It’s old news that managing expectations is usually the main challenge in finding success with an investment strategy. To paraphrase Pogo in the quest to earn a respectable return through time, we’ve met the enemy of prudent behavior and he is us. Less obvious is the tendency for this behavioral risk to go to extremes early on in the period immediately following the establishment of a new investment. By comparison, a decade or more into the holding period — assuming you make it that far — is relatively safe from a behavioral perspective.
The probability of getting whipsawed is high, in other words, soon after you deploy capital anew to a mutual fund, ETF or portfolio strategy. Therein lies the biggest risk that an investor will abandon a strategy in wake of steep short-term losses — or assume that unsustainably high performance early on is the norm. Either way, early impressions can be and probably will be misleading, which can lay the groundwork for trouble later on in the crucial task of managing expectations.
To hang some hard numbers on this issue let’s consider how performance varies across an expanding time horizon for three mutual funds representing the US stocks market, US investment-grade bonds, and a widely respected multi-asset class fund of funds:
Vanguard 500 Index Investor (VFINX)
Vanguard Total Bond Market (VBMFX)
Vanguard STAR (VGSTX)
In the first example, January 31, 1990, is the start date. The return is annualized in the first subsequent month, then for the first two months, then for three months, and so on. By the end of the time window, we’ll have an annualized return that reflects the entire 28-year-plus holding period.
The main takeaway is that performance is extremely volatile in the first few months or even years. As time passes, returns settle down and become contained within a relatively narrow band that’s usually more or less in line with the asset’s long-run projections. The lesson is that the rationale for an asset or strategy isn’t likely to deliver real-world confirmation of the return projections until well after the initial investment. As a result, the preliminary holding period will probably be noise in terms of the returns (or losses).
