Time for a Little R&R

7/31/2019 Time for a Little R&R

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time for a little r&rBy: Frank Armstrong, CFP, AIF

In our past articles we have worked hard and developed a prettygood portfolio. Now it's time for a little R&R--That's Review andReality 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 makespretty good sense, but if you think tomorrow is going to beexactly like yesterday, you need serious help, beyond the scopeof these articles. There are always going to be surprises we can'tanticipate today. That's why they call them surprises. Inparticular, we have to consider that the last 20 years of marketperformance might be better than the long-term trend.

The data covering the time span we studied have only recentlybecome available. The funds required to execute the strategyhave only been available for a couple of years. The data assumeno transaction costs, management fees, or taxes, and assumethat every penny was invested every second.

So, a wise investor might wish to trim off a little from theprojections, to be on the conservative side. If we end up doing

better than we anticipated, we can all celebrate, but if we getless, at least the whole investment plan won't fall apart.Even a pretty good strategy will have long periods ofunderperformance relative to some benchmarks or otherstrategies. A good strategy is no guarantee against losses,
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especially in the short term. So, investor discipline is animportant factor in long-term success.Having said all that, we have every reason to be pleased with outprogress. As investors, we must make decisions in an atmosphere

of uncertainty. Modern financial theory and better data on howmarkets really work give us a much better framework fordeveloping a strategy than we ever had before. It's not a miraclecure, but it is a distinct improvement!

Our strategy assumes only that capitalism works, markets willcontinue to function, and the value of the global economy willincrease. For a capitalist looking at the world since the fall offeudalism, 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 generatedby 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 ahistorical basis and the other one is the S&P 500 itself. We havepicked up significant additional return from small-company stocksand value-priced stocks. Because the various world markets are

not closely correlated with each other, we captured some of thehigher performance of the riskier markets while significantlydecreasing risk at the portfolio level. We have designed aninvestment plan with a higher expected rate of return than theS&P 500, yet our plan still contains a 40% stake in short-termbonds!

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 couldincrease rates of return and/or decrease risk. We did that, but inthe process we built something that doesn't resemble the S&P500 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 isa total waste of time to compare the returns to the S&P 500.Since 1975, the S&P 500 bested our portfolio 13 times,


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sometimes by wide margins, including one four-year period aswell as the most recent three-year period. In spite of that, ourportfolio generated pretty good rates of return at a very low risklevel.

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


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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 portfoliowould have beaten the S&P 500, and sometimes it would havefallen short.

We set out to include asset classes with low correlation to theS&P 500, so we shouldn't be surprised that each of the other

classes has had long periods of time during which itunderperformed the S&P 500. Value often falls out of favor foryears at a time. Small companies can languish for extendedperiods. Foreign markets zoom, then sputter. Short-termunderperformance by an asset class is not a reason to removethe asset class from the portfolio.

For instance, after three years of stunning advances, ourdomestic 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 previous10, 25, and 50 years! Every foreign market looks like trash incomparison. Foreign stocks have caused our portfolio to greatlyunderperform a domestic-only strategy for three straight years.Should we dump them? If so, the same logic would havecompelled us to dump domestic stocks in 1974 after a very badtwo-year decline, and again in 1989 when Japan lookedinvincible. Of course, had we done so, we would have missed

some of the great market opportunities of the century, and ourreturns looking back would have been pretty dismal.


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

History, economic theory, and common sense show us that nosingle country or region will dominate the world indefinitely. Theworld would be a very strange place indeed if that wasn't thecase.

So, what looks to an American investor like a disappointing resultfrom our portfolio over the last three years looks like a gloriousresult to a Japanese investor; a few years ago the two viewpointswould have been completely reversed. But, had each held adiversified portfolio over the entire period, they would both bepretty happy campers today.

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

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

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Time for a Little R&R