Divine Intervention Couldn't Keep (Many) Individual Investors From Selling! Or, Long-term Investment Success Means Living With Volatility...

On those occasions when we find ourselves entertaining whether a prospective new client is a good fit for us, and us for him/her, my first query always has to do with time horizon. Generally, folks come calling when they feel their portfolio needs professional managing and either a long-term client of ours or their accountant or attorney has directed them our way. Therefore, the time horizon question generally has to do specifically with the monies in need of management. 

If, say, we're talking about a retirement portfolio that's meant to provide a lifetime of income, perfect! If, however, we're talking about a windfall that needs managing until such time that it'll be spent on, say, that retirement home in Tahoe, aside from the client's tolerance for volatility, time horizon is everything.

When prospective client says it's Tahoe in two years, all I'm willing to offer is my input on the current interest rate environment and the term of the CDs they'll be buying from any number of banks (at $250k [the FDIC max] a pop). If it's three years, same advice. Four, same. Five-plus, we move on to strategy.

You see, to engage our firm an investor has to possess two traits: One: the desire to earn more than what mere deposit accounts can offer. Two: some stomach for volatility. My insistence that the time horizon must exceed 5 years (at a bare minimum) has to do with what, after nearly 32 years of advising investors, I've come to know about markets and cycles: That is, downward volatility is inevitable and is, alas, virtually untradeable (as in trading in and out to avoid the inevitable). Therefore, we have to have the time horizon and the temperament to let market storms run their course (and, frankly, do their good). Honestly, five years is not my ideal, I'm most comfortable with the lifetime scenario (and, by the way, that would be for the 90 year-old as well. As his/her aim is typically to pass the portfolio on to younger heirs). For the finite situation, closer to 10+ is a very comfortable proposition for me.

An article titled "Even God Would Get Fired as an Active Investor" by Wesley R. Grey, PhD with Alpha Architects (HT Bespoke) divulges the results of a fascinating study which illustrates vividly why I won't touch a portfolio that doesn't have at a bare minimum a five-year+ time horizon. 

Grey and his colleagues went back to 1926 and reconstructed the humanly impossible. They, essentially, calculated the results of a portfolio that only God could've assembled; one comprised of the best 50 performing (of the largest 500) stocks from July 1, 1926 to July 1, 1931. Then continued the exercise for every 5-year interval (the next being July 1, 1931 to July 1, 1936). They took the study all the way through 2009.

While, of course, the ultimate results were astounding---a 28.89% annual return versus 9.63% for the S&P 500---there was another, perhaps unexpected, astounding statistic that emerged from the study. Being perfect (on the long side) meant suffering frequent stretches of gut-wrenching downside volatility. The "worst" ten such stretches ranged from -19% to -76% (over periods ranging from 1 month to 2+ years). That's right, owning the very best performers in 5-year intervals meant suffering through periods that would've shaken the resolve of the most, well, resolute investor.

But, you know, being perfect actually wouldn't be going long (owning) just the 50 best performers; perfection would be buying the 50 best and shorting (betting they fall) the 50 worst. So Grey and company put that one together as well. And, of course, the results were out of this world! Up 39.74% per year! But, guess what, staying with the very best portfolio man could never produce would've meant suffering huge drawdowns along the way; the "worst" ten ranging from -25% to -70%! 

Now you know why I require longer time horizons before even considering whether to take on the responsibility of managing someone else's money and, more importantly, the task of keeping him/her from making the fatal mistakes that plague the average investor. The results of which are vividly illustrated in the CGM Focus Fund story I featured in an earlier post. Here's a snippet:

Imagine the following theoretical investment opportunity: Investors can invest in a fund that will beat the market by 5% a year over the next 10 years. Of course, there is the catch: The path to outperformance will involve a five-year stretch of poor relative performance. “No problem,” you might think—buy and hold and ignore the short-term noise.

Easier said than done.

Consider Ken Heebner, who ran the CGM Focus Fund, a diversified mutual fund that gained 18% annually, and was Morningstar Inc.’s highest performer of the decade ending in 2009. The CGM Focus fund, in many respects, resembled the theoretical opportunity outlined above. But the story didn’t end there: The average investor in the fund lost 11% annually over the period.

What happened? The massive divergence in the fund’s performance and what the typical fund investor actually earned can be explained by the “behavioral return gap.”

The behavioral return gap works as follows: During periods of strong fund performance, investors pile in, but when fund performance is at its worst, short-sighted investors redeem in droves. Thus, despite a fund’s sound long-term process, the “dollar-weighted” returns, or returns actually achieved by investors in the fund, lag substantially.

In other words, fund managers can deliver a great long-term strategy, but investors can still lose.

I.e., Long-term investment success requires "suffering" through some amazing periods of downward volatility...