Thanks for your answers! I think I’ll probably stick with broad indexes, since as you said investing in factors and managed futures can dramatically underperform the broader market in short time horizons and it will be hard to convince myself that it’s a good idea to hold onto them. (This actually happened to me recently. I found a small factor-based investment in my portfolio, saw that it underperformed and couldn’t remember the original reason for buying it, so I sold it. Oh, it was also because I needed to raise cash to buy puts and that investment had the lowest or negative capital gains.)
My biggest question currently is about international equities. Looking at historical data it seems that international equities have underperformed (had worse Sharpe ratio than) the US while being strongly correlated with it in recent decades (which made me want to have 9:1 ratio of US to international exposure, as I said in the above FB thread), but a source you cited is predicting much better performance in the future, to the extent that they’re recommending 0% exposure to US equities(!) and mostly EM exposure which is super surprising to me. Can you summarize or link to a summary of why they think that?
What distinguishes those from other, similar-looking opportunities that failed?
I don’t have a good answer for this. Basically those opportunities just kind of came to me, and I haven’t really had to do much to try to filter out other, similar-looking but actually less promising opportunities. I think I just thought about each opportunity for a few days and invested after still thinking it was a good idea.
Have you made any special investments that didn’t pan out?
During the dot-com bubble I tried stock picking, which didn’t work out. Recently I put some time/reputation (but no money) into a cryptocurrency startup which didn’t go anywhere. I can’t recall anything else. But there was another investment that did work out in the 10-100x range that I haven’t mention yet, which is that shortly after college I took a year off from work to write a piece of software (Windows SSH server, which didn’t exist on the market when I started), then handed it to a partner to develop/sell/manage (while I went back to work for another company) and within about 5 years it started throwing off enough income that I could “retire”.
ETA: Oh, I also worked at a couple of startups that compensated partly in stock options that later became worthless.
RE international equities, I wrote about this here to explain why I think most people should underweight US equities.
Looking at historical data it seems that international equities have underperformed
First, if EMH is true, there is no reason to expect US equities to have a higher Sharpe ratio than international equities.
Second, US outperformance is only a recent phenomenon (see this tweet and its replies), and the outperformance is pretty marginal if you look over a long time horizon.
Third, the recent US outperformance is the exact reason why Research Affiliates (RAFI) projects worse returns in the future. The US stock market has outpaced its economic growth, so RAFI is counting on valuations to revert to the mean. There’s a lot of historical evidence that markets tend to mean revert like this over sufficiently long time horizons (3-5 years or longer). I haven’t read any of the primary research on long-term mean reversion, but apparently the original source was Jegadeesh and Titman (1993), and data is available from the Ken French Data Library (see “6 Portfolios Formed on Size and Long-Term Reversal”).
(I cited RAFI for expected return projections, but the analysis is pretty easy to replicate. Just use the discounted dividend model and add in an assumption that P/E ratios will partially mean revert.)
I don’t see where RAFI recommends holding 0% exposure to US equities?
RE international equities, I wrote about this here to explain why I think most people should underweight US equities.
A large part of your argument is that one’s salaries come from a US source, which doesn’t apply to me (the company that provides most of my income has a pretty international revenue source). Also, as I mentioned in the FB thread linked above, US and international equities have become highly correlated in recent decades so using international equities to provide diversification against US economy tanking will not have much effect.
First, if EMH is true, there is no reason to expect US equities to have a higher Sharpe ratio than international equities.
EMH probably isn’t true across national boundaries, due to “equity home bias”. The US could have a higher Sharpe ratio because of that in combination with things like lower savings rate (higher time preference), better monetary policies (or more cost-effective policies due to reserve currency status), better governance (it seems terrible to me but perhaps still better than most other countries?), sole superpower status (allowing its companies to extract rent across the global with fewer political consequences), etc.
Second, US outperformance is only a recent phenomenon (see this tweet and its replies), and the outperformance is pretty marginal if you look over a long time horizon.
The tweet says outperformance was after 2009, so I asked Portfolio Visualizer to maximize Sharpe ratio based on pre-2009 data, and it says to allocate 8.31% to “Global ex-US Stock Market”, but that drops to 0% if I allow it to include “Total US Bond Market” (in which case it says 11% US stocks 89% US bonds). If I also add “Global Bonds (Unhedged)” it says to include 4.38% of that but still 0% of international equities.
add in an assumption that P/E ratios will partially mean revert
“This expensing of intangibles, leading to their absence from book values, started to have a major effect on financial data (book values, earnings) from the late 1980s, due to the growth of corporate investment in intangibles,” they wrote. Speaking to II, Lev explains that this “madness of accounting” has dragged down the performance of value investors ever since.
“All the important investments like R&D and IT are immediately expensed, and people are left with highly misleading ideas about profitability and about value,” he says. “Especially with respect to small companies and medium companies that are not followed by a lot of financial analysts and not written up by the media, people rely on the financial reports. And they are terrible.”
I don’t see where RAFI recommends holding 0% exposure to US equities?
I think it’s pretty dangerous to reason “asset X has outperformed recently, so I expect it to outperform in the future.” An asset can outperform because it’s becoming more expensive, which I think is partly the case here.
This is most obvious in the case of bonds—if 30-year bonds from A are yielding 2%/year and then fall to 1.5%/year over a decade, while 30-year bonds from B are yielding 2%/year and stay at 2%/year, then it will look like the bonds from A are performing about twice as well over the decade. But this is a very bad reason to invest in A. It’s anti-inductive not only because of EMH but for the very simple reason that return chasing leads you to buy high and sell low.
This is less straightforward with equities because earnings accounting is (much) less transparent than bond yields, but I think it’s a reasonable first pass guess about what’s going on (combined with some legitimate update about people becoming more pessimistic about corporate performance/governance/accounting outside of the US). Would be interested in any data contradicting this picture.
I do think that international equities will do worse than US equities after controlling for on-paper earnings. But they have significantly higher on-paper earnings, and I don’t really see how to take a bet about which of these effects is larger without getting into way more nitty gritty about exactly what mistake we think which investors are making. If I had to guess I’d bet that US markets are salient to investors in many countries and their recent outperformance has made many people overweight them, so that they will very slightly underperform. But I’d be super interested in good empirical evidence on this front too.
(The RAFI estimates generally look a bit unreasonable to me, and I don’t know of an empirical track record or convincing analysis that would make me like them more.)
I personally just hold the market portfolio. So I’m guaranteed to outperform the average of you and Michael Dickens, though I’m not sure which one of you is going to do better than me and which one is going to do worse.
Thanks for engaging on this. I’ve been having trouble making up my mind about international equities, which is delaying my plan to leverage up (while hedging due to current market conditions), and it really helps to have someone argue the other side to make sure I’m not missing something.
This is most obvious in the case of bonds—if 30-year bonds from A are yielding 2%/year and then fall to 1.5%/year over a decade, while 30-year bonds from B are yielding 2%/year and stay at 2%/year, then it will look like the bonds from A are performing about twice as well over the decade. But this is a very bad reason to invest in A. It’s anti-inductive not only because of EMH but for the very simple reason that return chasing leads you to buy high and sell low.
Assuming EMH, A’s yield would only have fallen if it has become less risky, so buying A isn’t actually bad, unless also buying B provides diversification benefits. Applying this to stocks, we can say that under EMH buying only US stocks has no downsides unless international equities provide diversification benefits, and since they have been highly correlated in recent decades (after about 1990) we lose very little by buying only US stocks.
Of course in the long run this high correlation between US and international equities can’t last forever, but it seems to change slowly enough over time that I can just diversify into international equities when it looks like they’ve started to decorrelate.
If I had to guess I’d bet that US markets are salient to investors in many countries and their recent outperformance has made many people overweight them, so that they will very slightly underperform. But I’d be super interested in good empirical evidence on this front too.
US stock is 35% owned by non-US investors as of 2018 and had been going up recently. Meantime non-US stock is probably >90% owned by non-US investors (not sure how to find the data directly, but US investors only have 10% international equities in their stock portfolio). My interpretation is that non-US investors are still under-weighing US stocks but have reduced their bias recently and this contributed to US outperformance, and the trend can continue for a while longer before petering out.
A lot of my thinking here comes from observing that people in places like China have much higher savings rates, but it’s a big hassle at best for them to invest in US stocks (due to anti-money laundering and tax laws) and many have just never even thought in that direction, so international investment opportunities have been exhausted to a greater degree than US ones, and the data seems consistent with this.
Let me know if the above convinces you to move in my direction. If not, I might move to a 4:1 ratio of US to international equities exposure instead of 9:1.
I personally just hold the market portfolio.
BTW while looking for data, I came across this article which seems relevant here, although I’m not totally sure their reasoning is correct. I’m confused about how to reason about “market portfolio” or “properly balanced portfolio” in a world with strong “home bias” and “controlling shareholders”.
But in Corporate Governance and the Home Bias (NBER Working Paper No. 8680), authors Lee Pinkowitz, Rene Stulz, and Rohan Williamson assert that at least some of the oft-noted tilt is not a bias at all but simply a reflection of the fact that a sizeable number of shares worldwide are not for sale to the average investor. They find that comparisons of U.S. portfolios to the world market for equities have failed to consider that the “controlling shareholders” who dominate many a foreign corporation do not make their substantial holdings available for normal trading.
Take this into account, the authors argue, and as much as half of the home bias disappears. A more accurate assessment of globally available shares, they say, would show that about 67 percent of a properly balanced U.S. portfolio would be invested in U.S. companies.
I’m surprised by (and suspicious of) the claim about so many more international shares being non-tradeable, but it would change my view.
I would guess the savings rate thing is relatively small compared to the fact that a much larger fraction of US GDP is inevestable in the stock market—the US is 20-25% of GDP, but the US is 40% of total stock market capitalization and I think US corporate profits are also ballpark 40% of all publicly traded corporate profits. So if everyone saved the same amount and invested in their home country, US equities would be too cheap.
I agree that under EMH the two bonds A and B are basically the same, so it’s neutral. But it’s a prima facie reason that A is going to perform worse (not a prima facie reason it will perform better) and it’s now pretty murky whether the market is going to err one way or the other.
I’m still pretty skeptical of US equities outperforming, but I’ll think about it more.
I haven’t thought about the diversification point that much. I don’t think that you can just use the empirical daily correlations for the purpose of estimating this, but maybe you can (until you observe them coming apart). It’s hard to see how you can be so uncertain about the relative performance of A and B, but still think they are virtually perfectly correlated (but again, that may just be a misleading intuition). I’m going to spend a bit of time with historical data to get a feel for this sometime and will postpone judgment until after doing that.
Thanks for your answers! I think I’ll probably stick with broad indexes, since as you said investing in factors and managed futures can dramatically underperform the broader market in short time horizons and it will be hard to convince myself that it’s a good idea to hold onto them. (This actually happened to me recently. I found a small factor-based investment in my portfolio, saw that it underperformed and couldn’t remember the original reason for buying it, so I sold it. Oh, it was also because I needed to raise cash to buy puts and that investment had the lowest or negative capital gains.)
Some discussions I’ve had on Facebook recently (after writing my question here) that you may find interesting: international equities, cheap leverage, dynamic leverage, bonds, bankruptcy risk
My biggest question currently is about international equities. Looking at historical data it seems that international equities have underperformed (had worse Sharpe ratio than) the US while being strongly correlated with it in recent decades (which made me want to have 9:1 ratio of US to international exposure, as I said in the above FB thread), but a source you cited is predicting much better performance in the future, to the extent that they’re recommending 0% exposure to US equities(!) and mostly EM exposure which is super surprising to me. Can you summarize or link to a summary of why they think that?
I don’t have a good answer for this. Basically those opportunities just kind of came to me, and I haven’t really had to do much to try to filter out other, similar-looking but actually less promising opportunities. I think I just thought about each opportunity for a few days and invested after still thinking it was a good idea.
During the dot-com bubble I tried stock picking, which didn’t work out. Recently I put some time/reputation (but no money) into a cryptocurrency startup which didn’t go anywhere. I can’t recall anything else. But there was another investment that did work out in the 10-100x range that I haven’t mention yet, which is that shortly after college I took a year off from work to write a piece of software (Windows SSH server, which didn’t exist on the market when I started), then handed it to a partner to develop/sell/manage (while I went back to work for another company) and within about 5 years it started throwing off enough income that I could “retire”.
ETA: Oh, I also worked at a couple of startups that compensated partly in stock options that later became worthless.
RE international equities, I wrote about this here to explain why I think most people should underweight US equities.
First, if EMH is true, there is no reason to expect US equities to have a higher Sharpe ratio than international equities.
Second, US outperformance is only a recent phenomenon (see this tweet and its replies), and the outperformance is pretty marginal if you look over a long time horizon.
Third, the recent US outperformance is the exact reason why Research Affiliates (RAFI) projects worse returns in the future. The US stock market has outpaced its economic growth, so RAFI is counting on valuations to revert to the mean. There’s a lot of historical evidence that markets tend to mean revert like this over sufficiently long time horizons (3-5 years or longer). I haven’t read any of the primary research on long-term mean reversion, but apparently the original source was Jegadeesh and Titman (1993), and data is available from the Ken French Data Library (see “6 Portfolios Formed on Size and Long-Term Reversal”).
(I cited RAFI for expected return projections, but the analysis is pretty easy to replicate. Just use the discounted dividend model and add in an assumption that P/E ratios will partially mean revert.)
I don’t see where RAFI recommends holding 0% exposure to US equities?
A large part of your argument is that one’s salaries come from a US source, which doesn’t apply to me (the company that provides most of my income has a pretty international revenue source). Also, as I mentioned in the FB thread linked above, US and international equities have become highly correlated in recent decades so using international equities to provide diversification against US economy tanking will not have much effect.
EMH probably isn’t true across national boundaries, due to “equity home bias”. The US could have a higher Sharpe ratio because of that in combination with things like lower savings rate (higher time preference), better monetary policies (or more cost-effective policies due to reserve currency status), better governance (it seems terrible to me but perhaps still better than most other countries?), sole superpower status (allowing its companies to extract rent across the global with fewer political consequences), etc.
The tweet says outperformance was after 2009, so I asked Portfolio Visualizer to maximize Sharpe ratio based on pre-2009 data, and it says to allocate 8.31% to “Global ex-US Stock Market”, but that drops to 0% if I allow it to include “Total US Bond Market” (in which case it says 11% US stocks 89% US bonds). If I also add “Global Bonds (Unhedged)” it says to include 4.38% of that but still 0% of international equities.
From https://www.institutionalinvestor.com/article/b1j0mvcy9792vt/Why-Value-Investing-Sucks:
“This expensing of intangibles, leading to their absence from book values, started to have a major effect on financial data (book values, earnings) from the late 1980s, due to the growth of corporate investment in intangibles,” they wrote. Speaking to II, Lev explains that this “madness of accounting” has dragged down the performance of value investors ever since.
“All the important investments like R&D and IT are immediately expensed, and people are left with highly misleading ideas about profitability and about value,” he says. “Especially with respect to small companies and medium companies that are not followed by a lot of financial analysts and not written up by the media, people rely on the financial reports. And they are terrible.”
On https://interactive.researchaffiliates.com/asset-allocation#!/?category=Efficient¤cy=USD&model=ER&scale=LINEAR&selected=160&terms=REAL&type=Portfolios, on the left side-bar click on “Efficient” to expand it, click on “14.0% Volatility” or any other one there, on the right side-bar click on “Equities” to expand it, and it says 0.0% for “US Large” and “US Small”.
I think it’s pretty dangerous to reason “asset X has outperformed recently, so I expect it to outperform in the future.” An asset can outperform because it’s becoming more expensive, which I think is partly the case here.
This is most obvious in the case of bonds—if 30-year bonds from A are yielding 2%/year and then fall to 1.5%/year over a decade, while 30-year bonds from B are yielding 2%/year and stay at 2%/year, then it will look like the bonds from A are performing about twice as well over the decade. But this is a very bad reason to invest in A. It’s anti-inductive not only because of EMH but for the very simple reason that return chasing leads you to buy high and sell low.
This is less straightforward with equities because earnings accounting is (much) less transparent than bond yields, but I think it’s a reasonable first pass guess about what’s going on (combined with some legitimate update about people becoming more pessimistic about corporate performance/governance/accounting outside of the US). Would be interested in any data contradicting this picture.
I do think that international equities will do worse than US equities after controlling for on-paper earnings. But they have significantly higher on-paper earnings, and I don’t really see how to take a bet about which of these effects is larger without getting into way more nitty gritty about exactly what mistake we think which investors are making. If I had to guess I’d bet that US markets are salient to investors in many countries and their recent outperformance has made many people overweight them, so that they will very slightly underperform. But I’d be super interested in good empirical evidence on this front too.
(The RAFI estimates generally look a bit unreasonable to me, and I don’t know of an empirical track record or convincing analysis that would make me like them more.)
I personally just hold the market portfolio. So I’m guaranteed to outperform the average of you and Michael Dickens, though I’m not sure which one of you is going to do better than me and which one is going to do worse.
Thanks for engaging on this. I’ve been having trouble making up my mind about international equities, which is delaying my plan to leverage up (while hedging due to current market conditions), and it really helps to have someone argue the other side to make sure I’m not missing something.
Assuming EMH, A’s yield would only have fallen if it has become less risky, so buying A isn’t actually bad, unless also buying B provides diversification benefits. Applying this to stocks, we can say that under EMH buying only US stocks has no downsides unless international equities provide diversification benefits, and since they have been highly correlated in recent decades (after about 1990) we lose very little by buying only US stocks.
Of course in the long run this high correlation between US and international equities can’t last forever, but it seems to change slowly enough over time that I can just diversify into international equities when it looks like they’ve started to decorrelate.
US stock is 35% owned by non-US investors as of 2018 and had been going up recently. Meantime non-US stock is probably >90% owned by non-US investors (not sure how to find the data directly, but US investors only have 10% international equities in their stock portfolio). My interpretation is that non-US investors are still under-weighing US stocks but have reduced their bias recently and this contributed to US outperformance, and the trend can continue for a while longer before petering out.
A lot of my thinking here comes from observing that people in places like China have much higher savings rates, but it’s a big hassle at best for them to invest in US stocks (due to anti-money laundering and tax laws) and many have just never even thought in that direction, so international investment opportunities have been exhausted to a greater degree than US ones, and the data seems consistent with this.
Let me know if the above convinces you to move in my direction. If not, I might move to a 4:1 ratio of US to international equities exposure instead of 9:1.
BTW while looking for data, I came across this article which seems relevant here, although I’m not totally sure their reasoning is correct. I’m confused about how to reason about “market portfolio” or “properly balanced portfolio” in a world with strong “home bias” and “controlling shareholders”.
I’m surprised by (and suspicious of) the claim about so many more international shares being non-tradeable, but it would change my view.
I would guess the savings rate thing is relatively small compared to the fact that a much larger fraction of US GDP is inevestable in the stock market—the US is 20-25% of GDP, but the US is 40% of total stock market capitalization and I think US corporate profits are also ballpark 40% of all publicly traded corporate profits. So if everyone saved the same amount and invested in their home country, US equities would be too cheap.
I agree that under EMH the two bonds A and B are basically the same, so it’s neutral. But it’s a prima facie reason that A is going to perform worse (not a prima facie reason it will perform better) and it’s now pretty murky whether the market is going to err one way or the other.
I’m still pretty skeptical of US equities outperforming, but I’ll think about it more.
I haven’t thought about the diversification point that much. I don’t think that you can just use the empirical daily correlations for the purpose of estimating this, but maybe you can (until you observe them coming apart). It’s hard to see how you can be so uncertain about the relative performance of A and B, but still think they are virtually perfectly correlated (but again, that may just be a misleading intuition). I’m going to spend a bit of time with historical data to get a feel for this sometime and will postpone judgment until after doing that.
The Institutional Investor hyperlink is broken. Here’s one that works: https://www.institutionalinvestor.com/article/b1j0mvcy9792vt/Why-Value-Investing-Sucks