Now that the capital markets have once again begun exhibiting a level of volatility not seen for a number of years, it’s appropriate to revisit the relationship between risk and return. Wesley Gray, CEO of Alpha Architect, a Pennsylvania investment advisory firm, has come up with an interesting thought experiment that brings this relationship into stark focus.  For purely dramatic effect I will paraphrase the situation he describes.

Suppose you were about to sit down on the only available chair at Starbucks one morning, your latte in your hand, when you noticed a Wall Street Journal (WSJ) newspaper neatly folded on the seat. You pick it up, plop down, and casually peruse the headlines as you sip your drink.  Suddenly something catches your eye.  It’s the date on the front page: June 29, 2021.  “Holy s***!” you exclaim, spilling your coffee all over the floor (to the annoyance of the patron next to you).  You hurriedly flip over to the Markets section.  Sure enough, there are all the prices of the S&P 500 stocks, five years from now.  What a miracle!  You know in advance how the largest 500 U.S. stocks will perform over the next five years!

You rush back home (forgetting all about your latte), pull yesterday’s WSJ out of the trash, and furiously begin to calculate the price returns of all the stocks on the page, looking for the best one.  You’re about to call your broker to put all your money on the number one stock when you hesitate.  As an avid reader of this column in the Town Crier, you’ve come to understand and appreciate the importance of diversification.  So instead of investing in just the one stock, you pick the top fifty, 10% of the total, instruct your broker to make the trades, and settle down to start planning your round the world cruise.

This is the premise that Gray starts with, namely what would happen if through perfect foresight you were able to invest in the best performing 50 stocks out of the largest U.S. companies, and repeat that every five years. Gray went back to July 1, 1926, calculated the forward five-year compound annual growth rate (CAGR) for the 500 largest U.S. stocks, including dividends, then compared the performance of the top 50 against the full 500, rebalancing once every five years (that is, reselecting the top 50).  The portfolios were weighted by market capitalization and returns were calculated through the end of 2009.

How well did the top 50 portfolio do? Not surprisingly, it generated a whopping 28.9% compound annual growth rate (CAGR), as compared to only 9.6% for the S&P 500.  It’s easy to be successful when you know what the future will bring!

But wait. How much volatility did the two portfolios experience?  A lot, as it turned out.  Over that 83-year period, the top 50 portfolio produced monthly losses 31% of the time.  Granted, this was better than the S&P 500, which experienced losses in 39% of those 996 months.  But even worse were the sizes of some of the losses.  From August 1929 through May 1932 the top 50 portfolio dropped by a dizzying 76%!  That would give even the most risk-tolerant investor pause.  What if that newspaper at Starbucks was actually a fake?  Should you really continue with this investment strategy or is it time to bail?

There were nine other periods of time, each one year or less, during which the top 50 portfolio lost 19% or more. And although the S&P 500 also had negative returns over these same periods, during three of them the top 50 portfolio actually lost more.  For example, from November 30th 1980 through September 30th 1981, the top 50 portfolio dropped by 22.9%, a full 9.2% (920 basis points) more than the S&P 500 did.

When you invest in assets that entail risk, such as stocks or stock funds, you have to be willing to live with the volatility that goes along with them. Even with 100% foreknowledge of the longer-term future, you will still be blindsided by daily, weekly, and monthly downturns.  And in real life, where you do not know the future, it’s always the volatility that causes you to change course, often incorrectly.  The moral of this story is that your investment strategy should be focused less on returns and more on controlling the risks that lead to volatility, so that when it strikes you can handle it emotionally.  Or else keep going to Starbucks hoping for that miracle to turn up some day.