Week 32 Day 5: The 10-Year Rule: Judge Results, Not Feelings

Value investing underperformed growth investing from 2010-2020. Many people abandoned value strategies. Then value outperformed growth dramatically in 2021-2022. International stocks underperformed U.S. stocks for a decade (2010-2020). Many people went 100% U.S. Then international caught up in certain years. Switching strategies based on recent performance is a recipe for buying high and selling low.

Why 10 years is the minimum evaluation period: The S&P 500 has had positive 10-year returns in 95% of all rolling 10-year periods since 1926. But it has had positive 1-year returns in only 74% of years. The shorter your evaluation window, the more noise dominates the signal. Strategies that look terrible over 3 years but excellent over 10 years: Small-cap value: underperformed large-cap growth by 5%/year from 2017-2020, then outperformed by 20%+ in 2021-2022. Dividend investing (SCHD): trailed SPY badly in 2023 (+4% vs +26%) but has been competitive over 10-year periods. International stocks (VXUS): underperformed VTI from 2010-2019, but there have been prior decades (2000-2009) where international dramatically outperformed. The pattern: every strategy has periods of poor performance. Abandoning a sound strategy during its weak period and switching to whatever worked recently guarantees you will experience the WORST of both strategies: the old one's bad years and the new one's bad years (since you switched just when the old strategy was about to recover). The rule: do not evaluate any investment decision over a period shorter than 10 years. If your strategy has underperformed its benchmark over a full market cycle (10+ years) by more than its fee differential, then it may be time to reconsider.

The 10-year evaluation rule is grounded in the statistical properties of equity returns. Campbell (1991) decomposed stock returns into expected return and unexpected return components and showed that the unexpected component (noise) dominates at short horizons but the expected component (signal) dominates at long horizons. The signal-to-noise ratio of equity returns increases approximately with the square root of the horizon: S/N at 10 years is approximately 3.2x the S/N at 1 year. For factor premiums (value, size, quality, momentum), the signal-to-noise ratio is even worse at short horizons because factor premiums are smaller and more volatile than the market premium. Israel, Moskowitz, Scalable (2020) showed that the probability of a negative realized value premium (HML < 0) is approximately 40% over 1 year, 25% over 5 years, and 10% over 10 years -- meaning that even a 'true' premium appears to fail approximately 40% of the time over short evaluation windows. Switching away from a strategy after a short-period failure has been termed 'factor timing' or 'strategy rotation,' and Arnott, Beck, Kalesnik, and West (2016) showed that investors who chase recent factor performance (buying the recent best-performing factor and selling the worst) earn approximately 2-3% less per year than investors who maintain static factor exposures. The evidence strongly supports patient, long-horizon evaluation over reactive, short-horizon strategy switching.