The perfect portfolio may not look like what you think. A common fallacy is that good active equity funds should deliver consistently good short-term performance with smooth upward trending returns. Investors who believe this have unrealistic expectations and often dump good investments too quickly thereby losing out on great long-term returns.
In his article, Even God Would Get Fired as an Active Investor, Wesley R. Gray, PhD examined the performance of a perfect-foresight fund showing that even with a perfect ‘look-forward’ view, returns would be fabulous, but would also produce significant drawdowns.
TEN LARGEST DRAWDOWNS OF THE “PERFECT PORTFOLIO” VERSUS S&P 500 (1927 – 2009)
The construction of the fictitious perfect foresight fund is a simple rebalancing on July 1st every fifth year beginning 1/1/1927 through 12/31/2009. Each five-year period, there is a new selection of stocks for which there is 100% certainty they’ll be the best performing 500 stocks over that 5-year period. All returns are gross of transaction costs, taxes, and fees. Wesley Gray, February 2016.
The compounded annual growth rate for the “Perfect Portfolio” over the period 1/1/1927 through 12/31/2009 was 28.89% compared to 9.63% for the S&P 500 Index. While the returns are great, clients would also have to tolerate large drawdowns, the worst being -76%. In fact, this portfolio experienced many dramatic drawdowns over the measured period, the ten worst averaging -34%. In other words, an active manager who knew with perfect clairvoyance which stocks were going to be long-term winners would likely get fired because investors would not be able to stay invested through the downturns.
It is also important to note that downturns and recovery take time and therefore periods of poor performance can be long. Even with the “Perfect Portfolio,” three of its ten worst downturns extended for at least one year and the average duration of the ten worst drawdowns was roughly 10 months. This reinforces that great long-term returns come with drawdowns and periods of poor performance. Having realistic expectations about the unavoidable bumpy performance of active equity management is key to creating the patience necessary for long-term success.
From the Behavioral Viewpoint
What is going on?
- Volatile investment performance triggers what is known as loss aversion, with investment losses feeling twice as bad as the comparable gain feels good. This can lead to poor sell decisions prompted by short-term emotional pain, even if the investment objective is long-term growth.
- Investors suffer from the cognitive error known as representativeness bias, which leads to poor decisions by thinking that recent performance is representative of what it will be in the future.
- Doing “something” when a fund underperforms in the short-term gives an investor the sense they are in control of their financial situation, but often in reality they are falling prey to the fallacy of control. They blame the manager for the inevitable ups and downs that come with equity investing, and take control by firing them. Done repeatedly, this is a sure recipe for self-inflicted wounds and mounting losses.
What can we do?
- To help avoid poor decisions driven by loss aversion, be sure to have a long-term portfolio strategy with a disciplined approach to buying, assessing and selling investments. Give managers a minimum of 3 to 5 years and a full market cycle before evaluating them on performance.
- To discourage focusing on the recent performance of one particular investment, build a portfolio of 5-8 different strategies that are selected to perform well in different ways and in different market conditions.
- To help hold on during tough periods, take your eyes off the short-term numbers by using a qualitative assessment of the manager. Take the time to understand a manager’s investment strategy. This information will help by addressing important process questions such as: How do they go about making investments? Is the manager staying true to their strategy? How are market conditions impacting the strategy?
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