Now that the capital markets have once again begun exhibiting a level of volatility not seen for a number of years, it’s appropriate to revisit the relationship between risk and return.
Wesley Gray, CEO of Alpha Architect, an investment advisory firm, developed an interesting thought experiment that brings this relationship into stark focus. For purely dramatic effect, I will paraphrase the situation he describes.
Suppose you are about to sit down in the only available chair at Starbucks one morning, latte in hand, when you notice a Wall Street Journal neatly folded on the seat. You pick it up, plop down and casually peruse the headlines as you sip your drink. Suddenly, something catches your eye. It’s the date on the front page: June 29, 2021. “Wow,” you exclaim, spilling your coffee all over the floor. You hurriedly flip over to the Markets section. Sure enough, the paper has all the prices of the Standard & Poor’s 500 stocks, five years from now. What a miracle! You know in advance how the largest 500 U.S. stocks will perform over the next five years!
You rush home, pull yesterday’s WSJ out of the trash and furiously begin to calculate the price returns of all the stocks on the page, looking for the best one. You’re about to call your broker to put all your money on the No. 1 stock when you hesitate. As an avid reader of this column in the Town Crier, you’ve come to understand and appreciate the importance of diversification. So, instead of investing in just the one stock, you pick the top 50, 10 percent of the total, instruct your broker to make the trades and settle down to start planning your around-the-world cruise.
This is the premise Gray starts with – namely, what would happen if through perfect foresight you were able to invest in the best-performing 50 stocks out of the largest U.S. companies, and repeat that every five years.
Gray went back to July 1, 1926, calculated the forward five-year compound annual growth rate for the 500 largest U.S. stocks, including dividends, then compared the performance of the top 50 against the full 500, rebalancing once every five years (that is, reselecting the top 50). The portfolios were weighted by market capitalization and returns were calculated through the end of 2009.
How well did the top 50 portfolio do? Not surprisingly, it generated a whopping 28.9 percent compound annual growth rate, compared with only 9.6 percent for the S&P 500. It’s easy to be successful when you know what the future will bring.
Factoring in volatility
But wait. How much volatility did the two portfolios experience? A lot, as it turned out.
Over that 83-year period, the top 50 portfolio produced monthly losses 31 percent of the time. Granted, this was better than the S&P 500, which experienced losses in 39 percent of those 996 months. But even worse were the sizes of some of the losses. From August 1929 through May 1932, the top 50 portfolio dropped by a dizzying 76 percent. That would give even the most risk-tolerant investor pause.
What if that newspaper at Starbucks were actually a fake? Should you really continue with this investment strategy, or is it time to bail?
There were nine other periods of time, each one year or less, during which the top 50 portfolio lost 19 percent or more. And though the S&P 500 also had negative returns over these same periods, during three of them the top 50 portfolio actually lost more. For example, from Nov. 30, 1980, through Sept. 30, 1981, the top 50 portfolio dropped by 22.9 percent, a full 9.2 percent (920 basis points) more than the S&P 500 did.
When you invest in assets that entail risk, such as stocks or stock funds, you have to be willing to live with the volatility that goes along with them. Even with 100 percent foreknowledge of the longer-term future, you will still be blindsided by daily, weekly and monthly downturns. And in real life, where you do not know the future, it’s always the volatility that causes you to change course, often incorrectly.
The moral of this story is that your investment strategy should be focused less on returns and more on controlling the risks that lead to volatility, so that when it strikes, you can handle it emotionally. Or else keep going to Starbucks hoping for that miracle to turn up some day.
Los Altos resident Artie Green is a Certified Financial Planner and principal at Cognizant Wealth Advisors. For more information, call 209-4062 or email [email protected].
