Note: This column was originally published on Nov. 28, 2017.
The Investment Game In 1993, The New York Times asked me to participate in a fund-selection contest, along with three newsletter editors and one financial advisor. Sure, I replied, confidently. The other four players each followed segments of the mutual fund industry, while I covered the whole shebang. Over the previous five years, I had spoken with just about every stock-fund manager in existence (the industry being much smaller then). Plus, unlike the other participants, I had a research team at my side.
What was not to like? I could demonstrate my ability to select mutual funds, while helping some readers along the way.
The first decision was how much to place in stocks. We were told that this would be a 20-year competition, so every participant, unless a market-timer, figured to favor equities. That we each did, in most cases overwhelmingly so. It was the winning decision, because the S&P 500 gained an annualized 20.8% during the seven years that the contest existed, before it was shut down in summer 2000.
Even though we all ended up on the right side of the ledger, recommending stock-heavy portfolios directly before a bull market, I realized as the contest proceeded the precariousness of our position. We were at the mercy of the U.S. stock market. If stocks rose, even the lowest performer among us could say, “Look, my portfolio made money. It did better than cash. It did better than bonds. It did better than alternative investments. You could have done much worse--and many people did.” If stocks fell, however, we were all losers.
And what stocks did was completely out of our control. None of us, of course, could time the market. We made our bed, we lay in it, and we hoped for the best. The best was indeed what we received. It need not have been that way. Immediately after the contest ended, the stock market had its worst two-year performance in almost 30 years. That could just as well have occurred at the beginning of the event--and then where would we have been?
Style Decisions Although I recognized the absolute danger of the stock/bond/cash choice, I missed the relative peril of the next decision: what type of stocks to own. That one struck me as easy. In the academic community, Ken French and Eugene Fama had recently published their seminal research on stock returns, which showed that small companies had generated higher returns than larger companies, and so-called "value" stocks beat higher-priced growth stocks. That matched my experience with mutual funds. Thus, for domestic stocks, I recommended only small-company and value funds.
Internationally, I favored emerging-markets funds. Securities that have higher risk tend to have higher returns; the portfolio had an extended time horizon; and my portfolio wouldn’t outgain the other contestants without doing something different. Getting exposure to fast-growing developing countries seemed like the sensible path to take.
(I would show that initial portfolio, except that I only partially recall those recommendations, and I can't find that NYT article with an Internet search. However, I did find the concluding article, from July 2000, which gives some indication of each participant's decisions.)
The Imperfect Storm Zero for three. Before the contest began, there had never been a seven-year period when the big U.S. growth stocks that my portfolio neglected had walloped both smaller firms and value stocks, and it had also been quite a while since U.S. blue chips had skunked the emerging markets. So much for history. The imperfect storm promptly ensued. The S&P 500's spectacular surge was fueled by 24% annualized returns from its large-growth stocks--more than 350% cumulatively, in just seven years! Everything else fell far short.
The Russell 1000 Large Value Index, for example, appreciated by just 15.7% per year. A delightful gain in absolute terms, of course, but pitiful when compared with how the big growth stocks had performed. The small-company Russell 2000 Index trailed further, returning an annualized 13.6%, with the value stocks among that group being the laggards, as the Russell 2000 Value Index was up only 11.5%. Emerging-markets companies fared worse yet.
Given those headwinds, my portfolio couldn’t possibly keep pace with the S&P 500. That it gained 13.8% annually was somewhat of a pleasant surprise. The 13.8% figure outdid the average of the portfolio’s three pillars (large-company value stocks, small-company value stocks, and emerging-markets stocks), and it came after paying some steep fund expenses. (In that day and age, almost all funds were actively run, and your columnist was nowhere near as cost-conscious as he is today.) My portfolio’s relative performance could easily have been worse.
Nonetheless, it did not shine. In addition to getting slammed by the S&P 500--which, in fairness, slammed just about every portfolio that existed over that period--my portfolio finished fourth among five. All results followed the asset-allocation decisions. The three competitors who finished ahead of me also put almost everything into stocks, while holding more large-growth companies. The one poor soul who finished behind me (the lone financial advisor) had invested more conservatively. Prudent when addressing the needs of a living, breathing client, but imprudent for winning a newspaper battle, held during a stock bull market.
Lessons Learned Since that occasion, I have appreciated the challenge that financial advisors face in communicating with clients. Did my hypothetical portfolio succeed? It made a whole bunch of money, in both nominal and inflation-adjusted terms. It also outgained the median mutual fund. Did it fail? A client would have profited much more yet by owning an S&P 500 fund. The modest skill that I showed with manager selection was overwhelmed by the losing investment-style choices.
This experience also taught me the virtues of staying in the mainstream. Might my portfolio decisions, based on academic research and seemingly reasonable logic, eventually benefit an investor? Yes, they might. But had I actual clients, who observed my investment beliefs flopping for seven years straight, they might well have moved elsewhere. Were I to give investment advice for real, it would not be so idiosyncratic. It is one thing to take such relative chances while playing a game, or even with one’s own portfolio. It is quite another to do so with a client’s.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.