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Time for a Little R&R

By: Investor Solutions

By: Frank Armstrong, CFP, AIF

In our past articles we have worked hard and developed a pretty good portfolio. Now it’s time for a little R&R–That’s Review and Reality Check.

First, repeat after me:

  • Past performance is no guarantee of future performance.
  • No single investor could have received these returns or executed this strategy.
  • Nothing works every day!

Good. Now say it all again until you have internalized it.

Our portfolio is based on historical data. This approach makes pretty good sense, but if you think tomorrow is going to be exactly like yesterday, you need serious help, beyond the scope of these articles. There are always going to be surprises we can’t anticipate today. That’s why they call them surprises. In particular, we have to consider that the last 20 years of market performance might be better than the long-term trend.

The data covering the time span we studied have only recently become available. The funds required to execute the strategy have only been available for a couple of years. The data assume no transaction costs, management fees, or taxes, and assume that ever penny was invested every second.

So, a wise investor might wish to trim off a little from the projections, to be on the conservative side. If we end up doing better than we anticipated, we can all celebrate, but if we get less, at least the whole investment plan won’t fall apart.

Even a pretty good strategy will have long periods of underperformance relative to some benchmarks or other strategies. A good strategy is no guarantee against losses, especially in the short term. So, investor discipline is an important factor in long-term success.

Having said all that, we have every reason to be pleased with out progress. As investors, we must make decisions in an atmosphere of uncertainty. Modern financial theory and better data on how markets really work give us a much better framework for developing a strategy than we ever had before. It’s not a miracle cure, but it is a distinct improvement!

Our strategy assumes only that capitalism works, markets will continue to function, and the value of the global economy will increase. For a capitalist looking at the world since the fall of feudalism, this shouldn’t require a great leap of faith. We make no predictions, and assume no special or “insider” knowledge. Because markets are efficient, our returns have been generated by the markets, not by managerial slight of hand.

We have diversified our equity portfolio into eight segments. Seven of those segments have outperformed the S&P 500 on a historical basis and the other one is the S&P 500 itself. We have picked up significant additional return from small-company stocks and value-priced stocks. Because the various world markets are not closely correlated with each other, we captured some of the higher performance of the riskier markets while significantly decreasing risk at the portfolio level. We have designed an investment plan with a higher expected rate of return than the S&P 500, yet our plan still contains a 40% stake in short-term bonds!

Our objective was not to outperform the S&P 500, of course, or to “beat” anything else in particular. Our objective was to see if, by diversifying the portfolio away from its original mix, we could increase rates of return and/or decrease risk. We did that, but in the process we built something that doesn’t resemble the S&P 500 very much at all. Our portfolio and the S&P are not going to “track” very closely, and that’s OK. On a year-by-year basis, it is a total waste of time to compare the returns to the S&P 500. Since 1975, the S&P 500 bested our portfolio 13 times, sometimes by wide margins, including one four-year period as well as the most recent three-year period. In spite of that, our portfolio generated pretty good rates of return at a very low risk level.

Year Portfolio v. 5.0 (%) S & P 500 (%) +/- S & P 500
1975 35.00 37.21 -2.21
1976 20.53 23.85 -3.32
1977 21.45 -7.18 28.63
1978 22.39 6.57 15.82
1979 13.97 18.42 -4.45
1980 21.95 32.41 -10.46
1981 10.54 -4.91 15.45
1982 18.78 21.41 -2.63
1983 22.26 22.51 -0.25
1984 8.34 6.27 2.07
1985 33.50 32.17 1.33
1986 26.54 18.47 8.07
1987 16.85 5.23 11.62
1988 17.98 16.81 1.17
1989 17.55 31.49 -13.94
1990 -6.27 -3.17 -3.10
1991 18.78 30.55 -11.77
1992 5.88 7.67 -1.79
1993 18.90 9.99 8.91
1994 2.30 1.31 0.99
1995 15.38 37.43 -22.05
1996 9.62 23.07 -13.45

Ups and Downs: On an annual basis, sometimes our portfolio would have beaten the S&P 500, and sometimes it would have fallen short.

We set out to include asset classes with low correlation to the S&P 500, so we shouldn’t be surprised that each of the other classes has had long periods of time during which it underperformed the S&P 500. Value often falls out of favor for years at a time. Small companies can languish for extended periods. Foreign markets zoom, then sputter. Short-term underperformance by an asset class is not a reason to remove the asset class from the portfolio.

For instance, after three years of stunning advances, our domestic market is the wonder of the world. The S&P 500′s annualized return for the three-year period ending September 30, 1997 was more than double its annualized return for the previous 10, 25, and 50 years! Every foreign market looks like trash in comparison. Foreign stocks have caused our portfolio to greatly underperform a domestic-only strategy for three straight years. Should we dump them? If so, the same logic would have compelled us to dump domestic stocks in 1974 after a very bad two-year decline, and again in 1989 when Japan looked invincible. Of course, had we done so, we would have missed some of the great market opportunities of the century, and our returns looking back would have been pretty dismal.


Triumphant Returns: Over the long run, our portfolio would have beaten the index.

History, economic theory, and common sense show us that no single country or region will dominate the world indefinitely. The world would be a very strange place indeed if that wasn’t the case.

So, what looks to an American investor like a disappointing result from our portfolio over the last three years looks like a glorious result to a Japanese investor; a few years ago the two viewpoints would have been completely reversed. But, had each held a diversified portfolio over the entire period, they would both be pretty happy campers today.

Our portfolio was developed to meet the needs of a particular type of investor. Of course, it won’t be suitable for everybody. Some investors will want more risk, some less. How can we adopt this strategy to meet our own needs?

Tune in next month to find out. Meanwhile, best wishes for a great new year.