Suppose you found a mutual fund where the portfolio manager knew for sure which 10% of the largest U.S. companies would earn the highest returns over the next five years, over each upcoming five-year period. The ultimate crystal ball … predicting the future of market returns. You’d invest 100% of your money in that fund and hang tight, right?
A research company called Alpha Architect posed this as an interesting thought experiment. It divided the 500 largest U.S. stocks into deciles and imagined that a hypothetical fund was investing in only the upper 10% returning stocks in the first five-year period, starting on January 1, 1927, and every five years it would switch the portfolio to the future top 10% of all stocks. (Hindsight makes it a lot easier to model what would happen if we were blessed with perfect foresight.)
Okay, so now you’re invested. If you could have bought and held this magical fund beginning in 1927, by the end of 2016, you’d have earned just under 29% a year. And, assuming you invested $1,000 and held firm during that entire period, you’d be a billionaire (if you earned 29% per year in a linear fashion for 90 years, you’d be a trillionaire)! What could be easier?
But, not knowing that this fund had a workable crystal ball, would you have held on while it was experiencing nearly a 76% downturn during a particularly bad bear market starting in 1929? Or, might you have been tempted to bail to safer bonds when this perfect fund fell more than 39% during a one-year period starting in March 1937? Overall, this perfectly engineered fund experienced drops of 20% or more ten times during this 90-year holding period.
Some of the times when you might have been sorely tempted to jump ship:
• The precipitous 31% downturn starting at the end of 1973.
• The 397-day period from Feb 1937 – March 1938 when your marvelous fund lost nearly 39%.
• The 2000-2001 downturn, when you witnessed 40% of your dollars evaporate.
• The nasty crash of 2008, when your perfect investment sunk 41%.
The long-term returns were terrific, but it took a lot of stomach to hold on for the full ride.
The point? Even a fictitious manager with perfect foresight would have lost a lot of clients during those times when the markets experienced rough patches. It’s fundamentally a lesson in humility and patience. Great long-term track records are not immune from pullbacks or corrections, and our all-too-human tendency is to lose faith in the face of adversity.