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July 4, 2016

Perfect foresight has great returns but still gut-wrenching drawdowns

What would happen if you were so lucky to find the best stock-picking fund manager in the world? A recent study shows that even if a fund manager had the uncanny ability to own only the stocks that would go on to be the top performers in the market, he would still suffer periodic drawdowns nearly as bad as the market itself. In fact, the drawdowns are so huge, even if you knew the big winners, most investors would probably still fire the fund manager. Which comes to show one of the key points we keep telling our clients: investor behavior trumps (nearly) everything else. If you can’t stick with a correct long-term plan because of short-term volatility, you will never reach your financial goals.

Can you stomach these drawdowns?

Alpha Architect published a study on the performance of a ‚perfect investor‘. They tried to find out, what returns an investor would have achieve if he had perfect foresight, i.e. if he could pick those stocks that would turn out to be the winners over the next 5 years. The best stocks delivered a remarkable CAGR of 29% vs 10% for the S&P 500. Very impressive. However, what probably comes as a surprise is that the worst drawdown of -76% is not much better than that for the S&P 500 (-85%).

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But this is not the only major drawdown over the 80+ year history of the study. If you look at the top 8 drawdowns, you get an average of -38%.

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Put differently – even if you knew the big winners, most clients would probably still run away because of the massive interim drawdowns.

But we can do even better. If our god-like fund manager can pick the winners, he can certainly also pick the losers (and short those). He would thus create the perfect hedge fund. So let’s look at the results then. In the following table, we can see that the CAGR would be even more staggering – a very impressive +40% p.a. However, the drawdowns wouldn’t be significantly better!

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Here comes the real surpise: in most drawdown periods of the perfect hedge fund, an index fund would have delivered strong positive results! As Alpha Architect puts it „even GOD HIMSELF would get fired multiple times over“. This table shows the fickle nature of assessing relative performance over short time periods.

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Summary: investing is simple, but not easy!

Warren Buffett has accurately stated that “investing is simple, but not easy.” What he means is that while it is simple to structure a portfolio, it is not easy to maintain.

The key issue is investor behaviour – whether an investor can stick with a strategy and stay invested in order to earn the long-term equity premium in the stock market. Too many investors fail to stay the course with their investment strategy, and instead tend to sell funds when they underperform, or rush in when a manager has been performing well. In doing so, investors can be their own worst enemies.

Before you spend time contemplating which fund is right for your, maybe you should think first whether you have a sound long-term investment strategy and whether you have the discipline to stick with it.

http://blog.alphaarchitect.com/2016/02/02/even-god-would-get-fired-as-an-active-investor/

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