Could You Stomach the Perfect Investment?

CA - 2016-2-5 - Perfect investmentSuppose a mutual fund knew for sure which 10% of the largest U.S. companies would earn the highest returns over the next five years, over each upcoming five-year period. You’d invest in that fund and hang tight, right?

A research company called Alpha Architect recently posed this as an interesting thought experiment. It divided all of the 500 largest U.S. stocks into deciles, and imagined that a hypothetical fund was investing in only the upper 10% returning stocks in the first five-year period, starting on January 1, 1927, and every five years it would switch the portfolio to the future top 10% of all stocks. (Hindsight makes it a lot easier to model what would happen if we were blessed with perfect foresight.)

Okay, so now you’re invested, and if you could have bought and held this magical fund, then at the end of the year 2009, you’d have earned just under 29% a year. What could be easier?

But, not knowing that this fund had a workable crystal ball, would you have held on while it was experiencing a 75.96% downturn during a particularly bad bear market starting in 1929? Or might you have been tempted to bail to safer bonds at some point during that catastrophe? This perfect fund fell more than 44% during a one-year period starting at the end of March, 1937, and overall it experienced drops of 20% or more nine times during your holding period—plus an additional 19% draw down that took it within a whisker of bear market territory.

Some of the times when you might have been sorely tempted to jump ship: the 2000-2001 downturn, when your marvelous fund lost 34% while the S&P 500 was only down 21%. Or a precipitous 22.11% downturn starting at the end of 1974, when the S&P 500 was gaining 19.94%. Or the 19.91% drop from the end of September through the end of November 2002, at a time when the S&P 500 was sailing along with a 15.28% positive return. The long-term returns were terrific, but it took a lot of stomach to hold on for the full ride.

The authors also looked at an even more marvelous manager, who not only bought only the 10% of stocks that would go up the most in the subsequent five years, but also shorted the 10% of stocks that would experience the worst 5-year performance. The mechanics of this fund are a little more complicated, but the results were even more dramatic: the fund experienced enormous losses at times when the S&P 500 was experiencing gains—as you can see from the accompanying chart, which shows this perfect fund’s biggest losses compared with S&P 500 returns during the same period. You really had to be intrepid to hold on and claim the fund’s remarkable 39.74% annualized returns.

The point? The authors say that even if God (who presumably has perfect foresight) were running a mutual fund, He would have lost a lot of investors who lost faith in His management skill during those times when the markets experienced rough patches. It’s fundamentally a lesson in humility and patience; great long-term track records are not immune from pullbacks, and our all-too-human tendency is to lose faith in the face of adversity.

Source:

Even God Would Get Fired as an Active Investor

 

About Objectively Speaking

Tom Batterman, founder of Vigil Trust & Financial Advocacy and Financial Fiduciaries, LLC is in the business of representing the best financial interests of his clients. Having provided objective, fee-only financial management services for over two decades, he specializes in managing the investment and related financial affairs of individuals and mutual insurance companies who do not have the time, interest or expertise to manage such matters on their own. As an objective, unbiased professional who takes on a fiduciary responsibility to his clients, he guides clients to the financial decisions they would make themselves if they had years of training and experience and the time and expertise to fully research and understand all of their options. Founded in 2010 as an outgrowth of Vigil Trust & Financial Advocacy, Financial Fiduciaries, LLC is a financial management solution for individuals and mutual insurance companies who recognize they do not have the time, interest or expertise to properly attend to their financial matters on their own. While there are many financial “advisors”, most of them have investment products to sell and the “advice” they provide is geared toward getting their clients to engage in a purchase. As one of the rare subset of advisors known as “fiduciary advisors”, Financial Fiduciaries does not sell any investment product so its guidance is not compromised by conflicts of interest which plague ordinary advisors. Prior to his employment in the financial industry in financial advocacy and trust positions, he worked at a private law practice in the Wausau area in the areas of estate planning, tax, retirement planning, corporate organizations and real estate. He is a graduate of the University of Wisconsin-Madison and the UW-Madison Law School and has during his career held Series 7, 24 and 65 securities licenses. A longtime resident of the Wausau, Wisconsin Area, Tom is active in the community. He enjoys golf, curling, skiing, fishing, traveling and spending time with his family.
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