutual funds since 1997. Presumably most such funds are run by sophisticated investment managers with data, tools, time, and experience on their side. Generally speaking, their common objective is to outperform a benchmark in any market environment. To do this, the managers may be authorized to invest in any asset class or sub-asset class of their choosing, at any time. This chart shows the record of these "flexible-allocation funds" since 1997 in five distinct periods—three bull markets and two bear markets. We compare them against a broad benchmark consisting of U.S. and non-U.S. stocks and U.S. bonds.

Market-timing versus a market benchmark: A spotty record
Performance of flexible-allocation funds compared with a 60% stock/40% bond benchmark, January 1997-December 2012

Top-performing stock funds

Notes: The balanced benchmark consists of the MSCI US Broad Market Index (42%), the MSCI All Country World Index ex USA (18%), and the Barclay's U.S. Aggregate Bond Index (40%). Flexible-allocation funds are those defined by Morningstar as having "a largely unconstrained mandate to invest in a range of asset types." Source: Vanguard, using data from Morningstar.

 

Two important conclusions can be drawn from this analysis: (1) in only one period did a majority of the flexible-allocation funds outperform the balanced benchmark; and (2) among those that did outperform in a particular period, less than half were able to carry that performance forward into the next period. The lesson? If market-timing is difficult for professional managers with all their advantages, investors without such advantages should think twice before altering a thoughtfully designed portfolio.

As we've shown, the failure of market-timing strategies has not been limited to mutual funds. Investment newsletters, pension funds, investment clubs, and professional market-timers have also failed to demonstrate consistent success.

Why is success so elusive? In a word—uncertainty. In reasonably efficient financial markets, the short-term direction of asset prices is close to random. In addition, prices can change abruptly, and the cost of mistiming a market move can be disastrous.

Ignore the temptation to chase last year's winner

Another component of performance-chasing has to do with investment managers themselves. For years, academics have studied whether past performance has any predictive power regarding future performance. Researchers dating back to Sharpe (1966) and Jensen (1968) have found little or no evidence that it does. Carhart (1997) reported no evidence of persistence in fund outperformance after adjusting for the common Fama-French risk factors (size and style) as well as for momentum. More recently, in 2010, Fama's and French's 22-year study suggested that it is extremely difficult for an actively managed investment fund to regularly outperform its benchmark.

The illustration below demonstrates the challenge of using past success as a predictor of future success. The ten years through December 2012 were split into two five-year periods, and the available funds were grouped based on whether they outperformed or underperformed their targeted benchmark indexes. Notably, only 37% of funds (2,136 of the original 5,705) managed to beat the benchmarks in the first period.

Even more telling is what happened to those outperformers in the second five years. Investors who selected one of them at the start of 2008 stood a significant chance of disappointment, as only 441 funds (21%) were able to top their benchmarks for a second five-year period.

Fund leadership is quick to change
How the top-performing stock funds of 2007 fared in the rankings five years later

How investors' returns lagged their funds' returns

Note: The chart is based on a ranking of all actively managed U.S. equity funds covered by Morningstar's nine style categories according to their excess returns versus their stated benchmarks as reported by Morningstar during the five years through 2007. Sources: Vanguard and Morningstar.

 

This inconsistency among winners is also a reason why abandoning managers simply because their results have lagged can lead to further disappointment. For example, in a well-reported study, authors Amit Goyal and Sunil Wahal (2008) looked at U.S. institutional pension plans that replaced underperforming managers with outperforming managers. The results were far different than expected. The authors found that, following termination, the fired managers actually outperformed the managers hired to replace them over the next three years.

Market-timing and performance-chasing can be a drag on returns

A number of studies address the conceptual difficulties of market-timing. Some examine the records of professional market-timers. The results are discouraging for proponents of market-timing. But what about the experience of the typical investor? Has timing been a net positive or negative?

We can answer that question indirectly by looking at the difference between fund returns and investor returns. The illustration below examines the annual impact of investors' buy/sell decisions on the returns they earn (investor return) relative to the returns reported by the funds they are invested in (fund return) across ten different fund categories since January 1, 1997.

How investors' returns lagged their funds' returns, 1997–2012
When investors chase performance, they often get there late

Rates of market return

Notes: The average difference is calculated based on Morningstar data for investor returns and fund returns. Morningstar Investor Return™ assumes that the change in a fund's total net assets during a given period is driven by both market returns and investor cash flow. To calculate investor return, the change in net assets is discounted by the fund's investment return to isolate the amount of the change driven by cash flow; then a proprietary model is used to calculate the rate of return that links the beginning net assets and the cash flow to the ending net assets. Sources: Morningstar and Vanguard calculations. Data cover the period from January 1, 1997, through December 31, 2012.

 

There are two key implications to be drawn from this data. First, investors generally trail the funds they are invested in as a result of the timing of cash flows.1 Second, the difference between balanced funds (to the left) and specialized, volatile funds (to the right) has been significant. Investors in these niche vehicles have often earned significantly less than the funds themselves—in part because many invest only after a fund starts looking "hot," and thus never see the gains that got it that reputation. The data suggest that, on average, market-timing is hazardous to long-term investing success.

Saving/spending > Market performance

Increasing the savings rate can have a substantial impact on wealth accumulation (Bruno and Zilbering, 2011). To meet any objective, one must rely on the interaction of the portfolio's initial assets, the contribution or spending rate over time, the asset allocation, and the return environment over the duration of the objective. Because the future market return is unknowable and uncontrollable, investors should instead focus on the factors that are within their control—namely asset allocation and the amount contributed to or spent from the portfolio over time.2

The illustration below shows a simple example of the power of increasing contribution rates to meet a given objective. For this example we have an investor who has a goal of $500,000 (in today's dollars adjusted for inflation), invests $10,000 to start, and—in the baseline case—contributes $5,000 each year (without adjusting for inflation). The example shows varying rates of market return.

Increasing the savings rate can dramatically improve results
Years needed to reach a target using different contribution rates and market returns

Rates of market return

Notes: This hypothetical example does not represent the return on any actual investment. The calculations assume a starting balance of $10,000, an objective of $500,000, a contribution of $5,000 in the first year, and an annual inflation rate of 2%. Contributions are not adjusted for inflation, but the portfolio balance and the portfolio objective are adjusted for inflation at each year-end.

 

The first set of two scenarios assumes that the contribution level is steady, with the investor relying more heavily on the markets to achieve the target. Simply increasing the contribution by 5% each year ($5,250 in year 2, $5,512 in year 3, etc.) or 10% per year significantly shortens the time needed to meet the $500,000 objective. Note that getting an 8% return while increasing savings by 5% a year produces almost the same result as getting a 4% return while boosting savings by 10% a year. In real-world terms, the big difference in those two scenarios is risk: An investor pursuing an 8% long-term return would most likely be forced to take on much more market risk than someone looking for 4%.

Four principles

This reinforces the idea that a higher contribution rate can be a more powerful and reliable contributor to wealth accumulation than trying for higher returns by increasing the risk exposures in a portfolio.

The key take-away

Because investing evokes emotion, even sophisticated investors should arm themselves with a long-term perspective and a disciplined approach. Abandoning a planned investment strategy can be costly, and research has shown that some of the most significant derailers are behavioral: the failure to rebalance, the allure of market-timing, and the temptation to chase performance.

Far more dependable than the markets is a program of steady saving. Making regular contributions to a portfolio, and increasing them over time, can have a surprisingly powerful impact on long-term results.

 

1. An investor's performance, of course, is influenced not only by the timing of cash flows but also by the return of the investments themselves.
2. It is also essential to control costs—another cornerstone of Vanguard's investment philosophy. The time horizon may or may not be within the investor's control.

 

Notes:

  • All investing is subject to risk, including possible loss of principal.
  • Past performance does not guarantee future results.
  • There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Diversification does not ensure a profit or protect against a loss in a declining market.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments. High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
  • Prices of mid- and small-capitalization stocks often fluctuate more than those of large-company stocks.
  • Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
  • The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
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