Even God couldn't build the perfect portfolio
Even with the gift of perfect foresight, a portfolio managed by the Almighty would still suffer gut-wrenching setbacks
When it comes to money, we have all sinned and fallen short. Our portfolio mistakes might not rank up there with murder or adultery, but any honest investor will be able to reel off a list of blunders and missteps caused by too much greed, too little research, and a hundred other failings.
So today, let us raise our eyes and search for something beyond ourselves. We're going to consider what would happen if you could hire God as your portfolio manager.
This is not intended to be sacrilegious. Instead, think of it as an honest attempt to imagine what would unfold if the person guiding your money could foresee the future with complete accuracy. It's natural to assume that this divine power would lead to amazing results and perfect contentment. But would it really?
To find out, Wes Gray of Alpha Architect, an asset management firm in Broomall, Pennsylvania, calculated how an investor who had God as his investment manager would have fared over the past 90 years.
Gray assumed that, once every five years, God would choose a portfolio made up of stocks worth 10% of the market's value. After five years, He would sell the old portfolio, cash in his gains, and reinvest in a new five-year portfolio.
An active manager who was clairvoyant, and knew ahead of time exactly which stocks were going to be long-term winners and long-term losers, would likely get fired many times over if they were managing other people’s money—Wes Gray of Alpha Architect
As you might imagine, God performs rather well. He does have perfect foresight, after all. Every five years, He infallibly chooses the stocks that will produce the highest profits for investors over the next five years. As a result, his portfolio generates average returns of nearly 29% a year between 1927 and 2016.
That level of performance leaves Warren Buffett and every other mortal investor in the dust. It is, well, heavenly. But there's a catch.
This divinely inspired portfolio also suffers sickening losses on a regular basis. Over the course of 90 years, it loses more than 20% on 10 occasions. Its worst drawdown wipes out 76% of its value between 1929 and 1932. It also loses more than 40% during the 2008 financial crisis, and suffers devastating injuries in 1937 and 2000 that knock its value down by a third or more.
"Our bottom line result is that perfect foresight has great returns, but gut-wrenching drawdowns," Gray writes. "In other words, an active manager who was clairvoyant, and knew ahead of time exactly which stocks were going to be long-term winners and long-term losers, would likely get fired many times over if they were managing other people's money."
It is a fascinating observation, and it leads on to three other thoughts that may never be engraved on stone tablets, but do merit your attention.
The first is that it's really, really hard to break the relationship between risk and returns. High profits are usually accompanied by high volatility—and that holds true even if you happen to be guided by divine inspiration.
We expose ourselves to evil if we forget this relationship. Bernie Madoff was able to bilk people by promising them great returns with little or no volatility. That simply doesn't happen in the real world.
A second corollary is that it's difficult to judge any investor by short-term results. You and I both know this, of course, but it's striking to look at Gray's results and see how regularly even an infallible money manager would suffer stinging setbacks. If you're tempted to throw stones at a strategy or manager with strong long-term results because of a couple of years of bad returns, it may be time to practise charity and patience instead.
A final thought is to cherish the weak and the lame. Gray's results demonstrate that even the smartest strategy in the world will regularly appear stupid. Rather than casting out underperformers, you might want to search for signs of a reversal in the making. Right now, for instance, value-investing strategies are shunned because of poor performance over the past few years. But the weight of history suggests a rebound is overdue. Perhaps the meek truly will inherit the Earth.
Ian McGugan is an award-winning Globe and Mail writer.