Executive Summary

• Perfect returns come at a price
• Volatility will always be part of the equation
• Even Genies can have a rough day at the office

The universal truth is that no one likes volatility

Investors try, with little success, to ascribe meaning to the chaotic behavior of complex systems (i.e., economies, markets & society). However, it’s a fool’s errand to ascribe ‘one single narrative’ to how they really work.

When it comes to investing, we all should try to be more grateful when things are going well as it is inevitable that the tide – at least temporarily – can break against us (statistically every 5 to 7 years for a multi-asset class portfolio).

As scholars of our own portfolios, we always take careful note of what works well and what doesn’t.

However, in our view, we think there is one universal truth all investors share which is…in practice, no one likes volatility!

What if your portfolio manager was a Genie?

We all think from time to time ‘we could have done it better’. That’s normal as we are human and all prone to hindsight bias. However, what if it were possible to handover the management of your portfolio to someone else who could see into the future and make the impossible - possible?

A recent study written by finance professor Hendrick Bessembinder at Arizona State University (July 2020) published several papers which analysed the market going back to 1927 which - with a couple ‘set parameters’ – allows us to illustrate what would happen if we had the ability to ‘know the future’ and pick the best performing stocks.

So let’s pretend your portfolio manager was a Genie with the power to alter time, see the future, and only pick the best performers throughout history!

“Hey Genie!”

Obviously, this is just a thought experiment but let’s have some fun! Genies throughout history have fascinated both young and old, are all-powerful but will often corrupt your wish by ‘over interpreting’ them (with humorous effect). So we will need to be very precise with our request!

So, maybe that conversation goes something along the lines of:

“Hello Genie!

With the Great Depression on the horizon I need a new portfolio manager.

I hear you’re pretty good at altering time & space, so you’ve got the gig!

There are just a couple parameters I want to set as I know you can be a bit cheeky with granting wishes.

First wish: I’m an investor, not a trader so keep my running costs down - so please - and only rebalance my portfolio every 5 years.

Second wish: I’m not interested in stocks or countries I’ve never heard of - so please - I only want large, quality (S&P 500) blue chip stocks!

Third wish: I’m looking for the best possible ‘positive’ returns - so please - look into the future and only pick the best performing stocks!”

So how did your Genie do?

Not surprising, Genie absolutely crushed it and delivered spectacularly over the course of almost 100 years.

I suppose there are no surprises here. Genie did get to pick the best performing stocks before they got to perform their best.

Obviously, these returns are EXPLICITLY IMPOSSIBLE to achieve in real life (as you must be able to know the future first), however this thought experiment reveals one very interesting finding…

Even Genie would get fired as a Portfolio Manager

The most revealing and shocking finding from this analysis is that even a perfectly constructed equity portfolio with perfect foresight still had gut-wrenching selloffs.

In fact, Genie’s portfolio was MORE VOLATILE than even the market! This goes against all intuition given the ‘perfect quality’ of the portfolio itself.

Source: Alpha Architect, 2017

Quality Does Not Equal Less Volatility

In the real world, many investors would not have been able to stomach the extremely high volatility of that ‘Perfect Portfolio’ especially given it was even worse than what the market delivered.

However, the drama doesn’t end there.

Genie’s portfolio had a string of selloffs greater than 15% which would have unnerved even the most seasoned investors.

In fact, this perfect portfolio:

• fell more than 10% twenty times,
• more than 20% ten times, and
• more than 30% five times.

There were even long periods of time when the market left our Genie in the dust — often beating Genie by more than 50%— and on multiple occasions!

So much for quality…no matter how perfect the portfolio, it appears volatility will always be part of the equation.

Source: Alpha Architect, 2017

Our Conclusion

As many investment pros painfully recognize, managing money is not just about managing performance but about managing volatility within the portfolio itself (or at least our emotional response to it).

Yes, the relative performance of Genie’s portfolio was amazing but the bouts of volatility experienced were equally gut wrenching.

The key takeaway from this exercise is that even a ‘perfect’ portfolio can bring a long-term investor a ton of pain at least from time to time.

So the next time your portfolio takes a bit of a short-term beating, just remember that even Genies can ‘have a rough day’.