We read a ton of stuff in our quest to stay on top of the financial/investing world for you. As such, it's fairly rare that we see information presented that has much of a "new/wow" factor to it. But the following is something I don't remember seeing framed up quite this way before. The implications are powerful.
Wes Gray of the alpha architect site recently wrote an article slightly sacrilegiously titled, "Even God Would Get Fired As an Active Investor." In it, Gray creates two impossibly perfect investing vehicles by looking ahead and selecting the most profitable investments ahead of time. In other words, if someone knew in advance what the most profitable investments would be over the next five years, how would their stock fund (or hedge fund, in his second case) do?
Not surprisingly, the answer is they'd do fantastic! Of course they would, as the study cheats and finds the winners ahead of time! But what's interesting about the study is what would have happened along the way to the ridiculously high long-term rate of return these funds would have earned.
What they found was that the short-term drawdowns (losses incurred along the way) of these portfolios were still pretty devastating, despite knowing in advance that all of the investments in the portfolio were going to ultimately be extremely successful! For example, in their first example of a long-only portfolio that simply owned the best-performing stocks in every 5-year period, there were still 10 instances in 90 years where the portfolio lost at least 19%, and sometimes significantly more. (The details of how they built these "perfect" funds are in the article.)
Perhaps more interestingly, at least to those of us who have been engaged with SMI's Dynamic Asset Allocation strategy over the past two years while it has struggled relative to the broad market's strong returns, was their second test. This one set up "the ultimate hedge fund" which applied the same idea of knowing in advance what the best combination of buying stocks "long" and selling them "short" would be.
This portfolio earned 49.24% per year — again, totally impossible without knowing in advance what the winners would be. But despite this being literally the PERFECT hedge fund, along the way it would have lost as much as 60% in a two-month period and would have lost at least 18% on nine other occasions! Perhaps more importantly, the losses in this portfolio weren't correlated to what the broad stock market was doing, meaning that in most cases the stock market was earning a double-digit gain while these losses in the hedge fund were occurring.
What can we learn from this hypothetical exercise? Well, for starters, even if you designed the PERFECT strategy that would earn impossibly great returns over time, it would still be emotionally difficult to follow it in real-time. Be honest: how many SMI readers would have stuck with this perfect strategy from 2/28/2009 – 8/31/2009 when it was losing -41.9% at a time when the broad market was rising 39.9%? I can hear it now: "The conditions of the past that allowed this strategy's phenomenal gains have obviously changed due to the unprecedented interference by the government and Fed, so what worked in the past isn't working anymore."
Was that really the problem? No. The problem was that any strategy — and this exercise proves we really do mean ANY strategy, even a perfect one invented in a lab — is going to have short-term periods when it doesn't look good.
Piggy-backing on this theme, Justin Sibears of Newfound Research ran a similar test on Warren Buffett's investing performance relative to the S&P 500. He established that from 1980-2016, Buffett's Berkshire Hathaway class A stock virtually doubled the S&P 500's return: 20.3% vs 10.4%. But along the way, Berkshire owners would have had to suffer through periods when their stock underperformed the market by as much as 67%! That happened in the slightly more than a year-and-a-half prior to the end of the tech bubble popping. Along with that gut-wrenching example, there were at least six other times when Buffett trailed the S&P 500 by a double-digit margin. That's seven times in 26 years, or about once every four years or so.
Translation: if you hitched yourself to the Buffett train and held on, you did great. Double the market's return! But if you constantly analyzed the short-term returns and wondered if the old man had lost his touch every few years, it would have been a tough ride. Most of those in that latter camp probably wouldn't have made it past the tech bubble, if we're honestly assessing it.
AQR's Cliff Asness is quoted in Sibears' article:
“I used to think being great at investing long-term was about genius. Genius is still good, but more and more I think it’s about doing something reasonable, that makes sense, and then sticking to it with incredible fortitude through tough times.
Of course [AQR] found [Warren Buffett] was fantastic – but not quite as fantastic. His track record was phenomenal…but human phenomenal.
What was beyond human was him sticking with it for 35 years and rarely, if ever, really retreating from it.
That was a nice little lesson that you have to be good, even very good, but sticking with it and not getting distracted is much more the job.”
SMI's strategies have a long track record of demonstrated success. The success of strategies such as Upgrading and Sector Rotation have been earned in real-time, while others like Dynamic Asset Allocation are based on mostly back-tested data. None of them involve the certainty of looking back knowing that they've been successful in the future, which means it's certainly reasonable to constantly assess whether factors have changed sufficiently that their future success is jeopardized.
But if this analysis teaches us anything, it's that an extremely high degree of "stick-to-it-iveness" is required for long-term success with any strategy that is going to outperform the market over time. Think about it: in order for a strategy to outperform the market over time, it has to BE different from the market. If it's truly different from the market, inevitably there are going to be periods like we've discussed in this post when its short-term performance is going to look poor relative to the market.
These are the times you simply have to will yourself through to be successful as a long-term investor. Otherwise, even a perfect strategy won't be of much long-term benefit to you.