For some time now I have wanted to address a really important subject head on:
The importance of VOLATILITY ADJUSTED returns.
If you have been following all things Plain English Finance for a while, you will know that we have our own investment fund – the VT PEF Global Multi Asset Fund (VT PEF GMAF). The back-tested annualised performance of that strategy was an average of 7.52% a year for the 16.5 years between January 2001 and August 2017 (the month before we launched the actual fund and our performance numbers went from being simulated / back-tested to being real).
The annualised rate of return in the real world in the three years since we launched is -1.9% (from 1st of October 2017 to the 30th of September 2020). More about this below...
"But I can make 7.5% a week"
When we launched the fund, in late September 2017, the bitcoin and crypto bubble was near its peak. Our back-tested performance numbers suggested we might aspire to returning about 7.5% a year as I say. I remember all too well the number of people at the time who said things like:
“…but I can make 7.5% a week in crypto.”
“I can easily make ten times that in crypto” – (i.e. 75%!)
It was a frustrating feature of a market gone mad. Back then and still now, people in the crypto world (and lots of other people busy trying to trade their spread-betting accounts) have a tendency to cite point to point price moves as performance numbers, as in:
“Look. If you’d bought bitcoin (or ether, or cardano or sexy tech stock ‘x’) on date ‘y’ when it was trading at price ‘£z’ you would have made ten (or twenty or fifty or one hundred) times your money blah blah blah… You could be a millionaire by now, blah blah blah…”
The trouble is that investment returns just don’t actually work like this in the real world – i.e. in the world of trying to grow your actual wealth over time. The reason for this is in large part due to a little something called “volatility”.
Why Volatility is SO important to investment
The “fact” that any asset price has moved from point ‘x’ to point ‘y’ over a certain amount of time is only of relevance to your ability to make money if you bought that asset at point ‘x’ and, crucially, sold it at point ‘y’.
If a certain asset travels from £1 to £100 over a period of time, say a few years – and does so slowly and surely in a straight line then you have quite a high chance of making significant positive returns. Perhaps you missed it at £1 but then bought it at, say, £20, £30, £40 or £50. If it is now at £100 – those are all still great results for you as an investor.
But what if during the journey from £1 to £100 that asset has been massively volatile? What if it has often gone up and down by tens of percent – sometimes even just during the course of one day? What if it peaked at £200 before coming back down to £100?
When this is the case – there is a very high chance, statistically, that you will lose money in that asset. You might have bought it at £190 for example – and now be down nearly 50% on your investment. Perhaps you bought it at £80 a few months ago, but sold it at £20 when it cratered because you were worried at that point it might be on its way back to £1. Even though the asset is up rather wonderfully from £1 to £100 (which is of course “a fact”), back in the real world you have actually lost 75% of your money. Your £10,000 is now £2,500 perhaps. Even worse: You have just endured the horrible experience of that asset zooming all the way back from £20 to £100. You have locked in a massive loss and sat on the side-lines watching the thing you sold at £20 go up five times thereafter.
…and this introduces the first of two really key considerations when it comes to thinking about how important the volatility of a given asset is:
- Human psychology.
- Something called "The break-even fallacy".
Human psychology – we are hard-wired for failure
As I have written on numerous occasions in the past, we human beings are quite literally hard-wired psychologically to be bad investors. The way our brains work hugely increases the likelihood that we will buy high and sell low. When we see an asset going up and “lots of people making money”, there is a high chance we will rush to buy it given how strong our FOMO (Fear Of Missing Out) is. When we then see it plummet, there is an equally high chance we will rush to sell it as we panic. This is gilt-edged human nature.
It is for this reason that point-to-point assessments of what a highly volatile asset may or may not have done (invariably over a robustly cherry-picked time frame) are of almost no analytical use whatsoever in working out whether someone is likely to actually make money from that asset.
(This is why the UK financial regulator - the FCA - imposes such strict rules about how performance numbers are calculated and presented when it comes to companies which function in the regulated space. These are rules that unregulated folks don't have to even think about - hence why they are able to spend so much time cherry-picking largely meaningless point to point price movements or only present good years whilst ignoring any inconveniently bad ones. A sad state of affairs if you ask me, but I digress...).
The simple fact is that if something goes up and down a great deal, our inbuilt psychological biases make it highly likely we will lose money in that thing.
The break-even fallacy
The fact that our brain is destined to buy high and sell low is bad enough, but there is a second consideration that means that the impact of volatility on your real-life ability to make money is actually even worse! This is something called “the break-even fallacy” which vanishingly few people understand (in my experience).
The break-even fallacy is all about how maths works at the most fundamental level when it comes to calculating percentage returns. It is the arithmetic fact that a higher percentage return is required to get back to break even than was suffered when an asset originally fell in price to that level.
If this sounds a bit complicated, hopefully the table below will help explain.
As you can see from the above – if something you own falls 50%. You will then need it to go up 100% to get back to where you started (not 50%). As I say - the phenomenon shown in this table is poorly understood by the general population. Many people naturally assume that if you lose 50% of your money, for example, you will then need to gain 50% to get back to square one. This is incorrect. If you are down 50%, you will need to make 100% to recover that loss. If you are down 25%, you will need to make 33%, if you suffer a 90% fall, you’d need that thing to go back up 900% and at 95% - you would need to be lucky enough to see no less than a 1,900% recovery!
It is extremely important to understand this. If you have £10,000 in bitcoin or, say, £100,000 in your pension or investment account, and you are unlucky enough to see a 50% fall in the value of your position (as people so often do in crashes), you will end up with £5,000 or £50,000. To get back to your original £10,000 or £100,000, you will then need to make a 100% return, NOT a 50% return.
This is why Warren Buffett, arguably the world’s greatest living investor, has said about investment:
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”
The Tortoise Beats the Hare
It is for this reason that the number one focus of any experienced investment professional is on VOLATILITY ADJUSTED returns – not on returns alone.
The better the volatility adjusted return of an asset, the higher the “quality” of those returns because, very simply, the more likely you are to actually make money from that asset in the real world.
Volatility adjusted return is quite literally the “holy grail” of investment.
Hence the headline for this article. It really is entirely possible for a low-volatility asset to make ten times lower a return than another asset over the period of, say, one year but for you to get a better result from that “tortoise” asset than from the “hare” asset over the course of your investing lifetime.
In fact, the reality is even stronger than that. It is actually PROBABLE that this will be the case, rather than POSSIBLE.
This is something that sophisticated (and invariably higher net worth) investors understand, and all those people who have just decided to become day-traders on platforms like Robin Hood or in the crypto or FX world invariably don’t.
Over a lifetime of investment, you are far more likely to see your money grow in lower volatility assets than in higher volatility ones. It is also worth making the related point that the vast majority of people are far more likely to succeed as INVESTORS than they are as TRADERS as a result. I explain why this is in some detail in my new book.
Let’s see some evidence
As I said above, our fund has so far averaged minus 1.9% since we launched it three years ago. This has been frustrating for our investors – and for me too, seeing as I have the majority of my liquid net-worth held in my ISA and pension accounts in our fund.
Unsurprisingly, I have fielded my fair share of inbound comms from people asking about the “poor” performance. But I am genuinely more or less relaxed about how things have unfolded.
Below I have reproduced the annual performance numbers for our strategy. From 2001 to August 2017 (light blue), these numbers come from our back-testing – and from September the 1st 2017 to September the 30th 2020 – from our actual performance in the real world (dark blue). This is a period of nearly twenty years as you can see.
Please note: These performance are net of fees and costs. i.e. AFTER they have been accounted for. In the back-testing - the assumed costs were also some way higher than what we are paying in the real world - more on this below.
(Please note: Past performance is not a reliable indicator of future performance).
We have highlighted negative years in red and positive ones in green. People are concerned that the strategy has performed “poorly” since it launched. I would argue that it is actually doing precisely what it is designed to do.
As with any fund – ours is designed to do a specific job and to seek to deliver a specific outcome. I have explained above just how crucial volatility-adjusted returns are given the very real challenges of human psychology and the way the break-even fallacy works.
Because of these things, our fund is designed above all else to be defensive: To minimise volatility and to reduce maximum “draw down” – that is to say to minimise the most it might fall in a given time period from peak to trough.
So far, the fund has performed this function admirably. In 2018 it was down 6.4% versus the UK stock market that was down nearly 19%. Through the coronavirus crash earlier this year it achieved the same sort of result.
The price the strategy pays to achieve this aim is that there can be relatively long periods of indifferent performance. But this is the compromise we have to endure in order to deliver the longer run result of very significantly protecting the downside.
People are quite rightly concerned that the fund has gone “nowhere” for three years. The key point I would make, however, is that this has happened before (and will happen again). If you look at the table above, you can see that the strategy didn’t go anywhere from January 2001 until early 2003. It wasn’t exactly hugely exciting from late 2010 through 2011 either. This having been said, if you have a look at the table above – imagine you had owned it from early 2003 to the end of 2007. You would have been more than delighted – and that is putting it mildly.
Over the long run – the evidence is that the strategy may be able to do something that is actually pretty astonishing in the investment world:
It may be able to produce not far off equity market annual returns but with very significantly lower than equity market volatility and draw-down.
In plainer English – that is to say:
…stock-market returns but with much lower than stock-market risk.
Taken at face value, this should make it a remarkable long run investment strategy – even if the price you pay is that there can be quite long periods over the years where not much happens.
Zero Interest Rates
This is most particularly the case when you consider that interest rates are not far off zero (or even negative) at present. It has never been more important to aspire to make equity market returns given that you will earn essentially nothing from bonds and cash. In fact – it is worse than that. Because of real inflation – you are very likely guaranteed to be destroying your wealth in bonds or cash at present (I explain all about this in my first book).
But equities are risky and volatile. A strategy that gives you a shot at making those equity market returns but with far lower risk and volatility should be of real interest – to amateurs and professional investors alike.
You can see the evidence for this graphically in the graph below (taken from our Fund Overview document). Compare the light blue and green line at the top to the red line at the bottom. This is our strategy vs the UK stock market. Over the last twenty years our strategy is miles ahead of the stock market – notwithstanding those periods where it didn’t do much.
Because of the toxic combination of how human psychology works and the hugely damaging effect the break-even fallacy can have on your wealth, over a life time of investing it is very likely better to have the return profile of a strategy like ours than it is to just buy and hold “the stock market” or, even worse, attempt to trade.
In fact, the reality for most people is quite possibly even stronger than the above would suggest. Comparing the red line to our blue and green lines assumes that someone still owns what the red line represents of course. Given the human psychology point I have made above, far too many investors actually fail to do something as simple as buy and hold in the real world.
The red line is miles below the blue line, but the reality is that a decent percentage of people would have given up on investment entirely if they were on the "red line" journey. The evidence is that at some point (between 2007 and 2009 perhaps), many people will have given up on stock-market investment. They would then have locked in a big loss and will not have captured the long run upside of even the red line - a disastrous result all round. This is the reality for far too many people when they approach stock market investment – and this happens because of volatility.
The fact that the S&P and the Nasdaq have gone bananas in the last two years doesn’t change any of this. Don’t forget that the S&P fell nearly 40% in 2008 and the Nasdaq by more than 40%. When this happens, you erase a great deal of the progress made in the good years very quickly – even after a period as strong as we have had of late. This happens time after time. And time after time people forget and, towards the end of the cycle, get swept into nonsense and bubbles at the wrong price.
And, of course, if you are down 40%, the table above shows us that you will then need to make no less a return than 66.7% just to get back to square one. It is human nature to forget this reality every few years, particularly at times like this when the hare is running particularly fast (and is some way ahead of our “tortoise”).
I would repeat – this is why VOLATILITY-adjusted returns are so much more important for actually growing your wealth than return numbers alone. Truly.
A note on back testing
Of course, everything I have written is entirely self-serving given that I am a guy selling a fund product and I have a pretty robust commercial incentive to make this case. But this doesn’t change the fact that I believe in what I am saying after a twenty-year career in the City of London and far, far too much time spent reading investment books. This is why I have been willing to spend several thousand hours of my life and a significant proportion of my life savings to get what we are doing off the ground (and invest most of what was left of those savings in the fund of course!).
I believe our fund product could very well be able to deliver near equity market returns with far lower than equity market risk over the long run. So do Professors Andrew Clare and Steven Thomas with whom we built the strategy.
This having been said, I am willing to accept that I could be wrong. One of the most consistent criticisms we face (and from smart people) – is that all those great performance years which suggest the strategy might be so compelling come from the back-tested period. These are simulated numbers.
This criticism is certainly valid as is any criticism of back-tested or simulated numbers. That having been said there are a couple of things that give me reasonable confidence in our back-testing:
First – I would argue that our strategy lends itself to back-testing more than many, because it uses a fixed allocation to large, liquid assets – often entire markets. We are not, for example, claiming we would have bought Facebook one day and Apple the next day (optimised for the days that would have delivered superb performance of course). We are showing what would have happened in the real world, using strict, rules-based processes to invest in entire markets – (the full list of these is in our Fund Overview document – but it includes shares from all over the world, bonds in three major currencies, property funds, various commodities, gold and so forth. We are entirely transparent about what we seek to own).
Secondly - we have "prudently" used trading cost assumptions in our back-testing that are some way higher than what we pay in the real world. We have assumed 0.12% (12 “basis points” or “bps”). In the real world we pay 5 bps to trade.
"It's different this time."
The years since we launched have been unusual, without question. They have been characterised by not far of zero, even negative interest rates and a massive outperformance of US tech over and above almost everything else in the world (although gold has also done well thankfully, given my stance on that asset class). Even Ray Dalio, the guy who runs the world’s biggest hedge fund and who has delivered more absolute upside than any other hedge fund investor in history, was only up 0.5% in 2019.
Perhaps this means that our strategy won’t work anymore. But “mean reversion” is one of the most powerful forces in all things financial. That is to say that over the long run things tend to return to how they were before, and the phrase “it is different this time” is almost always wrong.
Our strategy only trades once a month. People have asked if perhaps we need to re-engineer it to trade more often given how markets are behaving “at the moment”. I shared this challenge with our Professors some months ago. Their strong conviction is that we should stick with the strategy as is. Trading more often might have helped us capture more upside earlier this year but their considered (and evidence-based opinion) is that this potential short-term benefit isn’t sufficient to compensate for the fact that this approach would inject more cost and volatility into the strategy longer term.
Our Professors have tested the effectiveness of the trend following approach we use all the way back to 1872. For more than a century it has delivered higher returns with lower risk. I see no reason that this won’t continue to be the case in the long run, even if the world of coronavirus, Trump, tech to the moon and crypto have made things a little unusual of late.
Of course – to really prove that our strategy works in the real world and not just with simulated past performance numbers, we do need to deliver a big “up” year. I made this point in an interview I did a few months ago (if you’re interested you can watch this video from around minute 37).
As I said in that interview – one thing that gives me confidence that we should be able to do this is the fact that, since the launch, the fund has protected the downside through a couple of very big crashes – just as it did in the back-testing. The behaviour has been spookily similar (compare the -6.4% result in 2018 versus the -6.3% in 2008 for example). (Please note: Past performance is not a reliable indicator of future performance).
If the fund can protect the downside in the real world very similarly to how it did in the back-testing I see no reason why the same won’t be true when it comes to capturing upside - eventually. It is also perhaps worth noting that the fund has now had six consecutive positive months since the CV-19 crash in the first quarter of this year.
Although we haven’t seen a big up year yet in the real world, we are quietly confident that we will given the appropriate market conditions – and these are conditions we are likely to experience at some point if the evidence of more than a century is anything to go by. Of course, the irony is that if we do have a +20% year, lots of people will rush to buy the fund at that point (20% higher than it was before). Such is human nature and there isn’t much that we can do about this.
Geoff Boycott and Aesop’s Tortoise
I have already referred to our fund as a “tortoise” in this piece. Everyone knows that the tortoise wins the race in the long run. The other analogy that may be instructive here (and one I have used before) is to refer to our approach as the “Geoff Boycott” of funds.
Cricket fans will know that Geoff Boycott was one of the most statistically successful batsmen in history. He did this by focusing on defence above all else. He was happy to endure a fair number of zeros and then only “hit sixes” when he was sufficiently confident that he wouldn’t get bowled out. This is philosophically very similar to our approach. Our fund tries above all else to avoid getting “bowled out” – which, in the investment world, would mean suffering a massive fall – with the result that you might then sell out of your position or, at the very least, would then need to make those huge returns to get back to square one because of the break-even fallacy as explained above.
We believe that our return profile is more likely to build real wealth over time than many other more volatile strategies even if we have yet to “hit a six”.
In many ways our strategy is more like a "savings plan" than a conventional fund. If you save and invest a certain amount every month without fail - you will build a significant sum over time, even when the fund “goes nowhere” - just as you would by saving money in a conventional savings account. The difference is, of course, that in the event that those big up years do then arrive, you will be making returns on all that capital, meaning that your long-run result should be a long way ahead of what you could have achieved in a cash ISA, current account or mattress.
100 minus your age
All of the above having been said, the other thing that I would point out is that we have never suggested our fund is a panacea or the only option. This is a matter of record. As I say near the beginning of my new book "Live on Less, Invest the Rest":
"As you will see as you read on, our fund is only one possible component of how you might approach your finances. Like any investment fund, it is designed to do a specific job and is therefore only relevant and “appropriate” for people who want that job done."
Our fund is a defensive and conservative approach. For folks who aspire to make higher returns, I have written extensively about how they might go about attempting to achieve that, and I have referenced numerous other fund products and assets (such as large equity indices, global funds, investment trusts, smaller companies, biotech and precious metals for example). Many of these assets have had stellar returns for some years now.
In my view - there are ways of juicing your returns over and above high single digits - particularly if you have some time left before you want to retire. Biotech, gold, tech and smaller companies have all had returns in the mid teens going back more than a decade. In my new book and in a five-article series which began with this one on our website, I set out what I believe to be a reasonably elegant way of seeking to capture such returns with a weather-eye on that all important volatility and risk. To do this, I explain the merits of using the idea of “100 minus your age” to work out how much you might allocate your money to “defensive” as against “aggressive” assets when you think about how to invest.
The basic thesis is that the percentage of your savings you hold in “aggressive” assets should be “100 minus your age”, with the rest being held in “defensive” assets. For example, if you are 30 then you might hold about 70% of your investible capital in “aggressive” assets and have 30% positioned more defensively. If you are 70, you should be positioned precisely the opposite to that: i.e. 70% “defensive” and 30% “aggressive”.
Our fund might form the “defensive” component of such an approach but I have provided numerous examples of other assets you might consider for the “aggressive” bit more or less frequently in all that I have written over the years.
Regular monthly investment
The other thing I have advocating for nearly ten years now – is the merit of regular monthly investment (ideally by direct debit). All other things being equal, investing every month smoothes your returns – that is to say, reduces volatility. Automation is also a way of taking our inherent psychological weaknesses out of the equation – which is yet another way to increase the likelihood that you succeed.
As an example – long-time readers will know that I have always suggested investing a meaningful percentage in gold. The price of gold today is only a little higher than where it last peaked in 2011 and 2013. If you had simply purchased a chunk of gold then – you wouldn’t have made much progress, and you would have spent most of the last decade underwater too. Anyone who has been buying it regularly every month over that time period, however, will more than likely have made great returns. This is a really key point.
The big-picture approach to investment that I present in "Live on Less, Invest the Rest" is a combination of using “100 minus your age” to think about broad asset allocation and regular monthly investment into the assets that you choose by virtue of using that thought process. We believe that our fund is very likely a great option for the defensive bit of that exercise or, indeed, for anyone who is particularly risk averse and doesn’t trust themselves to continue to hold more volatile assets for all the reasons I have explained above.
In my notes for this article there were a number of other subjects that I considered addressing but, as ever, I think this article is quite long enough for today. I will address certain other aspects of our fund and write about volatility-adjusted returns more generally another time (for example - how you actually measure volatility-adjusted returns by using some moderately sophisticated financial tools called "Sharpe" and "Sortino" ratios).
The only other thing I will say before signing off - is that if you are interested in learning more about all of this, then please do consider joining our online "How to Own the World Community". We believe that our live and interactive Community is the most effective tool to help you actually take action and take the steps required to implement the sorts of ideas I've outlined in this email. You also get free digital and audio versions of my new book when you join for what it is worth...
Plain English Finance Limited has used all reasonable efforts to ensure the accuracy of the information contained in this communication at the date of publication.
An English language prospectus for the VT PEF Global Multi-Asset Fund is available on request and via www.plainenglishfinance.co.uk/funds. Investors should read this document in conjunction with the fund's Key Investor Information Document and the relevant application form before purchasing shares in the fund. Full details of each of the risks and aims for the fund can be found in the Prospectus and the Key Investor Information Document which are available from us or from this website (plainenglishfinance.co.uk/funds).
Some of the figures in this financial promotion refer to simulated past performance. Simulated past performance and actual past performance are not reliable indicators of future results.
Past performance is not a reliable indicator of future performance. The value of investments and any income from them may fall as well as rise, the return may increase or decrease as a result of currency fluctuations, and you may not get back the amount of your original investment.
Plain English Finance Ltd. does not make any recommendations regarding the suitability of this product for you and the information provided should not be considered as investment or other advice or a recommendation to buy, sell or hold a particular investment. If you are in any doubt about the information in this article or our website please consult your financial or other professional adviser.