Let's not beat around the bush... You're probably not going to like what I have to say in today's issue.
But that's OK. Many of you need to hear it.
Even 'Perfect' Portfolios Experience Painful Losses
I'd like you to consider for a moment an interesting find made by the folks at AlphaArchitect, a prominent "robo-advisor" firm. (A robo-advisor is an online wealth management firm that uses complex algorithms to custom design portfolios for clients.)
The question: If you were God, could you create a hedge fund so good that you would never get fired?
The study assumes you are able to know the returns for all stocks in the S&P 500 for the next five years ahead of time. This level of omniscience comes with a catch, though. You have to hold your positions for the entire five-year duration. Only then can you rebalance the portfolio by selling those positions and buying the best performers of the next five years ahead of time.
Sounds like the ultimate hedge fund, right? I mean, you already know what the best performing stocks are going to be...
So the study analyzed the returns for each rolling five-year period from 1927 to 2009. Here are the results:
Now, don't worry about some of the terms in this table you might not understand. The point is, the portfolio delivered an impressive return. A compound annual growth rate (CAGR) of 29% is absolutely phenomenal. But notice the row in the table that says "worst drawdown." This marks the worst period of losses during one of these five-year periods. Not surprisingly, this happened during the Great Depression (from August 1929 to May 1932, to be exact). But the painful losses didn't stop there.
Look at a table of the top 10 drawdowns:
Clearly, there were some painful periods on the way to those fantastic long-term results. And if you think this could have been mitigated by hedging those long bets, think again. The study also shows that a long/short strategy (in this case, buying the best performers ahead of time and shorting the worst) would still occasionally suffer terrible losses throughout history -- and in all the times you might expect.
So to sum things up, here's what the authors of the study had to say about their little experiment:
|Let those numbers soak in a bit.
What the chart highlights is that even GOD HIMSELF would get fired multiple times over. The performance on the perfect hedge fund would get crushed many times over by the passive index.
These results highlight the fickle nature of assessing relative performance over short horizons. We've shown this quantitatively, but Ben Carlson talks about the challenge of short horizon thinking here, and Meb Faber recently highlighted that investors are terrible at timing active investments.
1) Keynes was right: Markets can remain irrational longer than you can remain solvent
So knowing all of this, here's what you need to keep in mind during this selloff...
When stocks are rising and you're making money, you're not as smart as you think you are.
There. I said it.
But there's a silver lining. When markets are falling and you're losing money, you're not as dumb as you think you are, either.
In times like these, it's easy to experience periods of extreme self-doubt. Whenever you feel this way, remember the study mentioned above. If you know your strategy is sound, then don't get myopic. Stick to it. Even the "perfect" portfolio will go through occasional periods of painful losses.
P.S. For the past couple weeks I've been telling readers about my colleague Jimmy Butts and his successful Maximum Profit system. By following a simple set of buy and sell signals, Jimmy and his readers have been able to make gains of 39%... 46%... even 181% -- all in less than 13 months.
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